Description

Wick8809 wrote up a great write up of FELP last year. The situation is now better for FELP than a year ago, but I would still recommend you read it too.

What about the business? FELP is an ILB coal producer that produces/sells about 22 million tons of coal a year now. It is a low cost producer with cost coming in around $23 a ton and has the ability to export significant amounts of coal, which not all coal mines are able to do.

Warrants, MEC and outstanding shares:

A while ago Chris Cline top ticked the coal industry and sold most of FELP to MEC, Murray Energy Corporation, owned by Bob Murray. The problem was that when Bob Murray did the deal he wanted to be a little too cute when he tried to avoid paying a change of ownership fee to bond holders, they went to court and Murray lost. If you read into the whole story, it is just flabbergasting how Bob Murray got clobbered financially by this. Anyway, it required Bob Murray to renegotiate the capital structure for FELP with his back to the wall and they made him pay for it. And this all happened right at the same time that the coal industry took a nosedive. It ended up costly to Bob Murray and to the holders of the common units. It wasn’t just that the refinancing of the debt was expensive, but also the structure that Bob Murray used was convoluted, where MEC took subordinated units, most of the GP and few common units. He then had a subordinated units to common units conversion formula. (Read the following section called MQD below to understand how it works.) Anyway as of the last Q (Q1 2018) we now have 79,826,538 million common units outstanding and 64,954,691 million subordinated units outstanding. This brings me to the warrants outstanding. When Wick8809 wrote up FELP last year, we had 384,124 warrants outstanding for 12.8 common units per warrant at 0.8928 per common unit for a total of 4,916,787 common units. As of the Q1 2018 Q we have 142,530 warrants outstanding for 13.4 common units per warrant at $0.8531 per common unit for a total of 1,909,902 common units. Those warrants are owned by bond holders that are converting and selling common units indiscriminately into a stock that has little volume. The warrant conversion selling rate has been approximately 15,000 common units a business day for the last 11 months. FYI. The average volume for FELP is 14,200 common units a day. This average volume has been higher in the past, but you get my point. There has been a lot of indiscriminate volume pushed into the stock for the last year. Yes, you will rightly notice that there still are 1.9 million common units to be issued. It is always difficult to figure out when the indiscriminate sellers are done, but one cannot deny that we have gone through a large percentage of the indiscriminate sellers over the past 11 months. MEC currently owns all of the subordinated units, 12.3% of the common units and 80% of the GP.

One last thought on management, Bob Moore is the guy running MEC and he is also the CEO for FELP. My worry has been that MEC will try funny stuff with the common unit holders, but till now none of that has happened. They have treated all parties correctly. Where Bob Murray at times seems all over the place, Bob Moore is calculated. I like that Moore in multiple calls continues to show restraint around spending on new capacity. Also, over the last few years I have found him to be more on the conservative/realistic side on calls than other coal mine managements.

MQD

MQD stands for minimum quarterly distribution. It is part of the deal Murray did for FELP. Here is the language … “All subordinated units are currently held by Murray Energy. The principal difference between our common units and subordinated units is that subordinated unitholders are not entitled to receive a distribution from operating surplus until the holders of common units have received the minimum quarterly distribution (“MQD”) from operating surplus. The MQD is $0.3375 per unit for such quarter plus any cumulative arrearages of previously unpaid MQDs from previous quarters. Subordinated unitholders are not entitled to receive arrearages. The subordination period will end, and the subordinated units will convert to common units, on a one-for-one basis, on the first business day after the Partnership has paid the MQD for each of three consecutive, non-overlapping four-quarter periods ending on or after March 31, 2017, and there are no outstanding arrearages on the common units. Notwithstanding the foregoing, the subordination period will end on the first business day after the Partnership has paid an aggregate amount of at least $2.025 per unit (150.0% of the MQD on an annualized basis) on the outstanding common and subordinated units and the Partnership has paid the related distribution on the incentive distribution rights, for any four-quarter period and there are no outstanding arrearages on the common units.”

In short what it says is that FELP needs to pay the common unit holders a minimum of $0.3375 a quarter and if it pays quarterly for 12 non overlapping quarters with no arrearages, then the subordinated units can be exchanged for common units. There was also language that allowed for conversion after the payout of common units to be $2.025 over any four quarter period of time as long as the GP interest was paid and there were no arrearages. Given the current arrearages this is of little relevance for now. Also no GP interest can be paid out until the arrearages are paid in full. In practice what does this mean for common unit holders? Well the sum of the arrearages are currently $3.4743 per common unit. In practice this means that as long as the common unit holders have not been paid the MQD there is no economic value to the subordinated units or the GP. All the money has to go to the common unit holders till the MQD is paid off. And so MEC is screwed … not entirely though. There is a way for MEC to dig its way out of this hole and it is based on the “Retained Percentage” and higher coal prices. Both I will address later.

P.S. Regarding the GP, here is the formula for the IDRs. As one can see, common unit holders got a while to go before they start sharing with the IDRs.

Retained Percentage

“Retained Percentage” means, with respect to an Excess Cash Flow Period, 25%; provided that, commencing with the Excess Cash Flow Period for the fiscal year ending December 31, 2018, such percentage shall be (i) 50% if the Secured Leverage Ratio at the end of such Excess Cash Flow Period is less than or equal to 4.00 to 1.00 and greater than 3.00 to 1.00, (ii) 75% if the Secured Leverage Ratio at the end of such Excess Cash Flow Period is less than or equal to 3.00 to 1.00 and greater than 1.75 to 1.00 and (iii) 100% if the Secured Leverage Ratio at the end of such Excess Cash Flow Period is less than or equal to 1.75 to 1.00.

As part of the last refinancing round, FELP got stuck with a retained percentage, meaning based on an excess cash flow leverage ratio FELP has to use a certain percentage of excess cash to pay down debt, more specifically the first lien.

For the last four quarters FELP has paid out a total of $0.2382 in distributions to common unit holders or an average of $0.05955 per quarter. That is all related to the retained percentage being only 25%. As long as the secured leverage ratio is above 4.0 FELP had to use 75% of the excess cash flow to pay down debt or leases. Currently the leverage ratio is below 4.0 and in the last call management confirmed they believe they should be able to get it below 3.0 in the next 18 months under current expectations. I am not sure if they will raise the distributions to common unit holders soon to 50% or if the plan is to maintain the higher debt pay down percentage in order to get below 3.0 sooner. It is clear that Moore wants that number below 3.0 ASAP. Anyway if there was no retained percentage then the average quarterly distribution could have been $0.2382 per quarter. As you can see that number is already a lot closer to the MQD. If FELP now could have some pricing power then it wouldn’t be hard to see a scenario where a virtuous cycle bails out MEC … and the common unit holders. Let’s assume that FELP could get $5 more in netbacks per ton. That would add an additional $110 million in excess cash flow. If I take the current common units and add the still outstanding warrants I get to a total of 81,736,440 common units which would mean an additional excess cash flow of $0.3364 quarterly per common unit. That is on top of the $0.2382 per quarter it could currently distribute to common units if there was no retained percentage. At that level, FELP’s retained percentage would go to 100% and FELP could start paying the MQD and arrearages. At that time MEC can see a way to salvage a fair amount of the economic value it invested. It looks to me based on current export pricing and feedback from management that we might be on the way to get that $5 per ton extra in netbacks. I will address that pricing power later.

Buying back stock or second lien debt with excess cash flow.

With the current level of excess cash and retained percentage, there just aren’t that many options to get very creative for FELP management, but if we can get the extra $110 million in excess cash flow, then some interesting stuff seems possible. With an extra $110 million in excess cash flow, FELP’s leverage ratio would be below 1.75 at which point the retained percentage goes to 100% and it can then pay the quarterly MQD and start working on paying the arrearages. But I wonder if buying back FELP common units makes more sense around these prices. So if FELP buys back a common unit at $3.75 it avoids having to pay the MQD and the arrearage on bought back common units. Seems like a no brainer to me with the arrearage per common unit already being around $3.5. At a net cost of $0.25 it seems hard to see how that wouldn’t be massively accretive. So much so that it might make sense to just bring the payout to the common units to zero and just buy back FELP common units until it reaches a certain price. I would say such a strategy would be nicely accretive to a stock price of at least $7 a common unit conservatively.

Another strategy could be for FELP to take excess cash and use it to buy back the 2023 second liens in the open market. The 2023 second lien has an 11.50% coupon, but currently trades at a 14.5% yield. I prefer the buyback of the common units, but this makes sense too.

Lastly could FELP do something to refinance the debt if it makes $110 million additionally in excess free cash? The first and second lien can be refinanced. The second lien in the short term would require some refinance penalties, but in the whole scheme the benefits would outdo the costs pretty quickly. During Q1 FELP paid around $35 million in interest so every percent would make a big difference.

As one can see though that extra cash of $5 a ton can open up a nice virtuous cycle for FELP that should be reflected in the price of the common units.

Deer Run

Before I get to business expectations, I want to quickly address the closing of the Deer Run mine at Hillsboro. Since Wick8809 did his write up, FELP has decided to close down the Deer Run mine. On paper that was not good, as it was a low cost mine with lots of reserves. Management is wrapping up things related to that asset with the insurers and the royalty owner. According to FELP management it did receive $44 million in Q2 related to the insurance policy and another $59 million is expected. It looks though that that money will be used to pay closing costs and to pay down equipment loans and leases. For those that do not know, the Deer Run mine was self-combusting which made it dangerous to work in the mine. The Deer Run mine was clearly a write off, but there were other mines to be built in the Hillsboro complex. My worry was what happens if FELP spends another $100 to $150 million developing the new mine and then 6 months in that one start self-combusting too. Given the current coal pricing this looks like a decent risk adjusted decision, but it sure sucks. Another 5 million tons at $23 a ton in cost could have added nicely to cash flow. If it wasn’t for the risk of self-combustion, the $150 million invested would have paid off well. Anyway, that’s behind us … or maybe not entirely. I wonder if this is just a strategy to get a better royalty deal later on. The minimum royalty was clearly an issue too. I also wonder how that works with the insurance? I do think the odds are low for this outcome, but they are not a zero chance.

Exports

Last year FELP exported 5,769,000 tons of coal, most of it to Europe. When Wick8809 wrote up FELP last year, the API 2 price was around $75 per ton. Currently the API2 is about $20 to $25 per ton higher. Now API2 pricing is only an indicator as it does not tell us what the sulphur discount is or what the cost of transportation is. During the last call, Moore mentioned that the current sulphur discount was between $10 and $13 per ton and that transport costs had increased about $2 per ton versus the end of 2017. Versus the end of 2017 we see API2 prices that are about $10 higher per ton now. Was all that eaten up by the sulfur discount? I don’t think so. Management mentioned that they were seeing netback rates of $37 to $40 per ton. FYI, overall netbacks for 2017 were in the $36.50 range with export netbacks at that time being significantly lower.

So management already has 6.7 million tons contracted for 2018, but believes the total export tons might end up in the 9 million ton range. Increased US exports are also helping local pricing as they drain volume from the domestic market, but more on the domestic market later. I think the export trend will continue as long as pricing stays attractive and the domestic market lags.

So yes, short-term exports are an attractive alternative, but what about longer term, especially to Europe? I do agree on paper that there are risks to European exports. After all they are pretty enamored with climate change over there. I think Joschka Fisher, who used to be the leader of the Green party, a socialist/ecological political party, in Germany, said it best “If the Greens want to get out of coal at the same time they want to get out of nuclear, then we have a problem.” If you really dig into the political rhetoric around climate change in Europe you see politicians that have ambition and courage, but if there are no significant technological changes, I just don’t see how they will get even close to getting out of using fossil fuel for generating electricity in Europe. And it is isn’t just that they will need to replace current supply, but also future increased demand from electric vehicles and a move away from fossil fuel for heating, which they want to see in Europe. The numbers are huge, after all the European Union has 510 million habitants. Anyway, without technological breakthroughs Europe isn’t getting off fossil fuels anytime soon without increasing electricity prices massively.  

But if we ignore Europe or even the US, there is great news coming, mostly out of Asia. There will be plenty of demand going forward even if Europe stops importing coal. Globally there are 236,919 MW of coal fired plants under construction, mostly in Asia because of an unabated growth in electricity demand. That is an expansion of 11.8% of the current existing coal MW capacity or 89.1% of current US MW capacity. This is a just a thought, but it is my estimation that those building those plants are planning on using them. And another 365,049 MW is currently on the drawing board. If 50% of those are constructed over the next few years, then we got plenty of global demand for coal coming our way. We keep reading about all the coal plants that are closing in Europe and the US, but many don’t realize that others are building new capacity way faster than we are closing it. A fair amount of those new coal plants are built in places where there is no domestic/local coal available. For example in India they are building coal plants that require higher BTU coal than normally available in India. Also India has a hard time expanding capacity and transporting coal around the country reliably and at a reasonable cost. I believe a big driver for building these coal plants isn’t just massive growing demand for electricity in developing countries, but also that they have limited access to natural gas, meaning they have to get their gas through expensive LNG. It is either nuclear, which takes forever to build, or expensive natural gas or less expensive coal. Where ever one looks, it seems that everyone is wanting to switch to natural gas. Inside each country the numbers work, but if you aggregate them together you quickly start wondering where all that gas is supposed to come from at low prices. So many are wondering how they can diversify away from future volatility in LNG pricing. For people in the developed world, their utility bills are a fairly small part of their living expenses, but in many developing countries it eats up a huge part of the budget. Side note: India has 4 times the amount of cooling degree days than the USA with 1.3 billion people and sells half the amount of AC units yearly compared to the US. China sells more than 40 million AC units a year with the same amount of people and the same cooling degree days as the USA. When India finally hits similar per capita GDP levels as China did 10 years ago, meaning the GDP per capita level where people install AC, India’s electricity demand growth will be off the charts, so much so they won’t care how they get the power. It is hard to convince someone that he should not run his AC when the temperature outside is 115 degrees.

So let us now get to domestic demand.

Domestic demand

On the last call FELP management discussed how RFPs are coming in with netbacks in the high 30s, low 40s. Despite the continuation of low gas prices driving lower coal demand we have a few positive markers. One is the domestic inventory levels and two is the growth in exported tons.

A.      Export volume increases are limiting supply domestically. Every ton you export you are not selling in the domestic market. Since export volumes and pricing collapsed in 2016, we have been rebuilding volumes. Management described how exported volumes were playing a role in limiting domestic supply and for the first time in a long time management is seeing better pricing. It is not exclusively the reason why, but expanded exports do help balancing supply. Additionally, we also see a decline of imports, mostly from Columbia. FYI Bob Murray also owns a large Columbian mine.

B.      Inventories of steam coal has seen a significant decline since December 2015. On December 31, 2015 we had a total tonnage in inventory between coal plants and producers of 231.419 million tons. As of March 31, 2018 150.282 million tons was in stock. Or on average we have drawn down stocks at an annual run rate of 36.06 million tons. How low can the inventory of coal go? At some point inventory will bottom out, and I think we are close to that point, and we will see that demand added to the current domestic coal ton sales rate. 36 million tons yearly represents about 6% of the current burn rate for coal domestically.

C.      Will the tons of steam coal burned annually continue to decline in the US? In tons burned in Q1 2018 we were close again to the Q1 2016 lows after an 8 million ton bounce in 2017. A problem for steam coal has been low natural gas prices. But before I get to that I would like to point out again that FELP, together with Alliance, is the low cost producer of ILB coal. The marginal cost per ton in the ILB is significantly higher than the FELP’s or Alliance’s ILB cost per ton. ILB demand has held up pretty well over the last few years. Alliance and FELP have about 35% market share in the ILB. Still with the debt load FELP has we don’t want a few years of lower coal prices again so we can drive the competition out of business. This brings me back to the prospects for natural gas prices as they are the direct competitor for coal. It is amazing to see how shale has performed in this country. Especially the productivity growth of the last few years has been nothing but amazing. And if you think those productivity gains will continue at the same pace and you think we can easily produce 95 Bcf/d at the current prices, then things will likely stay more challenging for FELP than my expectations. But I don’t believe that to be the case. Shale gas has had to crowd out conventional natural gas sources over the last 8 years. Conventional natural gas sources can’t produce gas at prices this low, except from gas wells that already exist. Year after year though as shale gas takes a larger market share it has to run faster just to keep up. I do not think that natural gas prices can stay at this level when natural gas demand grows to 90 Bcf/d domestically. Without significant productivity growth, which looks like it slowed down markedly lately, I don’t see how natural gas prices stay at the $3 mcf level when shale gas production has to continue to grow daily and decline quantities increase on a monthly basis. We already see decent cost inflation currently, especially for completions. Current shale plays produce about 55 Bcf/d natural gas. Current demand is about 78 Bcf/d but that number is expected to go to 88 Bcf/d over the next few years as another 6.5 Bcf/d comes online in LNG exports and another 3.5 Bcf/d comes online in additional exports to Mexico.

And do not forget that when we replace coal for gas that that is additional gas demand. To give you an idea, if we would replace all coal with gas for electricity production domestically, that would add about 25 Bcf/d to natural gas demand. And that assumes we don’t close nuclear plants too. Might some of that supply be taken over by renewables? Sure, but less than people think. And that doesn’t include all the electric vehicles we are supposed to start driving. 37% of all energy used in the US is from oil. The numbers just don’t work. People that say we can go 100% renewables with the current technologies being considered are dreaming aloud, even 25% would be a challenge. Currently Germany, the country that is louded for its massive push into renewables, has renewables as 13.1% of its primary energy consumption … and the price of household electricity is already 70 percent higher than that for example of France. And here is the kicker. In 2016 Germany’s electricity production was about 10 times dirtier than the French one. And the Germans want to close down all their nuclear plants by 2022. You just can’t make this stuff up. Or as Napoleon said best, “In politics, stupidity is not a handicap.”

Lastly natural gas storage quantities are markedly below their 5 year average. Given “all the excess natural gas” so many talk about, I wonder why the storage numbers aren’t at least catching up with their five year average numbers. If we want to end up with the five year average by the end of October then we’ll need an additional 6 Bcf/d of storage. If we want to get to 4,000 Bcf then the average storage fill rate will have to be 18 Bcf/d. Much will depend on how hot the rest of summer will be. Anyway, I long for a hot summer and especially for a cold winter. I warn you ahead of time … when you own enough FELP common units all winter long you will be googling “Polar Vortex”. It is truly amazing how beautiful a weather map with a Polar Vortex on it has become to me. =) Anyway, in combination with the additional demand from LNG and Mexican export growth coming our way this could drive prices in the right direction.

Concluding

I think it reasonable that coal netbacks per ton for FELP will increase by $5 a ton. At 22 million tons that adds $110 million to the current excess cash flow. From reading the last call, management seems to confirm that things are already improving in that direction. If FELP can generate $5 a ton more in netbacks then a virtuous cycle starts up where the retained percentage becomes irrelevant and where we can get paid out on your MQDs or where FELP can buyback common units or second liens. If FELP could refinance the somewhat onerous debt over the next few years that could provide additionally cash flow too. I think $5 a ton is a reasonable number. If it becomes $10 a ton, then it will be lights out.

Let’s assume we get $5 a ton more in netbacks and FELP pays us out the $4.05 in MQD and MEC converts the subordinated units, then at this level of profitability FELP will be making $186 million or $1.26 per common unit. At that level the GP still gets zero. What do you think the price of FELP should be at that time? Still $3.74? And there are scenarios where the current common units get an MQD of more than $4.05.

And what if the $5 extra in netbacks does not happen or takes longer to happen. Based on the last four quarter run rate without retained percentage FELP could have paid out $0.2382 a quarter. Within 18 months the retained percentage will be 75%, or using the last four quarter run rate FELP will be able to pay out $0.17865 per quarter for a total $0.7146 annually and a 19 percent yield at a stock price of $3.75. All the while the MQD would continue to increase till we get $5 more in netbacks per ton.

Lastly, we should be a lot closer to the ending of the indiscriminate selling because of warrant conversion than we were last year. 1.9 million potential outstanding common units are still available where 11 months there were still 4.9 million. Those that will exercise and sell indiscriminately will do so earlier rather than later, but that is just an assumption. Anyway, most of the indiscriminate selling has already happened. Keep in mind that I took the 1.9 million number from the Q for Q1. We are a few months further now so likely that 1.9 million number is not valid anymore and could be significantly lower already.

Risk: Another mine self-combusting would not be good for FELP’s cash flow statement.

Catalyst

modest increase in netbacks