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Peabody Energy and why it is very tricky to make a decision right now

It is very hard to know what to do with commodity stocks right now. For those that have held commodity stocks into the run-up (which could even mean “since Monday” given the incredible melt-up we have had), we are sitting on big gains.

Do you sell on those gains or are bigger gains to come?

In my last post I described some of the risks of holding commodity stocks right now. They are:

1. Some sort of peace agreement
2. The removal of Putin from power, one way or another
3. Global recession
4. Western countries outside of Europe getting fed-up with paying high prices and starting to view this as a “Europe problem”

All of these are on the table I think.

On the other hand, you have the reward of holding commodity stocks. Yes, they are up a lot, but how much higher could they go in a scenario where prices are higher for longer?

Let’s take the case of Peabody Energy.

The great thing about looking at Peabody is they laid out their 2022 guidance in very understandable terms a few weeks ago. So it is very easy to model what their cash flow will be under different scenarios.

Peabody is, in a way, at the epi-centre of the crisis. Russia is the third largest thermal coal exporter. Russian coal accounts for roughly 30 per cent of European metallurgical coal imports and over 60 per cent of European thermal coal imports.

This guy put together a nice spreadsheet of Peabody. I’ve copied that below with a couple of changes.

The first scenario I’ve modeled is at $200 thermal and $365 met coal (Peabody receives a 15-20% discount on their met/pci coal). This is actually below current prices but well above the historical norms.

Peabody has a market cap of $3.3 billion and an enterprise value of $4.2 billion. So under this scenario, if these prices were realized for a full year, Peabody free cash flow would be roughly 80% of their market cap and 60% of enterprise value.

Now let’s look at the extreme. Right now, thermal coal is at $400. I don’t know what PRB coal is at, but the last time thermal was $400 PRB went to $30. What happens then?

While this scenario seems very unlikely over any long period of time, it could be approximate to what they earn in the very short-run. Peabody’s free cash is about $1 billion more than its current market cap.

Russia supplied about 200 million tonnes of coal to the world last year. China produces 4.07 billion last year. China had to push their producers late-last year to get to that level. You can see that below:

Australia is a big coal producer but this was their response a few days ago.

It is not entirely clear that the world can quickly make up any deficit.

That means the big questions are:

1. How long will the spike last
2. What is the new equilibrium if sanctions continue for a long period of time

The thing is, if there are still sanctions through 2023 much of the contracted coal that Peabody signed at lower prices is no longer under contract. The PRB coal, for example, is only 55% committed for 2023. It is pretty easy to see how even at much-reduced prices (from current levels), but still very high historic prices, 2023 would set up as another huge cash flow year for Peabody.

Are these the right prices for that scenario? I don’t know. But this is a scenario where we are in a conflict through 2023. If that is the case I know the prices are going to be higher than the 2021 prices. How much, its really hard to say.

Peabody is an easy example because they have given such detailed guidance. But working though similar scenarios with my other positions. Its the same result to varying degrees. For example, Cardinal, my biggest oil position, should do $400+ million of free cash at current prices. Cardinal’s market cap is $1.1 billion.

But… I am not actually trying to make the case to own Peabody or Cardinal or any other commodity stock here. FWIW I sold some of my position in Peabody (which I had added only on Monday) because it was up 40% in 5 days and I mean, holy cow, it feels irresponsible not to take some profits on that. I sold a little of Cardinal as well.

What I am trying to say is that it is really, really, really tricky to know what to do. It is truly about balancing the risk and reward based on your own individual circumstance and tolerance. Because Peabody could be a $50 stock in 6 months but it could also be a $15 stock in two weeks.

Outcomes to the upside and downside have suddenly become more extreme. That is why one of the only things I’m fairly certain of is you have to take down exposure to both.

World on tilt.

Don’t be a hero

It’s a bear market in stocks. It’s a bull market in commodities.

You don’t want to overthink that too much. But in bull markets there are times to be long, times to be very long and times to take some off.

I think we are at #3 now. While the rise in commodity prices makes it tempting to just keep adding to copper stocks, steel stocks, oil stocks, ag stocks, gold stocks and so on, that FOMO is usually best taken inverted. I have taken the opposite tact and started taking some profits on these names.

Rising commodity prices are your best friends until they are their own worst enemy.

I’m unsure what these rising prices mean for the global economy. I’m really unsure what rising food prices mean.

Consider these quotes:

• The Black Sea region (Russia and Ukraine) accounts for more than 30pc of global wheat exports
• Stocks in major wheat exporters – the European Union, Russia, the United States, Canada, Ukraine, Argentina, Australia and Kazakhstan – are set to fall to a nine-year low of 57 million tonnes by the end of the 2021/22 season, International Grains Council (IGC) data shows.
• If Russia and Ukraine are excluded, other major exporters account for 16% of global stocks or enough wheat to feed the world for less than three weeks.
• Russia is a major low-cost exporter of many kinds of crop nutrients. “No other nation has the same breadth of readily exportable fertilizer supply,” says Alexis Maxwell, an analyst with Bloomberg’s fertilizer analysis and news publication Green Markets. “Their fertilizers move to all continents.”
• ..in Russia, the share of imported seeds is almost 40%? And for potatoes, the share of imported seeds is 90%? That is, of course, farmers will come up with something over time, but at least in the short term, we should expect a shortage of basic agricultural products and a sharp rise in prices. And that’s not all either..
• The Ukrainian planting season comes up in less than 4 weeks

Meanwhile, China has been slowly accumulating wheat for some time now:

I don’t mean to imply a doomsday picture of food shortages. I really don’t know. In this blog I talk about what I see and how it influences the decisions I make with my investments. These headlines and the details make me uncertain. And I always lean to cash when I am uncertain.

That said, I don’t want to be too short. We have seen so many bad things happen over the last two weeks. If something good happens the market could flip on a dime.

I mean, what if Putin is taken out? That would be great for the world, a relief for everyone, but probably less so for commodity stocks and (maybe…) shorts of everything else. It seems a low probability, but its not impossible. I think its important not be to positioned to get punched in the face if some “white swan” like that happens.

I want to be careful to all possibilities.

Meanwhile the shorts I hold have been so bad (which is to say good to be short) that I am left wondering how much lower they can go. These names (I’m talking mostly about SaaS/momentum/covid beneficiary stuff) go down every day, even when the market rallies. There has to be some sort of bottom at some point.

The shorts I am more inclined to keep are those that are economically sensitive. At this point I’d rather have that small short dependent on consumer spending that has seen its price appreciate to an unseen level during covid than I would the SaaS name that has already fallen all the way back to where it started and is still growing 30%.

You add it all up and you end up with more cash. Less positions and smaller positions. My portfolio had a good couple weeks. I’m back to the highs. I don’t feel like this is the time to press.

It is worth taking a step or two back from the action in front of your eyes. It is not going to matter if you miss the last leg up or down or if you don’t time the bottom to the day. There are times to take risk because you can see that the market is at your back. There are times not to, because the winds, while not necessarily in front of you right now, are swirling unpredictably and so you can’t be sure just how they will settle.

Most important, I would rather wake up each morning and not have to worry too much at all. Except for the Upper Colorado River snowpack of course. I’m okay worrying about that. Its going to snow there this weekend by the way, but I think it will not be enough. It will be an average year at best and that is not going to change the trend.