Friday, May 4, 2012

Sixteen Tons

A Brief Guide To the Coal Industry

"You load sixteen tons, what do you get
Another day older and deeper in debt
Saint Peter don't you call me 'cause I can't go
I owe my soul to the company store"
- "Sixteen Tons" by Tennessee Ernie Ford

One of the industries that consistently pops up in my daily scan for attractive high yield bonds is the coal mining industry.  The coal industry has a number of peculiarities which investors should be aware of if they wish to dabble in these bonds, some of which offer double digit yields (Patriot Coal and James River Coal show up regularly in my daily screens with low teens yields).  Although I will have nothing to do with the industry due to personal ethical concerns, I have spent some time following the industry and will attempt to offer a brief guide to the basic economics of the industry, supply and demand drivers, and how to differentiate among the public issuers in the industry that investors might be looking at.
There are certain issues that affect all coal producers to a greater or lesser extent.  By and large, coal mining is a dirty, dangerous activity that entails significant operational and human risks.  Rarely do things go without a hitch for any given length of time.  Especially since most public coal producers operate multiple mines, you should expect to see things go wrong from time to time.  Examples include unexpected mine face moves, accidents that require a temporary closure (and perhaps investigations or fines), transportation difficulties, combustion events, etc.  Practically speaking, what this means for investors is that you should expect occasional interruptions in the flow of coal and revenue as well as occasional costly bumps in the road for any coal company, no matter how well run.  If a company will barely make it when things are going well, they will likely experience difficulty when mining operations inevitably experience difficulties.

Another critical industry issue is that coal producers generally experience a steadily increasing cost structure over time, especially when production volumes in the industry are increasing.  Among other things, coal producer costs are impacted by cost trends in steel, diesel fuel, explosives, mining machinery and skilled labor (there are only so many veteran coal miners out there).  If you are modelling out what a company's cashflow could be over a few years with a variety of coal price outcomes, don't forget to assume significant cost inflation regardless of what happens with coal prices.

Moving to the types of coal miners out there, companies can be distinguished by the type of coal they produce, where they produce it and how they produce it.  Coal is distinguished by various physical properties, but the basic breakdown is into two categories: steam coal and metallurgical ("met") or coking coal.  Steam coal is burned by utilities to generate electricity in coal-fired generation plants.  Steam coal typically has low energy content than met coal and emissions considerations (such as sulfur levels) can influence the value of a particular grade of steam coal.  Steam coal is produced in pretty much all coal-producing regions, but low sulfur (relatively clean-burning) steam coal is all that is produced in the Powder River Basin in Wyoming.  Met coal is used in the production of steel.  Due to the vagaries of the steel production process, met coal generally has significantly higher energy value and is of much higher specification than steam coal.  As a result, met coal is usually far more valuable per ton than steam coal and due to relative scarcity is often produced from mines which would be uneconomic (due to higher costs) if the coal mined were steam coal.  At times in the past when the steel industry was going through overcapacity, met coal has been sold as high grade steam coal.

Coal production in the US is largely centered in Appalachia (Virginia, West Virginia, Pennsylvania, Kentucky, Illinois) and the Power River Basin in Wyoming, although there are also active mines in other places including Colorado and Alabama.  As I mentioned above, Powder River Basin coal is primarily low sulfur, sub-bituminous (lower energy content) steam coal which is used all over the US from Chicago west, and increasingly is used east of the Mississippi and in export markets (mostly in Asia).  Powder River Basin coal has relatively good access to transportation infrastructure (very important when you are selling something by the ton), although there are rail bottlenecks in Chicago and on the West Coast (important for access to export markets).  Appalachian coal includes a wide variety of coal types, including low sulfur steam coal, met coal of various grades, and steam coal with high energy content but lots of sulfur.  Appalachian mines vary considerably in their access to transportation infrastructure, and proximity to rivers, rail lines and ocean ports can be a key consideration when reviewing mine economics.  Much of the met coal produced in the US comes from Appalachia.

Broadly speaking, mines consist of two types: open and underground.  Open pit mines (typical of the Powder River Basin) present far fewer safety and "whoops factor" issues compared with underground mines and often have more attractive economics, all else being equal.  However, it is often difficult to operate open mines in Appalachia because a large amount of rock and soil must first be removed (this can be very costly) and runoff into streams and other water sources can be a significant problem (it is hard to convince the EPA that it is a good idea to chop off the top of a mountain and chuck it into the river below so you can scoop out the coal).  Consequently, most Appalachian mines are underground.  Underground mining is considerably more challenging than open pit mining.  Underground mines are more expensive to operate, considerably more risky (cave-ins, combustion events, etc.), and are more easily affected by the geology of the coal seam.  As a result, in most cases open mines are the lowest cost, especially if the amount of soil and rock that must first be removed before you get to the coal is modest.  Underground mines are the most expensive, with considerable variation in cost structures among underground mines.  Generally speaking, in an era of declining coal prices, open pit mines will be the most economically resilient, followed by underground met coal mines, followed by underground steam coal mines.

So what should investors be looking for?  First, look at the operator's history of performance with its mines.  Some of the worst offenders (e.g. Massey) have been merged out of existence, but there are better and worse operators.  The better the operator, the more likely things will not go disastrously wrong.  Second, consider where the producer is on the industry cost curve.  When coal prices decline, the marginal producers with the highest cost structure will be in trouble the quickest.  Third, consider whether the producer you are looking at has market access.  China and India appear to have endless appetites for coal, while US utilities do not (they are facing flat or declining power demand and very cheap natural gas prices as an alternative fuel).  If a producer is landlocked and will have difficulty selling to anyone but the three nearest utilities, they have a much tougher row to hoe than a producer with a mine-mouth rail connection that goes straight to an oceanfront port.  Finally, consider whether the producer is predominately a steam coal or met coal producer.  These are effectively two different markets for two different commodities.  Met coal will be heavily influenced by global steel production and economic growth in the BRIC countries.  Steam coal will be primarily driven by US electricity demand and natural gas prices.

As always, consult your advisor, do your own due diligence, take your own risks, and be careful.  None of the above is intended as investment advice.  As it says on the housing of a claymore mine, "This End Toward Enemy."


  1. Are there any coal producers that derive more than 60% of production and revenue from met coal? I know ANR has substantial met coal but even there it is only about one third of production?

    1. There used to be, but after a wave of consolidation I do not believe there are any public met coal specialists left. There was even a company that owned Canadian mines which were solely focused on met coal (the name of which escapes me). When the met coal market heated up, they were acquired.