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Coal seeks stable 2018, reasons for hope, but challenges loom

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Coal mine manager Dale Winter, left, speaks with Illinois Coal Association President Phil Gonet at an underground coal mine in Illinois.

Source: S&P Global Market Intelligence

Political rhetoric around the coal industry may have sounded to some like the promise of a comeback, but many in the sector are simply hoping for a year of stability after markets finally took a turn for the better.

Coal companies, railroads and analysts have suggested 2018 demand could be roughly flat compared to 2017, a year in which coal volumes sprang back off record lows. A relatively warm winter so far could temper early domestic demand, while exports could soften after special circumstances including weather-related events sparked especially strong demand in 2017.

Peabody Energy Corp., the largest U.S. coal mining company, said on its third-quarter earnings call that it was evaluating the weather and other factors to determine its mining plan for the year but was expecting U.S. utility demand to be largely stable, with about 20 million tons of reduced coal demand from plant retirements expected to be largely offset by higher capacity utilization.

With the largest names in the coal space putting bankruptcy reorganizations behind them after a multiyear downcycle in coal markets, balance sheets are cleaner and production cuts have brought the market closer to balance in the wake of a wave of coal retirements. Still, the threat of natural gas displacement and coal-fired retirements looms on the horizon even as companies have been able to lean on recently improved export markets to make up for lost customers at home.

Playing offense

"This year companies have been playing a lot of defense," S&P Global Ratings analyst Chiza Vitta said. "You had a bit of a rebound in 2017 and I think in 2018 you'll begin to see what offense will look like."

Vitta said he expects that companies will now start thinking about the cash on their balance sheets and potentially using it on capital expenditures. In the prolonged market downturn, coal companies largely deferred capital expenditures on things such as greenfield projects or even some maintenance and repair work.

Agreeing with analysts from Moody's and S&P Global Ratings, American Coal Council CEO Betsy Monseu said some restructuring and consolidation is continuing as the sector settles into a better supply-demand balance. She said more changes, including mergers and acquisitions, remain possible.

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A tugboat prepares to move coal at a dock on the Mississippi River.

Source: S&P Global Market Intelligence

"Capital allocation on the mining side for growth, including organic growth, will be done in a thoughtful and well-considered manner," Monseu said.

Many coal companies have been funneling capital back to investors in the form of share buybacks or dividends. Ramaco Resources Inc. Chairman and director Randall Atkins warned in a recent interview that debt holders who were converted to equity holders in these coal bankruptcies are pushing such decisions as coal companies take on a "pretty short-term perspective" in terms of capital spending.

"The coal industry is probably one of the few industries where almost 90% of its shareholder base is hungover and grumpy," Atkins said. "It's hungover because almost 90% of the equity holders now of the large public entities are essentially carryover debt holders. ... They're still underwater on their positions."

Steve Piper, director of energy research with S&P Global Market Intelligence, is expecting a 2018 downturn in coal demand similar to what was seen in 2015 and 2016 because of expected coal plant retirements and natural gas prices that are substantially lower this winter than in the past. He said a further restructuring of the industry is to come.

"Against a backdrop of falling demand, there will be pressure to consolidate, reduce costs, and retain as much market share as possible," Piper said. "Production may come increasingly under private ownership to reduce the volatility of shareholder capital. I believe this will be a bigger focus in 2018 than regulatory issues."

Luke Popovich, spokesman for the National Mining Association, said they are expecting coal's market share of U.S. electricity will hold steady at about 31% in 2018. A recent note from Seaport Global Securities LLC described a conference call in which Seth Schwartz of Energy Ventures Analysis, who helps power producers develop fuel procurement strategies, said he is expecting flat coal burn in 2018. Schwartz believes that coal burn will grow from 679 million tons in 2017 to 682 million tons in 2018, according to the note.

Because of such low growth potential and despite positive impacts to domestic thermal markets, there is little reason for investors to get excited about thermal coal production. MKM Partners Daniel Scott wrote in a recent note that a one-two punch of weak winter demand and lower natural gas pricing could make for a rough start for thermal coal producers in 2018.

"Balance sheets are much better than in the past in general as a result of the bankruptcy wave of two years ago, but we are still comfortable remaining on the sidelines as inventories continue to slowly grind lower," Scott said.

Atkins said that after a spike in metallurgical coal prices and a subsequent crash, prices are now "crab-walking back up to the other side of the hill" and he expects 2018 to be relatively stable in terms of metallurgical coal pricing. He does not expect a surge in metallurgical coal markets but said the commodity "has a tendency toward irrational exuberance or depression."

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Coal is processed at a coke-making facility in Indiana.

Source: S&P Global Market Intelligence

Analyst Mark Levin wrote in a recent Seaport Global Securities note that investors are "waiting patiently for any sign of met coal weakness." He said it was hard to find any long-term investors on metallurgical coa,l as many are looking for clues the price is about to top out.

What to watch in 2018

Most of those in, or closely observing, the coal sector agree on the major themes to watch in 2018 that could disrupt the current trajectory of coal demand. At the top of the policy wishlist is the resiliency rule aimed at supporting coal and nuclear plants.

Popovich said the industry also wants to see the U.S. Environmental Protection Agency repeal the Clean Power Plan. If it is replaced, he said the sector wants to see a rule that could withstand legal challenge and provide certainty to utilities and producers.

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Early in 2017, U.S. Department of Energy Secretary Rick Perry visited Morgantown, W.Va., where he met with staff of the National Energy Technology Lab. Hours before, Perry toured the Longview Power coal-fired power plant nearby.

Source: S&P Global Market Intelligence

Other concerns of industry watchers in 2018 include further coal plant retirement announcements or a drop-off in coal contracting. Moody's vice president and senior analyst Anna Zubets-Anderson said the perennial concern of natural gas displacement will remain in 2018 but also beyond as more natural gas plants prepare to come online. A recent S&P Global Market Intelligence analysis found planned U.S. natural gas combined-cycle capacity totals more than 89,000 MW.

"It's important to note that natural gas plants are coming online in the next three or four years," Zubets-Anderson said. "They are going to have to burn natural gas and they are going to have to displace something. A lot of coal plants have already been shut down and I don't think much of anything is going to bring them back."

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.