Coal bonds suffering well before new EPA rules

Fri Jun 6, 2014 11:41am EDT

NEW YORK, June 6 (IFR) - While the bonds of top US coal producers plunged as news surfaced of proposed new carbon emissions limits, much of the sector's debt is struggling for very different reasons.

Bad bets on so-called met coal, which ballooned leverage levels, have left many producers burning through cash and battling to survive - even before the latest developments.

"It makes good headlines that the EPA is choking off jobs and killing the coal industry," said Matthew Vittorioso, credit analyst at Barclays.

"But the real immediate issues pressuring coal companies are cheap and abundant natural gas [replacing the use of thermal coal] and over-leveraged balance sheets."

Bonds from Walter Energy, Alpha Natural Resources and Arch Coal were well under par even before the EPA's emissions proposals were released this week.

Alpha's 6% 2019s, which were around a 78.00 dollar price on May 15, were already down to about 69.00 by the time the proposals came out.

Arch Coal's 7.25% 2021s went from 78.25 bid on May 12 to 69.5 on Monday, while Walter Energy's 11% 2020s are down from 87.50 mid-May to 73-74.00 earlier this week.

"Coal companies' bonds have dropped by about seven points in price since mid-May in anticipation of the EPA regulations," said Jon Sablowsky, head trader at Brownstone Investment Group.

"But the fact that the price of met coal has dropped well below production costs, which has caused companies like Arch and Alpha to eat up their liquidity, has been more of an overhang for these credits than the EPA news," he said.

Many coal companies have been caught out by their exposure to metallurgical or 'met' coal, which is used to make steel.

Met coal prices surged in 2011 as companies leveraged up to buy met coal assets, believing the demand for steel would keep rising in tandem with China's economic boom.

But with met coal prices down more than 50 percent since then, that exposure has put companies in very difficult circumstances indeed.

"Some of these coal companies paid high prices for met coal assets when met coal prices were at US$250 per tonne or more, but now that price is US$112 - lower than the cost of production in some cases," said Vittorioso at Barclays.

"If met coal prices don't recover, EPA regulations won't matter."

BURNING CASH, NOT COAL

According to CreditSights, the continued weakness in the met coal market since March has erased about a year off the length of time that Walter, Alpha and Arch's liquidity will last.

"Walter remains in the worst shape ... with 1.4 years of cash at the projected burn rate, while Alpha and Arch have 3.7 years and 3.3 years of cash, respectively," it said.

Walter and Alpha have extended their lifespan by issuing more debt to build liquidity, but the structuring and placement of the added debt has smacked a bit of desperation.

The drop in Alpha's senior unsecured bond prices happened when the EPA was dominating headlines in the sector, for example, but it also coincided with the company's issue of a US$400m second-lien note in mid-May, which pushed its senior unsecured bondholders down a rung in the capital structure.

To take another example, Walter Energy's US$350m 11% April 2020 payment-in-kind (PIK) deal in March traded poorly from the start, plunging six points in price on the break.

Two investors said left-lead Morgan Stanley had told some portfolio managers that they would only get allocation on a US$200m first lien add-on, which was issued by Walter at the same time, if they also bought into the PIK.

Amid the current turmoil, of course, some investors are starting to see an opportunity to get into the sector.

With the hunt for yield still strong in the market overall, the double-digit yields on these coal bonds will look attractive at lower prices - at least as long as the companies' liquidity holds out.

"I think their liquidity is adequate for the near to intermediate term, so I would be watching for an entry point when I feel the selling pressure has abated," said Sablowsky.

"I'd say the entry point has already been reached on Walter's bond prices, and Arch and Alpha have another two or three more points of downside in the near term." (Reporting by Danielle Robinson; Editing by Marc Carnegie and Shankar Ramakrishnan)

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