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Are production cuts positive for coal miners like Walter Energy?

Xun Yao Chen

Key investor takeaways from Walter Energy's 1Q14 earnings (Part 5 of 8)

(Continued from Part 4)

The impact of lower production

Are production cuts positive for the Market Vectors Coal ETF (KOL) and coal miners such as Arch Coal (ACI), Alpha Natural (ANR), Walter Energy (WLT), and Peabody Energy (BTU)? At a company level, lower production is negative. It leads to lower shipments and revenue. As companies benefit less from economies of scale and fixed costs are spread over a smaller volume, earnings will decline by a larger percent.

10 million tons of production cuts

It’s important to note, however, that each company is part of its industry. This means what Walter Energy decides to do will also impact the entire metallurgical coal industry. According to Walter Energy’s first quarter earnings call, management noted coal miners have recently announced production cuts equivalent to over 10 million tons, which represents about 3.0% of the global seaborne market. Most of these cuts are occurring in the United States and Canada, but management believes we’re starting to see cuts from some higher-cost Australian producers, which are closer to China.

Take-or-pay contracts

The chart above shows the cost of production curves for seaborne metallurgical coal suppliers, taken from Walter Energy’s third quarter 2013 presentation. Based on the chart, a large percent of seaborne coal was unprofitable at prices of $120 to $140 per metric tonne in the fourth quarter. Suppliers were willing to sell at these levels since they had agreements (take-or-pay contracts) in place to use a certain amount of capacity of railroads, and terminals—otherwise, they have to pay. Essentially, these railroads were fixed costs to the metallurgical coal producers.

Reactions or proactive measures?

Production cuts may sound encouraging, and it’s a matter of time until these agreements (or take-or-pay contracts) mature. But in a competitive market, production cuts are generally reactions to a weak market rather than proactive measures to push prices up and protect profits. So unless we see further cuts, we’d be cautious—at least over the short to medium term.

Continue to Part 6

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