Warrior Met Coal, a rising star in the metallurgical coal industry, is enjoying success due to strong operational performance and a thriving market for their premium low-volatility coal. Their recent earnings call presented a company poised for continued success, supported by their ambitious Blue Creek growth project, which is set to start producing development coal later this year. However, beneath this positive narrative lies a hidden risk, a potential weakness that could significantly impact Warrior's future profitability and their ambitious plans for Blue Creek: the looming threat of declining price relativities for their high-volatility coal.

The company recognizes the current market trend where premium low-volatility coals, like their flagship Mine 7 product, command a significant price premium over second-tier high-volatility coals, such as their Mine 4 product. This is evident in the price relativities, which have dropped from the low to mid-90s in 2022 to the mid-80s in 2023. While Warrior expects this trend to continue in the near term, with low-volatility coal retaining its premium status, there's a significant risk that these price relativities could further decline, potentially reducing the profitability of Mine 4 and, consequently, the Blue Creek project, which is anticipated to produce mainly high-volatility coal.

The earnings call transcript reveals a subtle but crucial shift in Warrior's sales strategy, a move that exposes them to this very risk. In 2023, their sales mix was 59% contracted and 41% spot. For 2024, they anticipate a more favorable ratio of 75% contracted and 25% spot. While this appears to reduce their dependence on the volatile spot market, it masks a geographical shift that could prove unfavorable. Dale Boyles, Warrior's CFO, estimates that 65% of their total 2024 sales volume will be directed to the Pacific Basin, primarily India and Southeast Asia, compared to just 35% to their traditional Atlantic markets.

This shift towards the Pacific Basin coincides with a notable increase in the proportion of CFR (Cost and Freight) sales, where the seller is responsible for the cost of freight. This is especially important for Mine 4, where Boyles estimates that "at least 50%" of the coal will be sold on a CFR basis. In contrast, Mine 7 sales are predominantly FOB (Free on Board) port, where the buyer takes on freight costs.

This convergence of factors – rising CFR sales, a growing focus on the Pacific Basin market, and potentially declining price relativities for high-volatility coal – creates a scenario that could significantly impact Warrior's profitability. Here's a hypothetical illustration of the potential magnitude of this risk:

Scenario:

Assume the PLV FOB Australia index averages $260/short ton in 2024, as per Warrior's cost guidance. Assume an 85% capture rate on Mine 7 (low-volatility) sales, resulting in an average net selling price of $221/short ton. Assume Mine 4 (high-volatility) sales achieve a price relativity of 80% to the PLV index, resulting in an FOB port price of $208/short ton. Assume average freight costs for CFR sales to the Pacific Basin are $50/short ton.

Impact on Mine 4 Profitability:

This scenario shows how freight costs on CFR sales can significantly reduce margins on high-volatility coal. If price relativities deteriorate further, the margin compression could become even more severe. Considering that Blue Creek is expected to add 4.8 million short tons of high-volatility coal to Warrior's production profile, a large portion of which is likely to be sold on a CFR basis to the Pacific Basin, the potential impact on overall profitability is considerable.

The Blue Creek Gamble:

Warrior's choice to develop Blue Creek amidst these market dynamics can be viewed as a strategic gamble. They're relying on the continued strength of the metallurgical coal market, especially for premium low-volatility coal. They're also wagering that the price relativities for high-volatility coal, while declining, won't fall substantially. However, this gamble is based on assumptions that may prove inaccurate:

The Hidden Risk:

While Warrior emphasizes their robust contract volume for 2024 and their aim to maximize margins, the potential vulnerability stemming from the combination of CFR sales, Pacific Basin market reliance, and declining price relativities for high-volatility coal remains largely unaddressed. This concealed risk could jeopardize their anticipated profitability and cast uncertainty over their ambitious Blue Creek project.

It's vital for investors to recognize this potential weakness and assess its implications for Warrior's future. The company's success depends not only on the overall strength of the metallurgical coal market but also on the delicate balance of price relativities between low and high-volatility coal. As Warrior focuses on the Pacific Basin with their new Blue Creek production, the fluctuations in price relativity could be more challenging than anticipated.

Projected Sales Volume by Region

"Warrior Met Coal is heavily investing in the Blue Creek project, aiming to significantly increase high-volatility coal production. A shift in sales strategy towards the Pacific Basin increases exposure to CFR sales and potential margin compression on high-volatility coal. Declining price relativities between low and high-volatility coal pose a significant risk to the profitability of Mine 4 and the Blue Creek project. Investors should carefully consider the potential impact of these factors on Warrior's future financial performance."

"Metallurgical coal, also known as coking coal, is a vital component in steel production. It's used to create coke, a high-carbon fuel that's used in blast furnaces to smelt iron ore."