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To swing or not to swing

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World Coal,

Steve Doyle

The past five years in the coal sector have shown us what happens when coal executives, investment bankers, consultants, equity investors and creditors are wrong in a big way. Other people’s money gets squandered; venerable coal companies file for bankruptcy; too many valiant coal miners lose their jobs; too few coal executives lose theirs. I would like to think that we learn from our mistakes, but my cynical side reminds me that we will probably make similar mistakes in the future. History does not always repeat, but it usually rhymes.

The coal sector’s bet was a binary one: coal demand would grow and it geared up accordingly. But in the seaborne market, coal demand from China has declined by 120 million t since 2014 and China’s exports of steel and coke probably took an additional 30 – 40 million t of annual demand away from the seaborne metallurgical coal market. China’s coal imports could very well decline by another 30 – 50 million t during the course of 2016. Meanwhile, the coal juggernauts had geared up to supply a volume that was even higher than the lost demand. The present price environment is evidence of that miscalculation.

In the US market, the coal producers had factored-in declining demand from utilities due to various EPA regulations, but they had not factored-in how much market share would be captured by the natural gas sector. The revolution in natural gas drilling and extraction not only resulted in much lower operating costs than anyone had expected, it also caused a glut of supply, which could only be rebalanced in the short and medium term by forcing it into the power sector. By the end of this year, thermal coal demand will have dropped 150 million t since 2014. To make matters worse for the US coal miners, utility inventories were so high entering 2016 (approximately 180 million t), the expected drawdown will provide yet another headwind. Adding insult to injury, export demand will have declined by 40 million t during this same period.

Production cutbacks and closures, which began in 2014, accelerated in earnest during 2015 and reached an epic level in 4Q15 and in the early months of 2016. What has captured my attention is from where the most recent cutbacks have been coming: highly efficient longwall operations. Bowie’s closure of the Bowie No. 2 operation in Colorado and CNX’s idling of its new Harvey mine in Northern Appalachia are the most recent examples, but the past few months have included short- and medium-term cutbacks by virtually all of the major longwall operators. Due to the high fixed-cost component of a longwall mine, the incremental tonne has always been considered the least expensive. The current round of cutbacks is the market’s way of saying in a loud voice that low prices no longer matter; it simply has no use for anyone’s incremental supply.

US coal production will probably overcorrect as it attempts to match output to weak utility demand and inventory drawdowns. On the positive side, natural gas demand will gradually grow as new industrial facilities come online to convert the inexpensive feedstock into marketable derivatives, pipeline exports into Mexico expand and LNG exports into the seaborne market start. Natural gas production will level off due to declining drilling in the natural gas fields and from the ailing oil sector, which will generate less associated gas. Natural gas prices, in turn, will finally recover to the degree that annual utility demand for coal could be a sustainable 670 million t.

Can the US continue to play its historical role as swing supplier to the seaborne market? After all, the export infrastructure remains intact and, from a cost perspective, the surviving coal sector has never been leaner, consisting mainly of highly efficient longwall operations in the Illinois Basin, Northern Appalachia, Montana and Colorado/Utah, and low-cost surface mines in the Powder River Basin. The answer is yes, but I am uncertain at what price. Depending on weather and natural gas prices, the US utilities could have occasion to call on a portion of their coal-fired generation fleet’s unused capacity, which could easily consume an additional 60 – 80 million t. In the seaborne market, a supply event (Big Wet III?) or a demand event (poor hydro output in China?) could easily create an equivalent shortfall, of which a portion could be supplied by the US. If significant demand from the US utility sector or the seaborne market materialised, coal companies would understandably command higher prices to bring any ‘flex coal’ to market. However, if the US and seaborne high demand scenarios coincide, coal prices have the potential to skyrocket.

I have no doubt the major exporting countries can serve seaborne demand in the long-term with little help from the US; however, history has taught us the speed of coal demand is always much faster than the speed of coal supply. Price volatility is the result of this disconnect and the rewards will go to those who are currently preparing for that inevitability.

Note: This article first appeared in the April 2016 issue of World Coal.

About the author: Steve Doyle has over 30 yr of experience in the coal trading business, founding Doyle Trading Consultants in 2002. He is now President of BtuBarron LLC.

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