Digging Into The Coal Industry

Sep 07, 2024

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Digging Into The Coal Industry

In 2020, it looked dire for the coal industry. Coal prices plummeted during the pandemic’ shutdowns and most miners were heavily indebted. Banks, bowing to ESG concerns, had pledged to stop financing the industry.

When lockdowns ended and economies reopened, coal prices rose. Then they went parabolic following Russia’s invasion of Ukraine. The miners, left for dead, minted money. Many completely retired their debt and paid out huge sums to investors. Consol Energy rose from a low of 3.40 per share in 2020 to over 100 in 2023 (29x). Alpha Metallurgical Resources (AMR) rose from a low of 1.90 in 2020 to a high of 452 earlier this year (238x) and retired a third of shares outstanding.

The easy money in coal has been made. Such a bonanza won’t happen again anytime soon, if ever. But the industry has a surprisingly promising outlook, especially if you know where to look.

In this article, I will provide an overview of the coal industry. I’ll explain:

The various types and grades of coal;
What gives a mine a competitive advantage; and
The outlook for coal demand and coal prices.

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All Coal Is Not Created Equal

Coal is a naturally occurring sedimentary rock in the Earth’s crust. It is formed when dead plant matter decays into peat and gets buried. Heat and pressure over millions of years turn it into coal. Coal is mostly carbon but may also contain hydrogen, sulfur, oxygen, nitrogen, and other gaseous hydrocarbons. These are coal’s “volatile matter.”

There are two main types of coal: thermal and metallurgical (“met”) or coking coal.

Met Coal

Met coal has more carbon, less ash, moisture, and sulfur than thermal coal. It is rarer and commands a higher price.

Met coal is a key ingredient in steel. To make steel, met coal is first turned into coke by heating it to 1,000ºC in the absence of oxygen. Without oxygen, the coal does not burn. The coal swells and then releases its gaseous volatile matter. Nearly pure crystalline carbon is all the remains. Coke is to coal what charcoal is to wood. Caking is a coal's ability to be converted into coke. Thermal coal has no caking ability, which is why it is much cheaper.

Coke is mixed with iron ore, flux (e.g. limestone), and hot air in a blast furnace to create iron. Iron is put into a basic oxygen furnace where oxygen reduces the metal’s carbon content. It is further refined to remove impurities and alloys are added to make steel.

The quality of met coal influences the quality of the coke, iron, and steel produced. A blast furnace fed with higher quality coke will require less of it, lowering production costs. Steel makers have an economic incentive to pay more for higher quality met coal.

It takes 0.8-1.05 tons of met coal to produce one ton of steel. (1.3-1.5 tons of met coal make one ton of coke. 0.6-0.7 tons of coke make one ton of steel.) That’s a lot! 70% of the world’s steel is made this way.

The other 30% of steel is made in electric arc furnaces (EAFs). EAFs emit 70% less carbon dioxide per ton of steel because they use electricity instead of coal. EAFs have three drawbacks compared to blast furnaces:

EAFs are only economical where there is plentiful, reliable electricity, and a well-developed electrical grid.
EAFs are more expensive to operate than blast finances.
EAFs cannot make virgin steel (i.e. steel from iron ore). EAFs make steel from scrap metal.

EAFs may be more environmentally friendly, but recycled steel is no substitute for virgin steel. Recycled steel may contain impurities that could affect its yield strength or hardness. Virgin steel is more consistent, which is why precision industries like automotive and aerospace manufacturing prefer it. Virgin steel can be engineered to precise specifications which is why it is always used in high-stress structures like bridges, skyscrapers, and rail tracks.

A growing world will always need more virgin steel, and there’s no way to make it without met coal. That’s good for met coal miners. There’s no obsolescence risk.

There are several grades of met coal: low-vol, med-vol, and high-vol. High-vol is further divided into high-vol A (HV-A) and high-vol B (HV-B). Low-vol has a lower volatile matter content and higher carbon content and is the most valuable. It’s primarily found (in the US) in West Virginia’s Central Appalachian Basin and Alabama’s Warrior Basin. Next is mid-vol, high-vol A, and finally high-vol B. These grades are common in the central Appalachian basin.

The type and grade of coal have a big effect on a mine’s through-cycle performance. The highest quality coking coal, like what’s often found in Alabama’s Warrior Basin, is increasingly geologically rare. They are the backbone of most coking blends. During periods of high steel production, these garner a premium price because producers can use less per ton of steel. During periods of low steel production, HV-B will trade down and approach high CV thermal prices. Met coal prices follow the steel cycle and are more cyclical than thermal coal prices.

The major met coal exporting nations are the US, Canada, and Australia. The major importers are countries with large steel industries relative to their domestic met coal supplies – China, India, Japan, and South Korea.

The US usually exports ~70% of its met coal. Export contract prices are tied to international benchmark indices. Domestic contracts tend to specify a fixed price and a fixed volume for one year. A miner with a mix of both has a natural hedge. When rise, the miner benefits from higher export prices. When prices fall, domestic fixed price contracts ease the pain.

Thermal Coal

Thermal coal has a lower calorific value (CV) and a lower cost than met coal. It is primarily used to generate electricity. It is also used to make cement. It takes 0.1-0.12 tons of coal to make one ton of cement.

Thermal coal has been in decline in Europe since the 1980s and in the US since the 2000s. It continues to grow in Asia. Worldwide, coal demand reached its highest level ever in 2022 and again in 2023.

The IEA writes:

The volume of coal trade has increased almost every year this century with very few exceptions. In 2015, China’s measures to protect its domestic coal industry, coupled with a slowing economy that weighed on consumption, led to the first contraction in coal trade since the 1990s. In 2020, the economic downturn driven by the Covid-19 pandemic triggered the second drop.

Today, coal remains the world’s largest energy source for electricity generation. Coal may be losing share as an energy source, but it continues to grow in absolute tons.

China is the world’s largest producer and consumer of coal. In the early 2000s coal produced 75-80% of its electricity. Today it’s more like 60-65%. Coal lost share but grew in absolute terms. Chinese electricity production rose eightfold and its coal consumption rose sevenfold. In 2022 China permitted two new coal power plants per week.

Coal's peak share of U.S. energy occurred around 2007-2008 at 50% of electricity. Today it’s 20-22%. That’s still a meaningful amount. The decline in US coal was driven as much by fracking and its byproduct, cheap natural gas, as environmental considerations. Should US natural gas get expensive, we could see a shift back towards coal. Europe’s 2022 energy shock showed that when the going gets tough, the world reaches for coal and nuclear power.

Some US producers have shifted to selling their products in the export market. Consol Energy, which owns its own export terminal in Baltimore, has led the pack. Landlocked mines, like those in Wyoming’s Powder River Basin, are most exposed to the structural decline in US thermal coal consumption. There are no export terminals on the west coast, and plans to build one keep getting blocked.

Some mines in the Illinois Basin (ILB) are close enough to the Mississippi and Ohio rivers to barge their coal to New Orleans for export. But, they have a structural cost disadvantage versus Northern Appalachian (NAPP) producers because they’re further from water transportation. ILB thermal also has a lower CV and higher sulfur than NAPP coal (3.0%+ vs 2.5%). The result is a lower netback to ILB miners. ILB exports are only economically viable when benchmark prices, like API2 (Rotterdam), are sufficiently high.

Shipping costs from the US to India are roughly $40-45/t versus Australia to India at ~$15/t. Europe is the logical destination for US thermal exports, but Europe has been aggressively closing coal plants. After high consumption in 2022, European coal consumption resumed its decline in 2023, falling 23%. Europe’s decline was more than offset by a rise in India. As coal demand shifts towards Asia, US producers are at a disadvantage.

US thermal exporters can still be competitive though. India buys about 30% of US thermal exports. US coal quality is top notch, especially the thermal coal coming out of Consol Energy’s Pennsylvania Mining Complex (PAMC). It has a very high CV (11,500 to 13,000 BTU/lb) compared to Australian (9,900 to 11,300 BTU/lb) and Indonesian (7,200 to 9,900 BTU/lb) coal. It takes fewer tons of US coal to produce the same amount of energy as Australian and Indonesian coal.

Competitive Advantages

Coal is a commodity industry which means having the lowest costs is a big advantage. One of the biggest factors affecting a coal mine’s cost is the method of mining used.

Surface mining is the cheapest method. There are two surface mining methods: dragline and shovel and truck. Draglines are the cheapest. They work best when the coal is near the surface (minimal overburden) and in a thick seam. Arch Coal’s Black Thunder mine in Wyoming’s Powder River Basin is a good example.

The shove and truck method works better for thinner coal seams than draglines (though still thick in an absolute sense) and when the coal has a soft and shallow overburdened. Various mines in the Powder River Basin, Illinois Basin, and NAPP use this technique.

There are two main underground mining techniques: longwall and room and pillar.

Longwall mining is the most efficient underground mining technique. It works best on thick and continuous seams of coal. It is highly mechanized and labor efficient. It also has high coal recovery rates. The downside is the machinery and mine prep requires a significant up front investment. Once a longwall is up and running, it needs to keep going to be efficient, like a factory humming a full capacity. Consol Energy’s PAMC is a good example of a high volume, low cost thermal coal mine in NAPP.

Room and pillar mining extracts “rooms” of coal, leaving pillars of coal in place to support the roof. This method is highly adaptable to various geological conditions, but has a lower recovery rate than longwall mining. It requires a significantly lower upfront cost than longwall mines. Most of the coal mines in CAPP are room and pillar.

Another major cost consideration is access to transportation. A mine served by a single rail line is at the railroad’s mercy. A significant portion of the coal mine’s profits will accrue to the railroad rather than the miner. The more transportation options a mine has, the better they’ll fare. Mines with access to barge transportation or a second railroad gain significant flexibility and leverage with a railroad.

Appalachian coal has an advantage over ILB and PRB coal because it is closer to Atlantic coal terminals. Warrior Basin coal has an advantage because it is close to export terminals at Mobile, AL. ILB coal can be barged down to New Orleans, a costly, but usually profitable endeavor. PRB coal is largely landlocked. These mines have little prospect of exporting their thermal coal if US consumption continues to decline.

Pollution

Pollution has been a problem for coal since the 1600s. Coal’s primary pollutant is Sulfur Dioxide (SO2). It creates acid rain and is responsible for the hazy air around coal-burning cities. There are two ways to remove sulfur dioxide: using scrubbers to clean a power plant’s exhaust or burning a type of coal that contains less sulfur. Scrubbers can remove 70-90% of the sulfur dioxide, but it is often cheaper to burn low sulfur coal from the get go.

US east coast coals tend to be high in sulfur. The Clean Air Act encouraged many power plants to shift to buying lower sulfur western coals, such as those from Wyoming’s Powder River Basin. The downside is that Powder River Basin coal tends to have less energy than its eastern counterparts. Power plants have to burn more western coal to produce the same energy as eastern coal. High sulfur coal trades at a discount because of the cost of scrubbing its emissions when burned.

Asian power plants were built with lower sulfur Australian coal in mind. When India buys American coal, they’ll require a discount to compensate them for either blending the coal down to the sulfur spec or paying to scrub the SO2 emissions. US coal tends to be higher CV than Australian, which helps earn back some of the discount.

Carbon dioxide, a byproduct from the combustion of coal, is a tougher problem to solve. Coal is the largest source of man-made carbon dioxide emissions in the world. Coal produces twice as much carbon dioxide as natural gas and a third more than crude oil. This has led many to declare coal “uninvestable.” Whenever I hear the word “uninvestable” I think about Howard Mark’s interview where he says “uninvestable” assets are usually where bargains lie. The history of tobacco stocks has certainly borne that out.

In recent years, banks and financial institutions have increasingly stepped back from financing coal projects due to growing concerns about environmental impact, climate change, and sustainability. This shift is part of a broader ESG trend. For example, in 2019 Goldman Sachs declared:

Goldman Sachs will not finance any new thermal coal mine developments or mountaintop removal mining,

Bloomberg’s Javier Blas on the Odd Lots podcast said,

Everyone is out of coal finance. You could not get a bank to finance a coal mine. And you know, some of the coal companies, I speak to the CEOs and say, why are you not now announcing a big expansion, and so on? They say because, if I announce that we are spending products on capacity, my share price goes down 10%.

Given the difficulty of financing, getting regulatory approvals, and overcoming pushback against new projects, coal companies are opting to acquire existing mines rather than develop projects from scratch. For example, Consol recently agreed to purchase Arch.

This ought to keep supply growth limited, at least in the U.S. and developed markets. Supply continues to grow in China and India, but still lags demand growth.

Fuel Transitions

The developed world has been working hard for the last twenty years to reduce demand for thermal coal and cut carbon dioxide emissions. And yet we continue to see record demand for oil, natural gas, and thermal coal.

Coal’s share of energy production is falling slower than the increase in total energy demand. Jevon’s Paradox describes this situation. Demand for energy is elastic. As energy costs decrease, demand for energy increases even more. On balance, energy demand increases, even as energy consumption becomes more efficient.

It is like RAM memory in a computer. RAM prices have fallen steadily and rapidly. 8GB today, a common amount, costs significantly less than 64MB cost in 2000. 64MB was a lot of RAM back then. The world was not content to pocket the savings and continue using 64MB of RAM. Cheaper RAM drove significantly higher consumption of it. Engineers wrote larger, more complex programs and worried less about efficiency (looking at you, Chrome). On balance, dollars spent on RAM increased dramatically, more than offsetting the precipitous price decline. The only way the world will use less RAM is if its price begins to increase.

Sheikh Ahmed Zaki Yamani, a former Saudi Arabian oil minister, once said “The Stone Age didn't end because we ran out of stones.” The stone age ended because better technologies came alone.

The age of coal won’t end because we run out of coal. It will end because other energy sources become significantly cheaper and as reliable. There are two ways for that to happen: either coal becomes very expensive, or alternative energy sources become much cheaper. If coal becomes expensive, it will only incentivize more mining and make previously uneconomic deposits profitable. So the only real way to kick coal is for the alternatives to become significantly cheaper. The last ton of coal ever sold in the world is likely to be very expensive, not very cheap. That’s good for coal miners.

We can use history as a guide to gauge the speed of energy transitions. One example is the shift from whale oil to kerosene.

In 1846 Canadian geologist Abraham Pineo Gesner gave the first public demonstration of kerosene, which he derived from coal. He received a patent for kerosene in 1854. In 1859 oil was discovered and production of kerosene from oil began. Kerosene burned brighter and cleaner than whale oil, making it a better fuel for lamps. It was also much cheaper than whale oil. There was plenty of petroleum to refine into kerosene, but whale populations were dwindling due to overfishing. Still, it took nearly 20-30 years for kerosene to replace whale as the dominant fuel and 60 years to completely take over.

The transition from whale oil to kerosene is one of the fastest in history. It helped that whale oil had relatively few applications and lamps did not need to be rebuilt to burn kerosene. There was minimal “infrastructure inertia.” It also helped that overfishing had caused whale oil to become exceedingly expensive.

In Energy and Civilization: A History (2017), Vaclav Smil explains that energy transitions often take more than a century. The transition from biomass (wood) to coal in Western Europe took 200 years. The transition from coal to oil began in the late 19th century, but oil didn’t overtake coal as America’s dominant energy source until the 1940s, approximately 50-60 years later. The transition is still far from complete, and that’s despite crude being more energy dense and easier to transport (via pipeline).

One of the factors affecting the speed of the transition is infrastructure. The transition from coal to oil in America was slowed by the need to replace steam engines with diesel engines. The modern analog is the cost and complexity of switching a power plant from coal to natural gas.

Price is another factor. If there’s a new fuel that is much cheaper than the legacy fuel, there’s an economic incentive to rebuild the infrastructure faster. A wide disparity between coal and natural gas prices that is expected to continue will drive more US coal plants to switch to gas. That’s less likely to happen in Asia, where gas is less plentiful and LNG infrastructure is more expensive.

Once again, this suggests that the last ton of coal will be very expensive, not very cheap. Thermal coal may be a sunset industry, but it is going to be a beautiful sunset.

Eagle Point Capital

Digging Into The Coal Industry

Announcement

Digging Into The Coal Industry

All Coal Is Not Created Equal

Met Coal

Thermal Coal

Competitive Advantages

Pollution

Fuel Transitions

Further Reading

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