Profiting from the tightness in energy markets

In this week’s episode of Talk Ya Book, Emanuel Datt sits down with Chris Judd to discuss the global energy crisis, underinvestment in some key energy commodities, and why he thinks the thermal coal trade still has some way to go.

Transcript

Chris Judd:

Well, Emanuel Datt, thanks very much for coming back on Talk Ya Book, fresh from holiday. I thought before we get into your stock pick of choice, if you could talk to us about Datt Capital and how you guys look to invest.

Emanuel Datt:

Yeah, sure. Thanks Chris. So Datt Capital, we're a boutique Melbourne based fund and we're an absolute return fund that focuses on achieving double digit returns every financial year. We've been doing it very successfully and we've more than almost doubled our promise to our investors since inception, which is a great place to be.

Chris Judd:

And you manage to do the double digits last financial year, I believe, which is no mean feat, is that correct?

Emanuel Datt:

Yeah, absolutely. We achieved a positive financial return over the last financial year in the low teens and since inception we've done about 17% per annum.

Chris Judd:

That's awesome. What stock did you want to talk about today?

Emanuel Datt:

Today I wanted to talk about Whitehaven Coal, which is an ASX-listed thermal coal player.

Chris Judd:

Maybe before we get into the nuts and bolts of Whitehaven, talk to us about the thermal coal market overall, maybe illustrate just how strong it's been over the last 12 to 18 months for those that haven't been following it as closely.

Emanuel Datt:

Yeah, sure. I think that probably the best place to start with, is to talk about the difference between thermal coal and met or coking coal. Effectively mets and coking coal is used primarily for steel production. Thermal coal's typically used for power generation. A lot of investors get that confused or don't really understand what the difference is. Effectively Whitehaven, as I mentioned before, it's a thermal coal producer. It's customers are primarily East Asian customers, so Japanese, Korean power plants that rely on high quality thermal coals. Don't sell anything to China, which is a good place to be.

Emanuel Datt:

I think that a really interesting dynamic that we've seen just over the last month or so, has been typically steel making coals, coking coals have been priced a lot higher historically than thermal coal, but now we've seen over the last month that that dynamic has changed. We're actually seeing met coals, being priced significantly cheaper than thermal coals, which really tells you a lot about how the supply and demand mismatch sits at this point in time. I'm actually seeing some met coals that may be able to be sold into thermal markets, starting to rotate towards being sold as thermal coal rather than being badged as they are historically.

Chris Judd:

Which speaks to just the tightness in energy commodities at the minute. We've obviously seen it in oil, albeit coming off a little bit overnight and the whole of Europe, and I guess the whole of world, wants to decrease their reliance on Russian gas. Given that nuclear power plants, at quickest, take 10 years to build, Europe wants to get off Russian gas and the solar and wind, whilst it can produce power, can't produce the quantum of power or the reliability over the 24 hours of a day that traditional power sources can. We're seeing Germany add thermal coal plants. China running a lot of thermal coal plants. Is that the logical step for the next 12 to 18 months while everyone really tries to decrease their alliance on Russian gas, that thermal coal plants will increase more so than perhaps was initially thought they would at this phase of their existence?

Emanuel Datt:

Yeah, absolutely, and I'd probably say that the situation will persist for far longer than 12 months. If Germany are going against their own previous ESG principles, as you mentioned, by restarting previously moth balled thermal coal power plants, then I think that really tells you that the situation is probably going to persist for longer than we probably expect. Also, I guess the other point is that cheap Russian gas has been really the basis of the EU economy for quite a long period of time, so I think that even if peace was to suddenly break out or some peace accord to be broken between Ukraine and Russia, I don't necessarily think sanctions will be lifted in any sort of form for some period of time. Ultimately I think the EU had clearly trying to move away from its past reliance on cheap Russian gas and move into other forms of energy. Nuclear is obviously one which I think is fairly obvious, but as you point out, it's going to take a long time to deliver these alternative forms of power.

Chris Judd:

There's a rule with commodity investors that you buy commodity stocks when they're high PEs and you sell them when they're low PEs, because it usually means they're about to mean revert as new supply comes on to squash the price. Is the dynamic in commodities like oil and thermal coal, a little bit different where they're almost... They're not allowed to be owned by many institutions due to mandates or ESG conflictions, and certainly a lot of banks now are unable to finance projects. Do you think it differs to that traditional rule about once you see a resource stock being on a low PPE that's probably time to think about selling it?

Emanuel Datt:

Yeah, absolutely. Well, I think as you point out, I think that a lot of investors and professional investors at that, as you say, may be unable to invest in these companies due to mandates or funder mandates, I should say. I think someone did some analysis around how funds window dress, so they might buy exposure to these companies at the start of the month and then sell prior to the month end, so it doesn't actually show up on their books when they report to their investors. It's a bit of a cheeky way, but I think that truly does demonstrate how... If you are investing in these commodity exposures that are being priced extremely cheaply, many cases, less than one times free cashflow at spot prices. I think that as an investor, you're probably missing out on something if you don't have some exposure to these opportunities.

Emanuel Datt:

Going to your point about buying when PEs at a cyclical high and selling when they're low. Sure, I think that may have worked in the past, but I think you really have to be flexible and understand what the rationale behind... Why this has worked perhaps in the past, but why I don't think it's necessarily going to work in the future. Just to give you an idea about the moves in thermal coal in particular. In March 2020, we had thermal coal priced at 50 bucks a tonne, well, thereabouts. This is in U.S. dollars. Today we see it at close to $400 a tonne at the front end. So for prices to move by that quantum and sustainably stay above 300 bucks, I think it's been for the last four or five months, that really does tell you that there's one, of the demand for these commodity products, but two, that there's just an object lack of supply. And as you mentioned, I think a lot of it has been due to these ESG considerations, which make permitting of the new mines very difficult.

Emanuel Datt:

In Australia itself, the average length of time it takes to permit a new coal mine is in excess of 10 years in many cases. It's a tap that can be suddenly turned on, but then again, there are permitted development assets, but these are reasonably difficult to finance, I'd say, in this sort of environment. That's why we're seeing a lot of these coal players, they're actually not even bothering to push development along because A, they're not assured of development financing, but also when these assets are delivered, if they've already got producing assets that are being priced of one times free cash flow, then what's the point in taking all that development risk and cost risk? You'd rather just pass on your cash earnings through to shareholders, whether it be buybacks or through dividends or whichever way the company chooses to, I think from a capital allocation point of view, why would you invest in something that's going to be valued at such a extremely low multiple?

Chris Judd:

I know no one's got a crystal ball, but when you model out these companies, what input do you use for thermal coal going out for two to three years?

Emanuel Datt:

Well, you can use transparent markers. The future's market is one obvious point to use prices for, but even... I think the really attractive element of this thesis is that you could assume the commodity price has been cut in half and given the extremely low valuations of these various thermal coal players, it really barely moves the needle. If they're trading at one times free cashflow at current spot prices, if the commodity price itself is cut in half, they might be trading it two times free cash flow, which is incredibly cheap to any other sector.

Chris Judd:

It's like a nightclub multiple, you just don't really see a lot of the listed companies with those multiples, do you?

Emanuel Datt:

Exactly. Exactly. Even at half the commodity price... I mean at current prices, Whitehaven has a gross margin of probably close to 80% or even over 80%, which is almost like a software company gross margin. It's just incredible that even if the commodity price was cut in half, these would still be wildly profitable either way you look at it.

Chris Judd:

Let's maybe dig into Whitehaven as specific. Whereabouts are they're producing assets.

Emanuel Datt:

Yeah, sure. So Whitehaven have three main assets. These are all in New South Wales. So Maules Creek is the flagship mine. Then you've got a couple of other smaller assets in Narrabri and Canada. I think that Whitehaven have a real advantage with the assets being located in New South Wales. You've probably seen, I think it was last week or the week before, Queensland actually enacted or increased royalties on existing coal mines. I think that really is detrimental to the industry as a whole, because as I was talking about in terms of the swings and prices, in the commodity prices itself, these industries are and have been historically very cyclical, but to get through the tough times, you have to be able to capitalise in the good times. If the government's taking a big chunk of that upside, then it really makes it a lot more difficult going forward.

Chris Judd:

It just speaks to a supplier response that's going to be slow to come again. It's just another hand break if you like, isn't it, to allocate as a capital looking to try and potentially fix the lack of supply in this area?

Emanuel Datt:

Yeah, absolutely, and I think that New South Wales is probably a more attractive jurisdiction than Queensland, just because of this royalty interest, but also for companies that are operating in New South Wales, they've suddenly been given a huge competitive advantage. It's no secret that all commodity companies or commodity producing companies are experiencing labour shortages, so if you're a mine in New South Wales, you can effectively pay a lot more to your workers relative to a Queensland located mine or based mine. So effectively the Queensland government has just given a big pre kick to the New South Wales producers. That's our opinion.

Chris Judd:

Talk me through the numbers. What pay multiple does it trade on? Maybe a little bit about their balance sheet and their capital management initiatives?

Emanuel Datt:

Yeah, sure, sure. So Whitehaven at this point, they are totally debt free. Our estimate is that, in terms of pre-tax margins for this last quarter, we estimate that they've probably earned about 1.2 billion dollars, Aussie. This is pre-tax of course. Post tax, you probably assume maybe 800 million. That's for one quarter, I should add to say.

Chris Judd:

On a market cap of what?

Emanuel Datt:

Of a market cap of about just over four bill. More or less one times pretax free cash flow it's trading at or even slightly less. I think that's just incredibly cheap, and I think one thing that is really pleasing to us, is that the company have started to return cash aggressively... Or value aggressively back to shareholders. They're at the tail end of a 10% buyback. I think they bought back about 360 million odd shares on market, and they've actually just recently upsized that to 550 million. They still have a fair bit of capacity left and no doubt, they'll probably start to buy back after they release the next lot of results in a couple of weeks. I just think that that's still just such a small drop in the ocean, given how much cash they've probably generated this last quarter. I wouldn't be surprised to see a lot more aggressive moves in terms of maybe more aggressive off market style buybacks or greater dividends going forward, and it makes it a really compelling opportunity for us, I think.

Chris Judd:

You've been talking about this stock for a long time online at far cheaper levels.

Emanuel Datt:

Yeah.

Chris Judd:

Where do you feel like you are in the trade? Do you feel like you're 50% of the way through it? Do you feel like you're 80% through and you just got 20% of the cream to go? How are you viewing it at this stage, and what's been a highly successful trade for you?

Emanuel Datt:

Yeah, absolutely. I think we started talking about this back in September, October last year, so it's been almost a year, but I think in that time it's been a significant return. Well above 50% to 80% I'd imagine. I think that we are still reasonably early, I'd say. I'd probably say that maybe... Off the top of my head, I'd say we're maybe one third of the way through the trade. I think a lot of that comes down to the fact that, A, earnings have definitely exploded in that timeframe, but we've seen the return in the stock itself has been in the 80% or slightly above, but earnings have exploded by hundreds of percent. I think that ultimately fundamentals have to win out over time, so effectively the next leg up we think will be in the PE or multiple expansion on these significant earnings.

Emanuel Datt:

I think that ultimately the market is perhaps telling us that it's still undecided on whether... On the sustainability of these earnings itself, but I think that each month that goes along, each quarter that goes along, we're just going to get more and more evidence that this situation in the market and for the company itself, is perhaps going to go on for a lot longer than the market is perhaps giving the company credit for. I think that at current pricing, it's highly attractive still. We've been topping up at these prices, I must admit, because it's really just one of the most compelling situations that we've seen ever in our time in the markets, and we are more than prepared to put our money where our mouth is.

Chris Judd:

Other professional money managers that have to manage redemptions and think about monthly performance when they do get a big winner, they might not be inclined to shave some out, maybe more so than a private investor that is prepared to have lumpier returns. Where do you fit in that context, if this runs, do you generally shave some out and use that to allocate elsewhere or with the type of capital you've got invested, are you able to take on that volatility a bit more and hold for a longer term position?

Emanuel Datt:

Yeah, look, we're prepared to hold for the longer term. Ultimately we think that the stock could double from here and still look incredibly cheap and we've seen various sectors and industries go through periods of time where they are perceived as unfashionable, and I think that the coal sector's really just going through a similar phase, but once a sector does come into fashion, that's when you see multiples increase materially. I think probably at that time you might think about taking off a bit of the position, but ultimately as long as the companies keep returning capital, the shareholders and taking care of this, not doing silly things, then that's what we want to see and that's where we want to be invested ultimately. Yeah. I think that just the opportunity itself is just so compelling. I didn't feel any impetus to try and trade around the position too much. I think it's just extraordinary.

Chris Judd:

Thank you, mate. Well, it's a very interest... I think that whole ESG dynamic where people are going to have to perhaps choose between, or understand that climate change is important, as is food security in third world countries, as is people not freezing to death in Europe and probably they're going to have to negotiate perhaps a more balanced approach to that whole ESG dynamic going forward, because energy prices and food prices are just inextricably linked and the potential coming food price looks like it's going to start in three or four months around the world, is going to be pretty horrible. And if oil's closer to 200 bucks, rather than 80 bucks, it's going to be a lot worse for those people. It's an interesting complex time.

Emanuel Datt:

Yeah, absolutely. Also, one other factor to consider is we are seeing interest rate rises pretty aggressively across the board in all these Western economies, so I'd rather have my money parked in something that is returning double digits to investors over a period of say 12 months, rather than sitting in the bank. And just understanding that there probably is a real opportunity cost in not being invested in these sort of exposures, and ultimately as you point out, I think that ESG has made these investments unpopular, but I think that's definitely going to change going forward.

Chris Judd:

Beauty. Thanks very much. Emanuel, thanks for coming back on the show.

Emanuel Datt:

No worries. Cheers, Chris. Thanks for having us.