“The interval between the decay of the old and the formation and establishment of the new constitutes a period of transition which must always necessarily be one of uncertainty, confusion, error, and wild and fierce fanaticism.” John C. Calhoun
And so it is with the coal industry. There are varying opinions on the outlook for thermal coal. Whether one is an optimist or a pessimist – or somewhere in between – the reality is that life is set to get even tougher for coal producers.
One school of thought is that changing environmental attitudes combined with stricter environmental legislation, will lead to further swift and terminal damage to coal’s reputation as an appropriate 21st century energy source.
Another view argues that thermal coal will remain an essential component in the energy mix of many countries (particularly emerging ones). There’s logic behind both arguments – however, recent developments suggest that coal’s future might be a lot more problematic than rosy.
Let’s begin with the collapse of the largest US coal miner, Peabody Energy, in what is a glaringly obvious warning sign for investors and coal operators the world over. Peabody noted in its filing that its competitors have suffered as well. Some 50 coal companies have filed for bankruptcy, according to Peabody’s estimate. Those include most of the top producers, such as Arch Coal, Patriot, Alpha Natural Resources and Walter Energy.
Peabody failed to make interest payments on its debt and warned that it was likely unable to continue as a going concern prior to entering bankruptcy protection. The miner has more than US$10 billion in debts and its shares have crashed by 99.8% over the past 5 years, with its market cap shrinking from $20 billion at its peak in 2011 to just US$34 million yesterday.
"The announcement shouldn’t come as a surprise to anyone," Rapid Ratings International CEO James Gellert, whose firm has been tracking Peabody, says. "Peabody has been on a downward trajectory for the last few years, and between low commodity prices, increased regulation and a crippling debt weight, it was only a matter of time before they filed for bankruptcy."
Major Domestic Headwinds
Over the past decade, the U.S. shale oil and gas boom has flooded the domestic market with cost-competitive natural gas, swiping market share away from coal and giving utilities alternatives. The U.S. Energy Information Administration has projected that 2016 U.S. coal production will equal about 752.5 million tons – representing a 25% decline from 2014.
During 2015, U.S. utilities burned almost exactly the same amount of coal as natural gas, with each commodity representing 33% of U.S. electricity generation, according to the EIA. The EIA projects that coal will still deliver 20% of U.S. electricity by 2040. But as recently as 2008, the U.S. burned more than double as much coal as it did natural gas, illustrating coal’s swift decline.
The commodity is also facing intense pressure from regulators and the Obama administration, which has erected regulatory obstacles that block coal-fired power plants because of their contribution to climate change.
Life for Coal Companies Getting Tougher
Coal is without doubt becoming less acceptable within the construct of modern Western world economies and this will inevitably impact upon demand – but at the same time thermal coal demand will likely continue to increase over the near-to-medium term, as a result of population growth and corresponding energy demand escalation in emerging economies.
The key issue however is that life is set to become increasingly more difficult for the companies that actually mine and produce thermal coal, irrespective of the overall demand outlook. This means that investors, for a range of reasons, are most likely going to be less inclined to invest in thermal coal producers.
Thermal coal plays are under all sorts of pressure from superannuation funds and other key investor groups to reduce, or ditch altogether, their coal-related activities. Companies are experiencing a rush of major ethical investors heading for the exits, which in turn has compounded the relatively poor share price performance of coal plays as a direct result of weak prices and softer demand.
Just last week, Australia’s two largest ASX-listed specialist "ethical investment" wealth managers, Australian Ethical and Hunter Hall Investment Management, vowed to completely divest from fossil fuels. The two fund management firms, each with $1.4 billion and $1.1 billion respectively under management.
Companies are also finding it increasingly difficult to source bank financing for new coal projects, with many financial institutions subjected to heightened shareholder pressure in this regard. Adani’s proposed Carmichael coal development in Queensland is just one very high-profile example of a major coal project where banks/financiers have gotten cold feet in terms of investment.
Coal producers are also under growing pressure from competing primary interests, most particularly the farming industry, in a battle over environmental credentials and the sharing of natural resources such as water – which in turn has also attracted the support of environmental groups and in many instances governments. In fact governments are typically viewing coal mining as potential vote-losers.
Even the most open-minded and objective of investors are therefore hard-pressed to view investment in a coal company as a prudent or investment choice. Investors will therefore increasingly seek to identify ‘easier’ or more appropriate opportunities where they can invest their funds.
Therefore, even those thermal coal companies that somehow manage to generate robust earnings will find that their business achievements won’t be properly reflected in terms of share price appreciation. This situation will in turn provide further disincentives for investors with respect to the sector.
Thermal coal companies will increasingly be faced with challenges and headwinds from almost every direction, as they look to maintain and grow their business activities.
Thermal coal is currently used to generate around 40% of the world’s electricity; however, the aggregate hides a distinct shift away from coal in a number of advanced economies. Over the past decade this has been more than offset by a sharp rise in coal usage from China.
Coal-fired power generation fell within the United States and the Euro-Zone over the past decade, reflecting a move towards cleaner energy sources and a more competitive gas sector. Australia remains dependent on coal-fired electricity generation, but we too have diversified our energy demand and supply over the past decade.
China
The major turning point for the coal market though sits with China, which has signaled a clear shift towards cleaner energy sources.
As part of its 12th Five Year Plan, “the Chinese Government announced plans to reduce energy use per unit of GDP by 16% from its 2010 levels by 2015, and reduce coal’s share of energy consumption from 68% to 65%”. More recently, the National Development and Reform Committee announced bans on coal that does not meet certain ash and sulphur content requirements.
Based on the need to address and adapt to climate change (and assuming that Chinese authorities achieve their goal), the coal sector may be on borrowed time as a viable energy source. At the very least, the coal market will be a very different beast ten years from now.
India
Now let’s turn our attention to India, which has been promoted optimistically as one of the largest growth markets for thermal coal for the next few decades. Contrary to general opinion, a decline in thermal power projects and a rapid up-scaling of renewable-energy projects indicates that India’s appetite for coal is actually dwindling.
Interestingly, even as domestic coal production has risen, growth in new thermal power projects is showing a decline for the first time in the last three years. According to data sourced from government departments by Reuters, growth in newly-installed thermal power capacity was recorded at 8.78% in 2015, down from 8.99% in 2014 and 12.48% in 2012.
In sharp contrast, growth in new capacity in the renewable-energy sector rose to the highest level ever at 18% during 2015. A senior official with the country’s largest power producer, NTPC Limited, said that the “pipeline of new thermal projects has completely dried up” and "no new plant are scheduled to come on stream in 2016”.
At the earliest in 2018/19, 10,000 MW of new thermal capacity could come on stream in the form of ongoing projects – delayed by varied reasons such as conclusion of fuel supply agreements, environmental clearances and/or scrimping of funding options by project promoters. Ultra-mega power projects (UMPPs), planned by the government were also turning out to be “pipe dreams” according to the official, with no such new projects put up for bidding since 2014.
Ominously, even UMPPPs put up for bidding in 2014 had all fallen through, with all successful bidders subsequently withdrawing from the projects. In sharp contrast, in the renewable space the country was poised to commission 2,000 MW of solar power between January and March 2016, equal to the total generation capacity added in the full year of 2015.
While the impact of these trends in the power generation sector on medium- and long-term coal demand consumption patterns was not readily available from government departments, current empirical data indicate that the ‘coal rush’ in consuming industries had eased, giving way to stockpiles at both the producer and consumer ends.
So the evidence in both China and India, two of the industry’s biggest consumers, indicates that thermal coal consumption growth is actually falling. This is enormously significant, because whilst industry watchers are acutely aware of a changing energy balance in Western nations, it has generally been accepted that emerging economies with their burgeoning populations and related growth in energy requirements, would continue to drive coal demand growth – perhaps for the next three to four decades.
Instead, government action in the world’s two most populous nations related to reducing emissions and prompting initiatives in the renewable sector, looks likely to significantly reduce the time period until we reach peak thermal coal demand.
Conclusion
Where it gets ugly for thermal coal producers is that the world has turned against coal at the same time that new production has come online. Coal production skyrocketed in response to elevated commodity prices, with some projects justified on the faulty assumption that Chinese demand would continue to grow at existing rates indefinitely.
It reflects the risks associated with new mining projects. The significant lag between project approval and completion means that miners are often dealing with a very different set of circumstances by the time they are ready to begin operation.
Australian coal miners are not among the lowest cost producers – though a weaker Australian dollar is certainly helping – which points to considerable consolidation or perhaps even bankruptcy within the sector over the next few years.
So the bottom-line is that irrespective of whether you are a climate change believer or skeptic, life is inevitably set to get even tougher for thermal coal producers, which will inevitably negatively impact upon investor appetite for coal plays. We will therefore continue to avoid the sector in terms of our equity coverage.
