Welcome to Episode 87 of Special Situation Investing.
Today we revisit Natural Resource Partners (NRP), a coal royalty company we previously discussed in Episode 64 and Episode 68 of the show, while also discussing the future of the broader coal industry.
My co-host and I recently reviewed our own royalty investment holdings to determine which of the companies that we own hold fee simple properties and which own severed mineral rights. Fee simple ownership is the broader, all-encompassing, ownership that we’re searching for and its also much rarer within the royalty space. After delving into the research, we quickly realized property ownership is a complex topic and very few companies are purely fee simple or purely mineral estate owners. NRP itself is no exception to this rule as some of their properties are fee simple and others include severed mineral and oil and gas ownership rights.
As is often the case in investing research, however, what began as an investigation in one area led to unrelated but useful insights in a separate area. Specifically, I began to investigate the operating companies that work and lease NRP properties rather than simply reviewing NRP financial statements in isolation. I did this for several reasons but one of the primary reasons was to better determine the nature of NRP’s land ownership. Was it fee simple or a severed mineral interest? If NRP’s ownership is fee simple I would expect the operator to pay more than just a royalty on the minerals extracted. I would expect to see payments for easements, water usage, and other items that could be monetized by the royalty company and while I did uncover some of what I was looking for, I found even more valuable information about the broader coal industry that led to the following two conclusions. The first is that coal isn’t going away anytime soon and the second is that NRP’s properties are being developed and expanded by the operators who work them in order to support growing coal demand.
My first stop in this investment investigation was a table in NRP’s recent annual report that listed NRP’s main coal producing properties along with the operator that works the property. Using this list, I worked my way through the publicly available information provided by the operators and while I did find some new information about NRP’s properties along the way I learned even more about the broader coal industry. Because the operating companies had such insight into the dynamics of the coal industry, I briefly put my NRP specific research on hold to review the investor presentation of one of the largest publicly traded coal companies in the US, Peabody Energy.
Contrary to my expectations, Peabody Energy is increasing mine capacity and pouring more capex into the coal sector. In fact, every coal company I reviewed forecasted growth in coal and is planning for disciplined capital expenditures in the space. This came as a surprise to me given all of the anti-coal sentiment in the world today. You can’t open an annual report printed in the last few years that doesn’t have an ESG statement stamped on the opening pages or get very far through a chairmen’s letter without reading a carbon neutrality pledge from the C-suite. This phenomenon goes beyond big tech companies and knowledge work businesses and applies even to the mining companies themselves. Oil, gas, and even coal companies, plan to be carbon neutral by some set future date but at the same time are simultaneously increasing capex in the fossil fuel space.
The disconnect between what companies pledge to do with their money and where they actually put their money is nothing new but the juxtaposition between the two conflicting themes caught my attention just the same. I remember observing this disconnect between expectations and reality when looking at natural gas consumption charts in 2015, they always looked the same with a historical consumption line going up and to the right year after year followed by a much fainter “projected” line of secular decline going into the future. Curiously, the secular decline always began tomorrow, and then the next year after another record year of consumption, the secular decline again, “began tomorrow.”
I’d never looked up an equivalent chart that reflected coal production but was inspired to do so in preparation for this write-up. While I should have expected it, I admit that I was surprised to see the same chart displayed before me once again. According to the International Energy Agency (IEA), 2022 saw humanity produce more coal than ever before in history and again they project that coal will enter a secular decline phase starting…tomorrow.
There’s a saying among physicists that goes something like this “cold fusion is 20 years in the future and it always will be.” Perhaps that cynical but humorous statement attempts to capture the disconnect between the dreams of man and the fact that reality always gets a vote. In other words, some things are easier to imagine than they are to accomplish. With that thought in mind, what constraints has reality placed on humanity that make it so challenging for us to reduce coal consumption?
Beginning with the present state of affairs, coal is responsible for more of the world’s electricity generation than is any other single fuel source. Furthermore, it is indispensable in steel making, concrete manufacturing, and many other other raw material production processes across the globe. Many factors are responsible for coal’s multi-decade run at the top of the world’s electrical generation leader board but three in particular stand out.
First, coal is energy dense. So instead of having to blanket a swath of farmland with solar arrays and wind turbines, who’s power is intermittent, a relatively small coal fired power plant can generate known and stable quantities of power twenty four hours a day, three hundred and sixty five days per year, with a high degree of reliability.
Second, coal stores well. Coal can sit in a pile with little consideration to its storage for very long periods of time and still perform its assigned task when called upon. Natural gas, which is even more energy dense than coal, cannot be stored as easily or with so little consideration of how it’s stored. Battery storage, while constantly improving, is still no match for coal as batteries. Batteries cannot be stored under all conditions and even the best batteries leak significant percentages of their power across time.
Third, coal is widely distributed around the globe. Not all countries have fossil fuel, hydro, wind, solar, and even nuclear resources available to them whereas coal is widely distributed and available in the earths crust. Even countries without direct access to coal can often import it affordably due to the first two characteristics of coal, namely that it’s energy dense (making transportation cheap), and that it stores well (making storage safe and inexpensive).
With that brief background behind us it’s easy to understand why coal rose to its position of preeminence but still not entirely clear why humanity is having such a difficult time moving past it. We can understand that coal was necessary to power the industrial revolution but that was then and this is now. Now we’re aware of the harm caused by CO2 emissions and we have solar and wind power poised to launch us into a green future. So why not make the switch from one power source to another and be done with it? Well, to even begin to answer that question, we’ll have to consider a few additional factors about the power grid itself and global demand for energy.
The first factor that we will briefly touch on is that of nonlinearity. Keeping it simple, modern power grids require a stable oversupply of power. Powerplants do not adjust their output up and down with every flick of a light switch but rather create more than enough power such that they’re able to meet any demand that the grid requires. If power production is unable to meet demand for any period of time then brownouts and blackouts result leaving scores of people without power.
Renewables, primarily wind and solar, have intermittent supply capabilities because the wind doesn’t always blow and the sun doesn’t always shine. Because of this, renewables can add power to the grid but make very poor baseload providers. Renewables as a percent of total power production have risen over the last several decades just as fossil fuels share of total grid production has fallen. The effect of this is undetectable, until it’s catastrophic.
In other words, the intermittency of wind and solar doesn’t cause a blackout until the day when you reduce the fossil fuel baseload low enough that any drop in wind and solar production can’t be covered by the remaining fossil fuel generation capacity. The first several megawatts of fossil fuel reduction had no noticeable effect but the last megawatt reduction that took fossil fuels capacity below the renewable power generation low point causes an outage, just like we saw in Texas during the winter of 2021.
During the ice storm in Texas, power demand rose just as all of the wind generation froze up and stopped producing and because the state had reduced it’s fossil fuel baseload generation capacity in the the years leading up to the event the power went out. As fossil fuel baseload capacity drops below the lower range of renewable powers generation capacity, the effects of any power reduction or increased demand become nonlinear to all of the changes that took place at an earlier point. The challenge moving forward is that we’ve already reduced the coal and gas baseload down to the point where further reductions will likely have nonlinear effects on the system, we’ve essentially picked the low hanging fruit. A solid baseload will have to exist going forward whether it’s provided by coal, gas, nuclear or some other source, or society will suffer the consequences.
Another factor making it difficult for the world to quit coal is the rising global demand for power. India, China and other massive population centers are ready to join the developed world and the main barrier between their current way of life and the life they aspire to live is access to energy. The developed world too is hungry for power, as we seek to convert our transportation system from internal combustion engines to electric vehicles and hope to harness AI in revolutionary ways. The collective goals of humanity are driving toward increased, not decreased, power consumption and the renewable energy space is not equipped to meet today’s challenges let alone the challenges of next year.
Moving now from a global macro view of coal down to the company specific level we see several added industry-wide tailwinds that should compliment the already positive macro setup in the coal sector. The first tailwind that we routinely come across in our research is that of disciplined capital allocation. Within a commodity space that’s legendary for its poor capital allocation decisions, we’re seeing more and more management teams talk abut debt reduction and disciplined capex. In the past, when commodity prices soared the industry would pile on debt and open new capacity only to drive prices down along with profit margins and watch the boom times fade along with their credit ratings.
This time, dare I say, it’s different. Across the board, energy companies seem to recognize that the ESG zeitgeist is against them, and because of that their access to capital will be restricted. They can’t overplay their hand with debt this time because, in part, capital markets don’t want to put money into a sector that’s going into “secular decline tomorrow,” neither do investors want to be associated with CO2 emissions. Knowing that they’re on their own, coal company executives are, rightfully, operating much more conservatively than they have in the past. This is evident in the balance sheet of the major energy companies where even though profits are soaring, debt repayment, rather than capital expenditures, are the order of the day, and the debt levels are coming down fast year after year.
It’s interesting to observe that just as the out of favor energy companies are paying down debt and shoring up their balance sheets, the market darlings, epitomized by the FANG, stocks are piling on debt. For a quick look at this phenomenon, visit the site roic.ai and type in the ticker symbol for Peabody Energy, CONSOL Energy, and Natural Resource Partners. There you can glance across years of long-term debt levels, debt levels that are declining. Compare the downward debt level trend in the energy sector with the FANG stocks who’s debt levels are moving in exactly the opposite direction and draw your own conclusions. This observation alone isn’t enough to justify an investment but the increased FANG stock debt, coupled with massive layoffs in that sector, compared to the opposite trend in the energy business, might be the proverbial canary in the coal mine telling us that a changing of the guard is at hand.
Now because this write up was meant to focus on both the coal industry generally and NRP specifically, we’d be remiss not to include what we learned about NRP’s prospects going forward. Studying NRP properties through the lens of the operating companies that work those properties, yielded insights consistent with the broader macro picture, mainly that coal is not going away and that anti-coal sentiment may in fact be the setup for a more profitable and disciplined coal industry going forward.
The first benefit to NRP that we read consistently throughout the operating company reports was that the permitting of green field projects is a growing challenge. Going back to the ESG mantra that dominates our societal discourse, this makes sense. After all, no politician wants to be seen at the ribbon cutting ceremony of a brand new coal mine and no HOA wants a railyard and processing facility constructed across the street. Because new mines are difficult to permit and construct, and because demand for coal continues to rise, operating companies must expand existing mine operations to ensure they can adequately supply the market.
Expanding existing mine projects is a tailwind to NRP because the operator pays for the infrastructure and increased capacity while the royalty company collects ever greater profits. To illustrate this fact here are the operating company plans for three of NRP’s major coal properties.
Major properties:
Carter Roag: The Carter Roag mine is operated by Affinity Coal, a subsidiary of Metinvest. The property is a Northern Appalachian property that has produced high quality met coal for decades. Future plans for the mine include several areas for expansion that will bring on additional capacity in the surrounding reserves over the next several years.
Kepler Coal Plant Property: Kepler coal plant property is operated by Alpha Metallurgical Resources and is one of four key capital expenditure projects highlighted in Alpha’s most recent investor presentation. Alpha’s ongoing project aims to increase the facilities efficiency and overall capacity that coupled with their Marfork expansion plans will boost the facilities coal production capacity by over 160,000 tons annually.
Elk Creek: Elk Creek mine is operated by Ramaco Royalty Company. Ramaco, recently listed their NRP facility as having the lowest cash cost per tone of coal in the nation. Furthermore, Elk Creeks year-long project to increase prep plant capacity by 50% from 2 million to 3 million tons annually is on the cusp of completion and should be online within the next 12 months. Additionally, new growth mines were added to the Elk Creek facility in 2022 and are now achieving predicted production levels.
That other companies are making capital improvements to NRP properties for the benefit of NRP shareholders but without any investment from NRP itself is staggering and is a testament to the royalty business model itself. We’ve already discussed the positive macro set up in the broader coal industry but can now see the added benefit of a royalty model overlay where owners receive a cut of the profits and benefit from the capital improvements of others. Of course, in the case of NRP you’re also getting the Sisecam soda ash mine, the aggregate royalties, the limited oil and gas resources, and the carbon sequestration optionality for free which combined should at least warrant additional research from investors.
With that we hope you enjoyed todays episode and that you gained greater insight into NRP and the global coal industry.
Here at the show we endeavor to share our own actionable and real time research with you in order to jumpstart your own investment research. We thoroughly enjoy the feedback from all of you and your support for the show. As always you can easily send micro payments our way via the fountain app if what you learned was worth your time. Thanks again, and we will see you again next week.
Coal's resilient future (NRP)