Clean or dirty, coal is here to stay

Wed Jul 23, 2014

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Adam Bain of Stormont explores a "not too shabby" method for investing in coal.


 
 
By Adam Bain

"It is easy to find fault, if one has that disposition. There was once a man who, not being able to find any other fault with his coal, complained that there were too many prehistoric toads in it." - Mark Twain

There are few industries that are viewed as negatively by the public and investors alike right now as the coal industry. While there's plenty to find fault in with respect to coal and fossil fuels in general, there is a lot more to the coal story than the media's version of "big bad coal" vs. Obama and the EPA. In any case, the turmoil and negativity in the industry has created some interesting investment potential. Sometimes, the best places to look for opportunities are those that are the most hated, especially if the hate comes from some emotional place - Save the Planet! I think we all want cleaner air and a world that looks like an Ansel Adams photo. Lofty ideals however, are a luxury and are often discarded, or at least postponed, in favor of more economically convenient decisions. The below writing is not an examination of the efficacy of the above statement but a nod to it as a truism.

Global Steam Coal

The coal business is a fascinating one, and one that only a small subset of investors seem to know anything about. There are numerous types of coal, encompassing everything from peat to graphite, but broadly, when it comes to burning coal to generate heat/energy that's then disseminated into our houses and factories, we're talking about thermal or "steam" coal. Coal is the largest source of energy on the planet. It accounts for about 40% of energy production globally and about 40% here in the US. Despite all the negative press and rhetoric from the White House, it was the fastest growing fossil fuel last year, up three percent from the prior year. By far and away the largest consumer of coal is China, which last year used a whopping four billion tons, which is more than four times that of the U.S. That trend does not look like it's slowing down either. Bloomberg projects that 343-450 gigawatts of new coal generation will be built in China in the next fifteen years, more than the total capacity of the entire U.S. coal base (300 gigawatts). According to science journalist Charles C. Mann, China's power needs are so big that even if it installs solar and wind facilities faster than any other nation has ever emplaced them, the nation will still bring online one large 500 MW coal plant *per week* from now until 2030. Skeptics might say, "Well, that's a developing country, we in the Western world are more enlightened than that." That, however, would not really be an accurate statement. "Germany, though often celebrated for its embrace of solar and wind energy, not only gets more than half its power from coal but opened more coal-fired power plants in 2013 than in any year in the past two decades," wrote Mann. Coal is also growing here in the U.S., off from its recent 2012 lows. One of the biggest drivers to growth being the expansion of the mining operations in the Illinois Basin. Fortunately, the U.S. has no shortage of coal. Estimates are that the U.S. holds more than 25% of the world's recoverable coal supply, which would likely be enough at current consumption levels for the next 250-300 years.

Media Battle vs. Real Battle in U.S. Coal

If you google coal or type "#coal" into your twitter feed, most of what you'll get is arguments from the anti-coal lobby citing this or that negative "fact" relative to the environment or a defensive position from coal supporters, usually pointing to China as the larger problem or highlighting the jobs and benefits created by cheap energy. The purpose of this writing is not to engage in that argument but to try and understand what the real drivers really are. In this case, the political components of certain powerful lobbies and a more believable motive emerge. Not surprisingly, the real drivers to coal consumption are less influenced by some altruistic movement and much more sensitive to the price of natural gas, coal's main competition as an energy provider. Therefore, the natural gas companies like Chesapeake Energy may stand to gain the most from EPA and government restrictions on coal burning, making energy production via coal more expensive. Additionally, a mild winter in 2012/2013 and the massive increase in supply from much publicized shale exploration drove gas prices to very low levels. Both increased cost of production (a lot of dumb money chased smart money into CAPEX then and is not returning at a rate supportive of those low prices levels) and a more aggressive winter are turning things back in favor of coal.

Additionally, there are some interesting dynamics between coal regions, notably where it is mined, its sulfur content, where it will be used, and how it gets there that are playing into the politics. There are a couple interesting theories behind the drivers here:

The Feds - Much of the coal in the Western part of the U.S. is low sulfur, low BTU coal. Which means that the regulations designed to mitigate the sulfur-related byproducts on coal burning are more easily met by burning low sulfur coal. Unfortunately, that coal also often has lower BTU, so more of it has to be burned to get the same amount of energy. Therefore, is it surprising that regulations incentivized power producers to use Western coal when the Federal government collects a 12.5% royalty on much of that coal (they sold surface rights to homesteaders out west but in many cases maintained mineral rights)?

The Railroads - Along the same lines as above, if power producers are incentivized by regulation to use Western coal, it must be sent to them via rail. Everyone's favorite investor, Mr. Warren Buffett owns BNSF, the second largest transporter of freight in the country. Being as smart as he is, it's not much of a leap to assume Mr. Buffett is well aware that one byproduct of current regulations is the necessity of his railways. Something like 40% of BNSF freight is coal, most of it from the Powder River Basin (PRB).

Keystone XL - Again, Mr. Buffett benefits from Obama's rejection of the pipeline proposal as the absence of the pipeline means BNSF gets to haul much of the material out of the Bakken. Between oil from the Bakken and coal from the PRB, there are much publicized delays on deliveries. Therefore, much additional capital has been put into expanding capacity for the rails. Conveniently, this administration is guaranteeing ROIs on CAPEX for big rails (via the TIGER grant program).

Illinois Basin (ILB)

The Illinois Basin, which basically consists of southern Illinois, southern Indiana, and northwestern Kentucky, has been the shining light at the end of the dark tunnel that is the coal business in recent years. Most of the coal that comes out of the region is high-sulfur, high BTU coal. So, it's very good for generating heat/power, but also on the "dirtier" side. However, that is about the extent of the drawbacks. As with all commodities, the major price drivers are quality and cost and the two major cost inputs for coal are extraction costs (mining) and freight. The U.S. coal picture breaks down as follows:

 

As such, ILB coal becomes very attractive, especially for users capable of curbing the sulfur output and/or those less concerned with sulfur output. Notably, about 1/3 of ILB coal is being shipped abroad as it's easily tossed on a barge and sent down the Ohio/Mississippi Rivers. The export number for Illinois coal alone has grown from 2.5 million tons in 2010 to more than 13 million tons in 2013. That coal is increasingly bound for Europe and South America, though with expansion of the Panama Canal underway, the viability of further coal exports to Asia is also growing. With more than a 100 coal-fired power plants reportedly being built in both India and China, the prospects for ILB burn bright.

Opportunity Set

The above outlines a case for coal growth in general, and specifically ILB coal, but the likely path to investment in the industry is much less a commodity play and much more of a business financing one. Due to environmental scrutiny, cheap natural gas, and to a smaller degree the expansion of clean energy alternatives, coal miners/producers have taken their lumps at the corporate level. Many of the major players in the industry (Peabody, Arch, Westmoreland, Murray, Foresight, et al) have made moves to purchase competitors, mines, and other assets to gain market share and increase shareholder value. Add that CAPEX to the already capital intensive business that is mining and you have companies with quality assets, but cash-short balance sheets. Again, given the aforementioned public scrutiny on the business as a whole, capital infusion (either debt or equity) via traditional public markets is a poor option. Producers could raise capital by selling assets, but that defeats the purpose of the previous CAPEX if they don't get to actually mine the coal. So, selling to a competitor is a poor option as well (unless of course you could get them to pay too much for a weaker asset). That leaves the potential for third party investment in the form of what is effectively a sale-lease back. The investment would work as follows: Third party buys mine from ABC Coal. Third party then leases rights to mine and sell the coal back to ABC coal in exchange for royalties (a percentage of price/ton on sold coal). In many cases, ABC enters a long-term contract with a utility to sell the coal at a specific price (thus, eliminating much of the price risk of the coal itself). Third party collects royalties on coal being bought in long-term contracts from utility (generally carrying a much better credit rating than the miner itself) for the life of the mine. While the ROI on this type of investment is clearly dependent on many of the above inputs, the ballpark numbers for investors are a 15% to 20% per annum return for +/- 10 years. As my father would say, "not too shabby," for effectively loaning money to a highly rated utility.

"Every basket is power and civilization. For coal is a portable climate. It carries the heat of the tropics to Labrador and the polar circle; and it is the means of transporting itself whithersoever it is wanted. Watt and Stephenson whispered in the ear of mankind their secret, that a half-ounce of coal will draw two tons a mile, and coal carries coal, by rail and by boat, to make Canada as warm as Calcutta; and with its comfort brings industrial power." - Ralph Waldo Emerson

Adam Bain is founder and managing partner of Stormont Capital Advisors, a business development consulting firm serving alternative asset managers. This column was adapted from a client communication.

ISSN: 2151-1845 / CDC10004H