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Surviving Coal Mines - what operational parameters have changed for surviving coal mining industry with depressing financial results

A lot is happening in the coal mining industry of late, most of which is quite painful for the stakeholders involved. There have been mine closures, suspension of coal fired power plants, bankruptcies and layoffs, to name a few. The coal industry today is stricken with number of interlinked problems, all at once: price decline, overcapacity, continuous demand contraction, haunting indebtedness, environmental liabilities and inadequate profitability.

The demand for coal has increased continuously over the last decade (2003-2013), though it slowed down a bit during the last few years, particularly in 2015. It is expected to grow at a further slower pace in near future. Both steel and power sector (the key industries driving coal demand) are responsible for this decelerating demand. With strict government regulations to curb GHG emissions and enough availability of natural gas (fracking technology can be blamed for this), demand for coal for power generation has taken a big pounding. This has led to many coal fired power plants being shut down. Moreover, with steel industry itself suffering with problems of overcapacity, demand from this sector has also declined. Demand pressure on coal from all the directions, has resulted in declining coal prices (by 15-20% since 2010). We believe this is a usual cyclicality associated with different commodities including coal, however this time it's a bit longer and is not expected to rebound any time sooner.

 

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In response to the declining demand, the global coal production has slowed down over the past couple of years. However, the exception to this are the countries whose currencies have depreciated recently. Countries like Indonesia, Australia and South Africa saw their currencies depreciating against the U.S dollar over the last couple of years, making exports cheaper from these countries. This has incentivised the coal players to increase production in these countries. While the global production increased by ~3% since 2010, coal production in Indonesia and Australia increased by ~19% and ~6% respectively over the same time frame.

With overall industry trembling, some companies are shutting few of their mines, while others are forced to file for bankruptcy. A number of US based companies filing bankruptcy under chapter 11 are restarting their operations after restructuring their debt. This implies that filing for bankruptcy does not necessarily mean cut in coal output.

On the financial front, although the industry is running on losses, some companies are still operating with enough cash and liquidity to survive for another few years. The survival of any company depends on 2 key factors - its cost of production and leverage (coupled with the ability to pay its creditors given its debt structure).

 
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As above charts depict, companies like Peabody and Arch coal filed for bankruptcy despite relatively low cost structure, challenged by high debt and almost no ability to pay it off. In fact, till a few years back, Peabody was considered better positioned than peers because of its geographic diversity, quality of assets and low cost structure. But its debt driven expansion into Australia, followed by the slump in coal prices, reversed the whole situation for this largest coal player. Foresight is another example which runs at relatively low cost but very high debt. It was fortunate enough to escape bankruptcy recently, as its debtholders agreed on an out of the court settlement to restructure over $1.25 billion of its debt.

On the other hand, companies like Adaro and Alliance resources operate on relatively higher per tonne production cost and are feeling the pressure on their profitability, however, are able to meet their debt obligations because of low leverage.

This altered panorama of the industry has not only changed the financial position of the players but has also transformed the way one analyses this industry. For example - from a financial perspective, one is now more concerned about the leverage and survival rate than the profitability of these companies as most players are operating at losses. Similarly, parameters like injuries, illnesses, and fatalities are now being replaced with employee cut down as the industry is now swamped with layoffs.

Mid and long term outlook

Given the elongated bearish cycle this time, nobody is sure when will the industry revive, however some green-shoots are emerging in the demand-supply numbers. The decline in demand has pushed the Coal industry into surplus since 2010. Fortunately, this demand supply gap has narrowed down significantly during the last 2 years (from 236 mm MT in 2012 to 40 mm MT in 2015).

This reduction is due to substantial number of mine closures and production suspension coupled with slow, but incessant growth in demand. This sluggish recovery, might soon result in industry reaching close to demand supply balance. However, once this surplus is removed, growth in demand will motivate companies to resume their suspended production. If the production rate exceeds the demand, prices will again start to tremble. Hence, for the industry to bounce back, significant growth in demand is the key over the medium term.

This interim improvement in demand (mainly driven by sudden increase in imports by South Korea in last couple of months) have led to the upsurge in coal prices. Newcastle coal price increased from $53 in Jan 2016 to $59 per MT in July 2016. Similarly, Richards Bay coal price improved from $49 to $60 per MT during same time frame. However, given the slow growth in emerging as well as developed economies and globally low oil and gas prices, a further substantial increase in coal prices look unlikely, at least in the near term.

From a long term perspective however, coal demand is expected to improve as power hungry emerging economies would continue to look to cheaper and sustainable fuel source wherein, coal fits the best. Also, while the so-called shift in energy mix towards natural gas and other renewable sources is being discussed for long, it may actually take decades to get implemented. We agree, the demand growth for coal towards power generation is anticipated to go down by 2030, but still it will account for 30-40% of the overall electricity production. Additionally, recovery of the steel industry is also likely to boast demand and hence prices of coal in coming years. We believe, by the time this will happen, the face of the industry would have changed significantly as lot of consolidation will take place and it would be interesting to see, how players are able to survive through this gloomy tide.

         

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