Alliance Resource Partners: A Diamond In The Rough Among The Unloved Coal Industry by Saibus Research
Alliance Resource Partners (ARLP) is a diversified coal producing MLP strategically concentrated in the Illinois Basin. Alliance is the third largest coal producer in the eastern United States, and the largest in the Illinois Basin, producing 40.7 million short tons in 2014. Unlike their largest competitors, they are not materially involved in metallurgical coal (used for steel production), or thermal coal destined for the export markets. ARLP exclusively produces thermal coal used to generate electricity at power plants in the Eastern United States.
Executive Summary
Thesis
Alliance Resource Partners (ARLP) is a deeply undervalued and overlooked company due to the perceived uncertainty in the coal industry, making it a highly asymmetric bet with negligible downside but huge upside potential. Trading at just 7x forward earnings, they are clearly an excellent value. ARLP is not inexpensive for fundamental reasons, but simply because of an industry-wide discount, which reflects bearish sentiment on coal. In addition to the attractive price, they are the beneficiaries of these key trends that reduce risk while magnifying potential gains:
- Unwarranted pessimism: Despite the distaste and pessimism towards coal, it is not going anywhere. Government agencies such as the U.S. Energy Information Administration and the EPA, as well as private entities such as utilities and investors, all recognize that coal will maintain significant market share for decades to come.
- Reduced pricing pressure: The downside from natural gas competition is already fully priced in, and potential price increases from shutting down wells due to low oil and gas prices, as well as the shutting down of competitors’ mines due to low coal prices, adds further upside for Alliance Resource Partners.
- Increasing market share: As one of the most efficient producers in the country, with top notch management and conservative execution, ARLP is taking share from competitors that are near bankruptcy from their reckless over-leveraged bets on international demand for metallurgic coal and high cost domestic mines.
- Higher ILB demand: Utilities are switching from higher priced Appalachian coal to Alliance Resource Partners’s Illinois Basin (ILB) coal, and this trend is expected to continue indefinitely.
Valuation
Risks
- Coal plant closures: Many coal plants are closing due to EPA regulation requirements, as well as unprofitability. Our primary research indicates that the impact of these forces on ARLP in particular should be minimal, because 98.5% of ARLP’s customers already meet EPA requirements.
- Global coal demand: Global demand for coal has dropped sharply, but Alliance Resource Partners is insulated from this because they produce only U.S. thermal coal.
- Renewable energy: Breakthroughs in renewable energy could lead to a decline in future coal demand. However, renewables are still a long way from economic viability for electricity generation.
- Environmental regulation: In light of the Supreme Court’s MATS decision, the EPA will not be able to force costly regulation without going through Congress. If they try, there will be a serious legal battle.
Coal Is Not Going Going Anywhere
There is a major difference in perception between the general public and energy professionals. People outside the energy industry sees coal as a dying fuel, already well on its way out. In reality though, according to every group that deals with energy on a regular basis, coal will continue to be essential to America’s power generation.
Long Term Forecasts
Every large energy group sees a long-term future for coal. For instance, in their 2015 Annual Energy Outlook (AEO), the Energy Information Administration (EIA), the U.S. government’s energy analysis arm, shows coal holding significant market share through the next quarter century. According to the EIA’s reference case, coal’s share of total electricity generation will remain strong at 34% in 2040, and will still account for the largest share of total electricity generation. It also shows that even though coal’s market share will fall slightly, total coal consumed will actually increase by 7.11% due to higher overall electricity demand.
Even under the EIA’s worst case scenario for coal, market share is expected to remain high at 27%, which would only be a 10% reduction in tons shipped compared to current levels. But, for this to occur, natural gas prices would have to be 44% lower than in the reference case, which the EIA states is very unlikely.
Further validating these forecasts, Moody’s published a report on July 27th titled “Coal-fired power plants will remain a major electricity provider for US”. The title speaks for itself. In the publication, Moody’s defends the EIA’s forecast assumptions and explains that the only coal generation that will come offline in the foreseeable future are a handful of the least efficient plants that have become less cost competitive due to extremely low natural gas prices. Moody’s reinforces that after some of the less efficient coal fired plants have been taken offline (a small share of total capacity) the remaining plants will be the lowest cost producers for decades to come.
Natural Gas
In recent months, natural gas has offered more competition to coal than ever before. However, there are a number of reasons why natural gas is not able to completely overtake coal as the largest source of electricity generation in the United States.
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