Description

CONSOL Energy is a Northern Appalachia-based, high-quality, low-cost, predominantly thermal coal producer. The company owns ~81% of its reserves and an export terminal for accessing the seaborne market. A spin-out from CNX Resources in 2017, the company has de-leveraged its balance sheet to become debt free and is committed to returning 75% of FCF to shareholders and favors repurchases over dividends. On a DCF basis I see ~100% upside, and on a more near-term basis the shares could re-rate 50% from buybacks alone. Downside in the operations is protected by its debt-free balance sheet and prudent management, but this is a coal stock and would likely trade poorly in any economic downturn. To better understand CONSOL it makes sense to take a brief detour to understand the global coal market.

Global Coal Market Overview

Global coal demand reached an all-time high of 8 billion metric tons (henceforth: “tonnes”) in 2022. This represents a new peak since the last high put in a decade ago. For the sake of simplicity, I’ll describe supply and demand on a per tonne basis and ignore differences due to the type of coal mined. I am happy to get into the details in the comments if necessary.

The biggest coal consumers, in round numbers, are China (4B tonnes), India (1B), the rest of Asia (1B), followed by the United States (500M), and the EU (450M). Falling demand in the developed world is expected to be more than offset by growing demand in the developing world. China is the largest coal producer with 4B tonnes of production, followed by India (900M), Indonesia (600M), the United States (540M), and Russia (400M). Of the 8B tonne market, approximately 1B tonnes are seaborne exports for consumption outside of the region in which the coal is produced.

If you live in the United States you might think that coal is being phased out because it’s the dirtiest form of energy. And you’d be right. In the United States, coal is predominantly burned for electricity and now comprises 20% of electricity generation, down from 39% a decade ago when we saw the prior peak in global coal demand. This timeframe also coincided with booming (and then busting) coal equities, most of which are no longer publicly traded.

If you look outside the United States you’ll see an entirely different picture. Countries in the Asia Pacific region consume roughly 80% of global coal production. APAC coal consumption has grown at a 2% CAGR for the years 2011-2021 vs. a -6% CAGR in the United States. The second biggest coal consumer, India, grew consumption at a 6% CAGR over the same time period.

Coal is predominantly used for generating electricity, and is cheaper and easier to transport than natural gas. You can rail coal to an export terminal, load it on a ship and send it on its way. Compare this to natural gas which needs to be piped on fixed pipeline infrastructure, super-cooled at a purpose-built LNG facility, loaded on a boat, shipped, re-gasified at its destination and piped to its consumption point. While I expect natural gas to continue to grow in importance in the global energy mix, coal is the most convenient form of energy and will continue to appeal to the developing world.

China, the biggest coal producer and consumer, permitted two new coal-fired power plants per week in 2022. India, the second biggest coal consumer, has less gigawatts under construction than China, yet is expected to consume even more incremental coal than China through 2025 per the IEA. How is that possible? High-quality thermal coal is used in cement production and the ratio of cement to coal, on a per mass basis, required in production is 2:1. India’s cement capacity is expected to grow 10% in 2025 from 2022 levels to 550 million tonnes. The India Brand Equity Foundation, a Trust established by the Government of India, expects India’s cement consumption to increase from 272 million tonnes to 430 million tonnes in 2027. The surplus of production over local consumption puts India in an ideal position to become the main exporter of certain cement grades to the Middle East, Africa and other developing nations.

Before we get to CEIX, any discussion of commodities would be incomplete without a picture of recent capital expenditures. Global coal capex is back to 2008 levels despite consumption growth of 10%. 

CONSOL Energy Overview

CONSOL Energy (“CEIX”) is predominantly a thermal coal producer (94% of 2022 sales) with a small footprint in metallurgical coal (2%). CEIX’s thermal coal is sold to customers for power generation (44% of sales) and non-power generation (56%), with 29% of sales to domestic customers and 71% to exports as of 1Q23. Industrial demand for brick kiln and cement manufacturing was 28% of sales. Metallurgical coal currently makes up such a small percent of the company’s sales that it will not be discussed in this writeup. The company also owns an export terminal on the east coast, providing the company low-cost access to the ~1B tonne seaborne market.

The low cost producer wins in commodities, and CEIX’s thermal coal is in the lowest cost-quartile amongst seaborne coal producers. Recall that most coal is consumed locally, so the export market is where CEIX competes with other global producers. Exports are priced by the marginal tonne. To understand CEIX’s position on the cost-cruve, a look to recent history is instructive. Since 2015, which includes both a bust and boom period for coal, the seaborne market has required on average 940M tonnes of coal. That level of production supports a price of $100/tonne. Compare this with CEIX’s cash costs which are in the lowest quartile at $40/tonne. CEIX’s advantaged cost position allows the company to earn a profit even if seaborne demand collapses by 50%, providing a margin of safety for the company’s operations. Seaborne thermal coal demand is expected to remain steady in the mid-900 million tonne/year range through 2030, according to S&P Global Market Intelligence and IHS Markit, driven by Indian and Southeast Asian demand. Other forecasters such as Liberum think demand will grow over this time period.

CEIX’s ability to produce coal cheaply is driven by its asset base. Its coal reserves are large and productive. The company’s mines are underground and utilize the longwall mining technique which keeps operational costs down. Lastly, the company owns an export terminal that is connected to two Class I railroads, providing it cheap and easy access to seaborne markets. The export terminal, CONSOL Marine Terminal, is located in Baltimore, MD and can export 15.0 million short tons (“tons”) per year and has a storage yard with 1.1 million tons of capacity. (One metric ton is referred to as a “tonne” and is equivalent to 1.10231 US short tons or “tons”.). It is the only east coast export terminal served by two railroads.

CEIX's coal is high-quality: its thermal coal’s heat content is 13,000 BTU/lb which compares favorably to other U.S. coal basins such as the Illinois Basin (11,300 BTU/lb) and Other Northern Appalachian Producers (12,300 BTU/lb). As well, its sulfur content is lower, at 2.41% vs. 2.90% and 3.34%, respectively.

The company has had success leveraging its export terminal to effectively market its coal. In 2020, no individual country outside of the United States was attributed greater than 10% of total revenue, whereas both India and Europe were >10% customers in 2022. The company has been marketing more coal to the export market at an opportune time. Historically, coal export revenue tended to be derived from spot or short-term contracts with pricing determined closer to the time of shipment or based on a market index. However, the Company has recently begun to secure several long-term export contracts with varying pricing arrangements. Some domestic and export contracts span multiple years. This provides the company with more visibility than historically was the case, and at the least, paints a picture of a bright near-term future.

How does the company make money? CEIX's mines coal at a cash cost of $28/ton and $35/ton and sold it at a price of $46/ton and $70/ton in the years 2021 and 2022, respectively. Management’s 2023 guidance calls for flat cash costs at $35/ton and a growth in realized coal revenue per ton at $81/ton. The rolling off of hedges provides a bump in revenue/ton for the company in 2023.

What’s It Worth? Valuation

There are a few ways to look at the valuation of CEIX. The simplest is to take a DCF of its thermal coal business. We know reserves, so we know how long to run the DCF which avoids complications that result from guessing the “terminal multiple” in a DCF for a non-reserve based company. The DCF is meant to be conservative and ignores any upside from the newly commissioned metallurgical coal mine, Itmann, and ignores any cash flow contribution from the export terminal.

The PAMC complex has 622 million tons of reserves. Annual production is 26 million tons, so the reserve life is 24 years. This assumes CEIX will never book another reserve, which is unlikely and therefore conservative. The real question is pricing: what’s the right price to plug into the DCF? The model is sensitive to pricing assumptions. Here’s my base case. CEIX has good visibility into 2023 and 2024 tons and pricing. I give CEIX full credit for 2023 guidance: 26 million tons at $79/ton vs. cash costs of $35/ton. What about 2024 and beyond? Since over half of 2024 tons are sold, let’s instead start with the long-term coal price. The 10Y average Central App thermal coal price is $54. Before increasing exports, CEIX has historically received 88% of that price, or $48/ton. Let’s assume in the long-term, CEIX sells 10 million tons per year at this price. This would imply 16 million tons are exported, which is 80% utilization of the export terminal. What about the export price? The 10Y average price for international steam coal is $82/ton. Let’s assume CEIX receives 88% of that price on 16 million tons. This implies an average long-term price of $63/ton. To back into 2024 pricing I assume the average of 2023 ($79/ton) and the long-term price ($63/ton), and 2025 and beyond use $63/ton. Sense-checking this price, $63/ton is the marginal cost of production to produce approximately 825 million tonnes, which is a price that would imply the export market contracts by ~120 million tonnes, or 13%. Depending on whose forecast you use, seaborne demand is expected to grow or only slightly contract over the long-term, so this price is well-supported by the supply/demand balance and production curve.

This methodology implies an enterprise value of $4.5B vs. a current EV of $2.1B. The company is debt-free so that implies a double for the shares. My DCF suggests there is significant upside in the shares if coal prices revert to historical averages from their highs and CEIX is able to capture an increasing share of the export market.

For those unwilling to look that far into the future, the short-run is instructive. The company has committed to return 75% of FCF and has recently announced a preference for share repurchases over dividends. Using the same assumptions above, through 2024 I estimate that the company could repurchase ~34% of its shares outstanding. Assuming no change in the P/E multiple, this represents a 50% return.

In a blue-sky scenario, if the business is stable, the company could repurchase a significantly higher amount of its shares. Mohnish Pabrai has talked about this at length, and shows that with no change in the P/E multiple, an 80% reduction in the share count results in a 5x return, something that is possible if the coal market develops according to my model

The downside case in the shares is that the company does not receive pricing in excess of its costs of production. This is mitigated by the company’s first quartile position on the cost curve. Their balance sheet gives them staying power to withstand any prolonged downdraft in pricing. Anyone who has invested in commodities knows that the downside can be frightening, so I will not attempt to model it, but it’s worth keeping in mind before making an investment. Basically, I’ll be wrong if demand for coal does not stabilize/grow and/or there is a massive oversupply in coal production, which would weigh on pricing.

Catalyst

- Sustained operational performance by the company

- Sustained coal demand and pricing

- Share repurchases