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Headwind that pushed coal to bankruptcy potentially changing course


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Headwind that pushed coal to bankruptcy potentially changing course

is hoping toreturn to the market after its Chapter 11 bankruptcy reorganization, but its abilityto do so may depend on assumptions about a market that has proven difficult to predict.

While decreased domestic demand due to regulatory constraints,cheap natural gas, and warmer weather have impacted the coal sector's bottom line,the largest industry bankruptcies, like Peabody's, came after multi-billion-dollar,debt-fueled bets on themarket for metallurgical coal, used in steel making. An analysis ofSNL Energy data shows combined market capitalization of Peabody, and has closely trackedthe price of the international met coal benchmark settlement.

Until the most recent quarter, the met coal benchmark had beenon a steady decline since a wave of acquisitions coal companies made in a bid totake advantage of anticipated robust growth in Chinese steel demand.When China's growth slowed and demand from other parts of the world did not pickup the slack, the debt load many of the country's top coal producers took on todiversify coal portfolios became unsustainable.

In a recent report on met coal buys driving coal's stress, theRhodium Group noted China accounts for roughly half of global steel consumption. However, Chinese economic growth slowed frommore than 10% each year on average between 2002 and 2012, to just 6.9% in 2015.

"Moreimportantly, the structure of the Chinese economy is changing — moving away fromthe investment and heavy industrial production that defined the past decade to theservice sector activity and private consumption that will be the main engines ofgrowth going forward," the report states.

Is the met coal market reversing?

Now, just as the latest and largest U.S. company that madea major investment in met coal has succumbed to bankruptcy, the international metcoal benchmark price finally ticked up for the second quarter. Prompt-month Australiancoking coal futures have also been on the rise, climbing 17.3% year-to-date to $92.75/tonneas of April 21.

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FBR & Co. analyst Lucas Pipes wrote in an April 14 reportthat he maintained a favorable outlook for met coal, but on the expectation thatthere would be continued supply cuts in the U.S. Pipes estimated that about 20%of seaborne supply is "still out of the money" at prices around $90/tonne.

Teck ResourcesLtd., a Canadian mining company, offered a few glimpses into what ishappening in a market it said "continues to get closer to being balanced"on an April 26 earnings call.  President andCEO Don Lindsay said Chinese imports of coking coal rebounded to over 5 milliontonnes in the month and was up 73% so far in the for the first quarter of the year.

"On the supply side, closures on noneconomic mines havecontinued, as the US coal companies work their way through bankruptcy proceedings,"Lindsay said. "And then recent weather issues in Australia also seemed to havedisrupted more production than was originally understood."

Real Foley, Teck's vice president of coal marketing, said 65million tonnes of met coal productioncuts have been announced since the start of 2014, with about 60% estimatedto have already been implemented. He added that while pricing has improved, strongerCanadian and Australian currencies have offset much of the price improvement whilethe U.S. continues to bear the brunt of weak met coal markets.

Production curtailments following severe mining accidents inChina and other announced reductions have also helped tighten the met coal market.

Reuters recently reported that Australian coal mines are bracingfor potential flooding from a La Nina weather pattern. A similar weather patternfive years ago was behind the large spike in metallurgical coal prices. If floodingwere to again shut down major supply in Australia, U.S. producers could benefitfrom higher prices and demand for alternative sources of coal.

In an April 21 note, Pipes said FBR sees potential forgradual increase in met coal prices with some upside potential coming from a sustaineddemand pull on lower-cost supply. FBR raised its met coal price expectations forthe remainder of 2015 from $82/tonne to $89/tonne. FBR also now projects $105/tonneaverage pricing for met coal in 2017 and $120/tonne average pricing in 2018.

"Over the last week, investors have increasingly asked aboutthe incentive price that would bring U.S. supply back to the seaborne market, a180-degree turn from earlier this year when consensus squarely anticipated the needfor further U.S. supply and export reductions," Pipes wrote. "We do believethat the marginal ton of supply for the seaborne market does come from the U.S.and that depending on the demand pull, the marginal ton could be very expensive."

Pipes reiterated FBR's view on "long-term sustainable metcoal prices" of around $125/tonne. He also noted that the current price improvementin the met coal market is probably not enough to reverse closure decisions and bringback idled capacity just yet. "Thus, investors have started to make the casethat $120/tonne prices could arrive much sooner than we currently anticipate,"Pipes wrote.

A rally could offer some hope to U.S. producers as domesticthermal coal markets remain oversupplied. However, in an April 21 research note,Macquarie analysts warnedagainst reading too far into the recent price surge."It islikely met coal prices remain supported near-term, though we expect them to fallback [during the second half of the year] given our more conservative structuralview on China has not changed," the note states.

Room for a comeback?

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Peabody, which has significant exposure to both met andthermal coals, said in a recent bankruptcy declaration that it hopes to emerge fromthe bankruptcy process as a coal industry leader. In its filing, Peabody insiststhat the ongoing market weakness that has led to approximately 50 coal company bankruptciesis a temporary condition that should be offset by future international and domesticmarket trends.

Peabody's assumption relies on third-party estimates projectingU.S. and global coal demand will stabilize. The company expects that will be drivenby U.S. gas prices rebounding from recent lows and global thermal coal demand growingfrom "hundreds" of existing plants and "scores more that are underconstruction."

When Patriot filedfor bankruptcy in 2012, executives also told investors they planned to emerge "stronger and more competitive"and believed it had "an excellent platform for Patriot's future success."Once the restructuringwas complete, Patriot CEO Bennett Hatfield said in an interview that Patriot epitomized a successful reorganizationand predicted Patriot would be going forward with "one of the strongest balancesheets on the playing field."

Eventhough Patriot may have emerged a leaner company, and even built-in anticipated net losses through 2018, intensifiedmarket pressure and a string of environmental, safety and labor problems guidedthe company back into bankruptcy court protection less than two years later.

Evenwith a diverse asset base primarily scattered across the globe, Peabody may experiencedifficulty securing investors. In a recent publication from S&P Ratings Services,it was noted the market conditions leading to the recent wave of bankruptcies couldpersist for some or "get even worse."

S&Psaid since the bankruptcy filing, it was less confident than it was a few monthsago that Peabody's secured creditors have strong recovery prospects. It warned thata number of factors, including a failed deal between Bowie Resource Partners andPeabody, could indicate there is little room for the sector to recover.

"From our perspective, Bowie's struggles to finance the dealit struck with Peabody — even at a seemingly low implied purchase multiple of roughly3.5x — suggests uncertainty about asset values and waning investor appetite forcoal, which may augur depressed coal asset values across the board,"S&P wrote.

However, S&P does see some advantages for Peabody as it attemptsto come out on the other side of the bankruptcy process.

"Relative to other coal producers, however, we think Peabody'ssize and asset mix (it mines both thermal coal and metallurgical coal), its geographicalscope (it operates primarily in the Powder River Basin in the western U.S. and Australia,where its metallurgical coal mines are well-situated to serve Chinese markets),and its lack of exposure to Central Appalachia (where costs can be prohibitive andthe ongoing viability of coal mining is especially in doubt) may make the companymore attractive to investors," S&P wrote.

SNLEnergy and S&P Rating Services are both owned by S&P Global Inc.