Patriot Coal Bankruptcy: A Sign of the Times for the Energy Sector

Last Monday, Patriot Coal (PCX) filed for Chapter 11 bankruptcy protection and was the first ship to go down in the declining coal industry. This bankruptcy and the current rock-bottom valuations of the US coal stocks (ACI, ANR, WLT, BTU, ect.) are a sign of the shifting sands in the energy sector as natural gas rises in importance and developing countries rely less on energy imports.

“The coal industry is undergoing a major transformation and Patriot’s existing capital structure prevents it from making the necessary adjustments to achieve long-term success,” Irl F. Engelhardt, Patriot’s chairman and chief executive, said in a statement. “Our objective is to use the reorganization process to address important issues in an orderly way and make the company stronger and more competitive.”

Patriot may have secured some $802 million in restructuring financing, but it may just be delaying the inevitable as the coal industry is experiencing both a cyclical and structural decline.

The current decline is cyclical because of waning global energy demand and the unusually warm winter which built up excessive energy inventories. More importantly, the decline is structural because the new threat from the shale gas boom in the US. Further, power companies are retooling plants to handle both coal and gas for electricity generation in order to be able to opportunistically switch between the energy sources.

Furthermore, international demand for US coal imports is declining as well due to many new coal mines springing up in Indonesia, Australia, and Mongolia. Not only are those mines flooding the demand coming out of India and China, but demand is also coming up flat. Steel production (the other major use for coal) is flat as China's sky scraper building spree is not what it used to be, and new efforts to put up nuclear (Fukushima be damned) , solar, and other forms of energy do not speak well for future coal demand growth.

The icing on the cake is that none of the Coal companies really saw this coming and prepared for this much cannibalization. With the exception of maybe Peabody (BTU) who has been aggressively buying Asian coal assets and Console Energy (CNX) who has been diversifying into the LNG business, the typical US domestic players (Arch Coal, Alpha Natural Resources, Walter Energy, ect.) have been expanding domestically and adding on debt. Arch and Alpha are both guilty of big coal acquisitions in the last 2 years which puts further strains on their cap structures.

Of course for every bear case, there is a bull case. Despite coal falling as a percentage of global electricity consumption, it should maintain its role as a staple energy source for decades to come and should generate at least a quarter of global power consumption (unless more innovations in alternative energy change that path).

Rapid population growth in developing continents should continue to spur the need for more energy production. In the developed markets, we should also see greater electricity consumption per capita as more electronics are used and as society switches away from crude oil to use the much more efficient electricity grid.

Finally, the fact that coal companies are going out of business should tighten up supply for the coal companies that can ride out the storm. However, the coal companies that will do the best are the ones that follow the BHP model in that they start heavily diversifying both geographically and into other materials. I do think some of the coal stocks are technically over-sold while others are likely to go bankrupt.

As I alluded earlier, this is not just about coal. Cheap coal has implications for the entire energy sector and will likely be a drag on the viability of Nat Gas and solar. One thing we can probably rely on is for cheap electricity to stick around as a theme. The utility companies have been fueled by low interest rates and low input costs now for several years. As utility monopolies get broken up, prices could see meaningful easing or at least stay relatively stable. From an investment perspective I will keep an eye out for companies in industries with high electricity input costs and strong growth profiles.

If you are interested in learning more about the coal space in more detail, I have attached a power point I presented to colleagues and will be posting a detailed financial breakdown of the more capital constrained coal companies (ACI & ANR) on my finance and investing blog (in signature) sometime tomorrow.