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Coal Enters New Phase of Insecurity

Coal is the fastest growing source of energy across the world, as the developing world seemingly puts a new coal-fired power plant into operation as fast as they can build them. Coal provides 40% of the world’s electricity supply, and despite swift gains by renewable energy, it will remain a dominant source of power for the foreseeable future.

However, the ubiquity of coal belies the very real cracks in its foundation. Those weaknesses could portend a much graver future for coal than many realize.

Investors watching the energy picture in the U.S. are fully aware of the threat posed to coal from natural gas. After all, coal’s share of the electricity market dropped to just 38% in 2013, down from nearly half only five years earlier. Most of the blame for the loss in market share can be pinned on cheap natural gas.

The onslaught against the coal industry took a bit of a respite earlier this year, however. Natural gas prices more than doubled from their 2012 lows of less than $2 per million Btu (MMBtu), and in the winter of 2014, they spiked even higher due to the extreme cold.

For a while, natural gas prices remained elevated. Several states on the East Coast became concerned about their overreliance on natural gas, and due to a dearth of pipeline capacity, the dependence would expose their economies to volatile swings in natural gas prices.

This all worked in coal’s favor, which hoped to enter a period of revival this year.

Then came the announcement by the White House that it would begin regulating greenhouse gases on existing power plants. This promised to be the nail in the coffin for coal, but after an initial celebration by environmentalists (and panic by the coal industry) the facts gave way to a more nuanced interpretation of the regulations, which ended up appearing a lot softer than they could have been. The Environmental Protection Agency used a favorable baseline that instantly gave credit to many states for partially reaching their goals to reduce greenhouse gas emissions by 30% by 2030.

By EPA’s own estimate, coal will still generate 30% of the nation’s power in 2030, even after the most painful parts of environmental regulation take effect. In other words, carbon regulations will take a smaller bite out of coal’s market share than shale gas did over the last decade.

“If anything, it’s a little bit better than expected,” an analyst at Clarkson Capital Markets told Bloomberg News in an interview shortly after EPA published its carbon limits. “There’s no change to coal burn for at least the next six or seven years and that’s not talking about legislation or any litigation that will come from this.”

So, even though the market will gradually shrink, the coal industry will remain largely intact. Moreover, the best operators could even do better under the rules as the market consolidates and the least efficient companies get forced out.

On the other hand, there are underlying weaknesses in the coal industry that are not getting reported in the mainstream media.

Specifically, coal mining companies are finding it increasingly difficult to secure long-term contracts with utilities. The significance of this development is hard to overstate – long-term contracts provide stability for coal producers, and protect them from price fluctuations.

Due to the abundance of natural gas and the burgeoning renewable energy industry, utilities have a menu of options to choose from. That has them turning to short-term contracts and even the spot market for electricity.

Data from an exclusive report from SNL Financial, a consultancy, shows that the coal industry’s ability to secure long-term contracts is eroding. Only 16% of coal deliveries for March 2014 were done so under long-term contracts, down from 20% for the same month in 2010.

According to the 10-K filings by Alpha Natural Resources (NYSE: ANR), the company warned its investors of the pending threat. “In large part as a result of increasing and frequently changing regulation…and natural gas pricing, electric power generators are increasingly less willing to enter into long-term coal supply contracts, instead purchasing higher percentages of coal under short-term supply contracts,” the company wrote in its filing. “This industry shift away from long-term supply contracts could adversely affect us and the level of our revenues.”

Arch Coal (NYSE: ACI) also said that environmental regulations “could deter our customers from entering into long-term coal supply agreements.”

At the same time, spot market purchases by utilities have surged, jumping from 6% in 2010 to 13% this year. That means that even after natural gas and coal inventories were severely depleted, utilities did not go on a buying spree to build back their stockpiles.

Coal companies were caught off guard by the lack of demand. The tepid interest in long-term contracts suggests that utilities feel secure enough to simply rely upon the sport market for supplies.

This could be the start of a new era of insecurity for coal companies as they become increasingly exposed to the vagaries of the free market. If coal prices drop, as they have been for several years, producers will be exposed. For example, James River Coal Co., a coal mining company based in the U.S., declared bankruptcy in April 2014 after falling coal prices forced it to close a dozen mines.

And in this regard, it is not just the U.S. market that is killing off coal.

A flood of new coal capacity around the world – particularly in Australia – came online in recent years as mines were drawn up during the boom years in the mid-2000’s.

Much of that capacity could have been profitable if China’s growth projections had been realized. But, a slowing Chinese economy has caused growth in coal consumption to a halt. Years ago, China regularly experienced double digit growth in coal consumption, but that dropped to just 3.7% last year. This year is expected to be even worse, with demand growth halving to just 1.6%.

The slow growth in China has caused international thermal coal prices to hit a six-year low. Metallurgical coal – which is used to make steel – is also selling at a six-year low.

That comes despite the huge cutback in production. Metallurgical coal saw 40 million tons of production go offline in the last two years, but still the market is oversupplied.

Glencore PLC (LON: GLEN), an Anglo-Swiss mining company, plans to close an Australian mine this year that it spent $1 billion on to acquire in 2008. It also cancelled a major coal export terminal last year.

The pain for coal producers in Australia is set to continue. China has abundant reserves of coal, which are inconveniently located in its far western territories. Rail bottlenecks have prevented the country from moving sufficient volumes to its major cities in the east. Until now, that caused it to depend on imports, largely from Australia and Indonesia. But China is rapidly building more rail capacity, which will boost shipments of coal by 35% – or 800 million tons – by 2018. That will further undermine international coal producers, particularly in Australia.

The cascade of bad news continues against the coal industry, after a very brief period of renewed optimism this year. In the U.S., the coal industry is entering a new period of insecurity, as it is increasingly finding it difficult to sign up customers to long-term contracts. In Asia, where China drives coal demand, China’s slowing economy is deflating the entire coal market, shutting down mines in Australia. And when China’s infrastructure catches up – to say nothing of its efforts to replace coal with natural gas or renewables – international coal producers will be fighting for a shrinking market.

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