What can the US oil and gas business learn from the coal bust?
It might be tempting for U.S. oil players — particularly the upstream segment, still dominant though currently suffering — to dismiss the thought that the near-total crash of the U.S. coal business holds any lessons for them, with prices currently creeping back up from historical lows. Coal is the smaller, dirtier, older sibling, right? It does not operate on an enormous scale, produces no gigantic fortunes and has little effect on international politics (outside the realm of climate change debate). Unlike its younger, wealthier brother, coal is not a globally traded, ultra-high-visibility commodity that starts wars and shapes nations.
Yet from a business point of view — and from an investor’s perspective — the situation in the coal industry offers plenty of potential lessons to consider. And as U.S. oil production (at least the tight or “shale” variety) has once again become a local business, and with exports possible, the parallels are becoming more evident every day.
Both active and passive investors should take notice because many traditional energy analysts may be uncomfortable even conceding that there has been a coal bust. But the facts remain: Coal production has dropped almost 20 percent from peak levels, despite an increase in exports to almost 10 percent of total and too little low-cost transport available to further increase that number. January’s production of 59 million short tons was the lowest since 1983, during a recession.
Major players such as James River Coal (OTCMKTS:JRCCQ) and Arch Coal (OTCMKTS:ACIIQ) are bankrupt, and others are worth a fraction of their value five years ago. The Dow Jones U.S. Coal Index is at a record low, 98 percent below the 2008 peak and 85 percent below the 15-year average, in nominal terms. Employment in coal has dwindled consistently since the Reagan years, incidentally flattening in recent years under Obama. And plummeting prices since 2011 have exposed an industry previously buffered by long-term contracts to the new reality. With essentially no operating income, its power industry customers disappearing and more than 60 percent of remaining power plants more than 40 years old, coal can no longer live in denial of its grim outlook.
So, what lessons can the oil and gas business — and energy investors — learn from all this?
- Don’t blame the regulators or the climate change “alarmists.” The EPA is a factor, as some of the Clean Air Act requirements included expensive upgrades that industry fought and delayed for many years. But in the modern coal crisis it is the Mercury and Air Toxics Standards announced in 2011, a full 13 years after the original deadline, that are the primary driver of power plant closures to date, particularly set against the background of an aging and inefficient fleet that is not worth additional investment anyway. If the coal industry and its primary customers — utilities — had not delayed plant upgrades for decades, using funds to lobby for grandfathering older power plants rather than to improve the fleet, the coal industry would potentially have far more customers today.
Companies that are busy blaming regulators for all their troubles and not carefully tending their assets are not doing their job.
- Understand and be part of fuels competition. Few coal companies took natural gas seriously over the past 10 years or so, a period that began with record profits and valuations. They were blindsided by the enormous increase in supply and the new extraction economics of fracking. Elsewhere in the world the coal industry itself is a major gas supplier — of coal-bed methane, for example, in Australia — but the U.S. players (other than CONSOL Energy (NYSE:CNX) did not seek to diversify, despite the risk reduction and the far less damaging extraction regime inherent in the cleaner fuel. Coal companies might even have applied the same logic to solar and wind, which have also taken share from coal, if they had been agile enough to develop the relevant assets or capabilities. Without a technical breakthrough new, “clean” coal will be too expensive to play more than a niche role.
Forward-looking companies and investors are incorporating gas, renewables and efficiency to become winners in the power-generation game.
- Demand destruction is real, and mechanical projections seldom capture it. The U.S. GDP is now fully decoupled — and even moving in the opposite direction — from coal consumption. The erosion of thermal coal demand and the subsequent weakening of prices have made the traditional business model uneconomic for many miners. In a business where dozens of new mines pop up each year, reinvestment has slowed, and rightly so. The lack of bidders in even the lowest-cost U.S. coal-producing geography — the Powder River Basin, where lease rates on the order of $1 per ton are already a near giveaway — shows how poorly the economics are shaping up.
With new technologies rapidly changing the game, bringing intelligence and the Internet to efficiency, energy businesses now need to be more sophisticated than ever about following shifting demand.
- Don’t just wait for an upturn to happen. Many coal companies, thinking yet another upcycle was inevitable, fooled themselves and shareholders into confidently planning on a rosy future, long after the writing was on the wall. From 2011 through mid-2013 the now-bankrupt James River Coal issued a series of statements along with its alarming quarterly operating results, forecasting an imminent cyclical upturn despite the very serious possibility — now essentially proven — that many of the changes were structural rather than superficial. Peabody Energy (NYSE:BTU) is still making such predictions in its shareholder reports.
Commodity energy producers and their investors must acknowledge when their financial pain is the real thing, not an aberration to be outlasted.
- China and India are not the answer. A handful of markets, primarily China and India, have led global growth in coal use and in imported steam coal, to the point that coal use overall is now virtually the same, in energy content terms, as oil. But China’s consumption has begun to fall — intentionally, according to plans announced over the past year — in part because of air quality issues. India may continue coal growth for a while, as large plants are great sources of permitting fees and other side benefits, but it too has made promises in response to pervasive air quality concerns and COP21. Furthermore, India is concentrating on fixing a leaky grid and developing its own resources, including solar. At any rate, Indonesia and Australia have the U.S. coal business at a disadvantage when it comes to shipping product to China or India.
U.S. energy businesses will gain nothing from depending on someone else to bail them out.
- Placing big bets is a losing strategy. Some of the worst coal industry performers are those that made major acquisitions or bought back their (declining) stock over the past five years. When the biggest risk is stranded assets or inability to service debt from a recent deal, such desperate moves are perplexing at best, made by boards and management teams that seem not to care whether they survive to fight another day. Increasing the hurdle IRRs for all projects, thus ensuring a high-risk premium for all new project development, is a move more likely to aid survival. Low breakeven prices are part of that equation too. Any new fossil fuel investment must take into account the realities of the accelerating transition to a lower-carbon energy system.
Companies that create resilience to value destruction and develop their ability to adapt are the keepers.
Coal companies may be, as Carbon Tracker’s recent report emphasized, the canary in the coal mine for fossil fuel extraction overall. Industry players and investors who look closely, however, will note the lessons in these crucial errors made by coal company management.
Entelligent’s modeling suggests that, based on its competitive economics with other energy sources (and assuming no significant price on carbon), coal has a chance of staying in the game on a global level. But successful investors will require fossil energy companies — coal, oil and gas — to pass over a much higher bar than in the past. Some such companies have already gone bankrupt, and others, such as Linn Energy (NASDAQ:LINE) and Chesapeake Energy (NYSE:CHK), are at risk of going under. Yet others, like Canadian integrated player Husky (TSE:HSE), have already covered themselves for the downside scenario of ongoing $30 oil. Which company is better managed and financed is becoming clear.
Of course, the oil business is strongly influenced by the global political picture too, but the alarming news from elsewhere must not drown out the just-as-alarming steady march of game-changing economics and technology in the U.S. electricity and automotive businesses.
Demand growth and high prices are not for sure anymore. And that is for sure.
Robert “Hutch” Hutchinson, MBA has 35 years of experience in energy research, design, business strategy and decision-making. He is currently a Senior Fellow at Rocky Mountain Institute (RMI), an investor, advisor and Board member for startup companies in the energy, environmental and impact spaces, a consultant to breakthrough efforts in industrial and buildings efficiency, and a writer and speaker on energy topics.