Description

I’m recommending a long on Alliance Resource Partners (ARLP). 

ARLP has two main assets:

• $135mm in EBITDA from shale oil and gas royalties
• Low-cost coal mines in the Illinois Basin and Appalachia + some coal royalties (small).

I’ll make a case for the coal assets in a moment, but it’s the shale oil and gas royalties that are most misunderstood. 

A quick primer on oil and gas royalties.  Let’s say an E&P company produces 300k barrels of oil on acreage where a royalty owner has a 12.5% royalty. The opex and capex associated with the lease are borne entirely by the E&P company, while both E&P and royalty owner are required to pay state severance taxes on produced volumes.  

Depending on the price of oil, a mineral right owner can earn more operating cash flow than the E&P, despite being entitled to only 12.5% of the revenue.

A shale E&P with scale and good acreage will typically need to spend ~60% of its annual EBITDA on capex to maintain flat production. If this E&P had substantial runway for growth, it might be able to justify a 5% unlevered cash flow yield. A 5% unlevered FCF yield would drive a 6.4x EV/EBITDA multiple. How should we value a mineral right MLP with identical growth prospects and asset longevity? Applying the same unlevered FCF yield, the mineral right vehicle warrants a 20x EV/EBITDA multiple.

The example illustrates how not having to contribute capex has immense value and warrants massive multiple premiums.  The more growth, the more extreme the value disparity. It could also be argued that the mineral rights operator deserves an even lower unlevered yield for the same growth because it has higher margins, making valuation less volatile.  Additionally, mineral rights are often structures as MLPs, which have tax advantages.  ARLP is an MLP.

To be clear, I don’t think ARLP’s royalties justify a 5% unlevered yield.  The ARLP royalties are too mature for that.  However, because of the high mix of Permian royalties, ARLP is indeed in possession of a growing royalty stream.

If you look at other Permian-weighted royalty companies like STR, the market puts a ~10x EV/EBITDA multiple on them.  That still feels low to me given these are an inflation-protected, growing cash flow stream.  But EVs are right around the corner, so let's go with that.  The ARLP oil and gas royalty assets do about $125mm in annual EBITDA at current price decks.  That gets you to about $1.25b in value, covering about 40% of the current TEV.

Coal Assets

Next up are the coal assets.  ARLP has mines in both the Illinois basin and Appalachia, as well as some coal royalties.  ARLP pre-sells most of its volumes at fixed price contracts 9-24 months in advance.  The company’s coal assets are on track to do about $900mm of EBITDA this year.  These assets require about $325mm in maintenance capex annually.  My estimate is that there is about $350mm in coal FCF locked for the rest of 2023 after deducting maintenance capital. 

We know the 2024 realizations are at decent levels because they provide the following schedule in their quarterlies. This schedule when checked vs. the contracted sales volumes suggest price realizations are down about $10/ton in 2024.  That makes sense because coal was in backwardation, driving weaker realizations into 2024.  My rough math suggests they are on track for another ~$500mm in coal FCF for 2024 after netting out cash costs and maintenance capital.

That means I have line of sight to about $850mm in FCF from coal over 18 months. Including the oil and gas royalties I’m covering more than $2b of my enterprise value.  This is a $3b TEV company.

Am I expected to believe that the 2025+ coal value of the business is only worth $1b, or 1x current EBITDA?

That feels like far too little.  The macro context of natural gas is important.  The Haynesville gas shale gets very low in inventories in 2029-2030.  I know this because my day job is looking at E&Ps.  The Northeast isn’t helping the gas supply situation because you can’t build gas pipelines from the Northeast anymore (see the disaster that is the Mountain Valley Pipeline).  Meanwhile, 2025 is the start of a massive ramp in LNG export projects.  I wouldn’t be surprised if gas settled at $4.75/mmbtu.

Below is a chart that tracks the progression of coal as a % of the U.S. power stack.  I feel strongly that while this chart is going to keep going down, the pace is going to rapidly decelerate as gas prices rise for the next 3-4 years.

It seems entirely plausible to me that the residual value of ARLP’s coal assets are really worth more like 3-4x EV/EBITDA, which would make ARLP stock a double.  If I’m wrong I don’t think I’m losing my shirt because I have the oil royalties and a clear line of sight to a bunch of contracted cash coming in the door in.

Catalyst

Catalyst investing is dumb.