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Coal starts focus on shareholder return, but executive warns of lack of capital

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A coal miner at an Illinois underground coal mine operates a piece of underground mining equipment.

S&P Global Market Intelligence

After a bounce in 2017 and hopes for a relatively stable year after a long period of decline and pessimism, one industry executive said he still sees at least one storm cloud brewing for the coal sector.

Aside from domestic thermal coal demand being squeezed by ongoing coal plant retirements and new natural gas capacity pushing out more coal customers, the broader industry is also finding itself capital-constrained, said Ramaco Resources Inc. Executive Chairman and Director Randall Atkins. While Ramaco debuted an initial public offering earlier in the year, Atkins said the IPO essentially amounted to a refinancing of the company's development capital, which was already in place on the momentum of a surge in metallurgical coal pricing seen in 2017.

"I think that window stayed open for a reasonably short period when you really think about it," Atkins told S&P Global Market Intelligence.

While the industry utilized nearly six times the leverage loan volume in just the first quarter of 2017 as it did in all of 2016, Atkins said the industry is still suffering from a lack of availability of new capital.

"I think if you look at what happened, post those offerings, debt holders by virtue of converting their debt into common equity are really retaining a majority ownership in these newly emerged companies out of bankruptcy," Atkins said. "The coal industry is probably one of the few industries where almost 90% of its shareholder base is hungover and grumpy. … 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."

A recent S&P Global Market Intelligence analysis showed hedge fund managers own about 34.9% of the outstanding shares of Peabody Energy Corp., the largest coal company in the U.S. About 20.4% of Arch Coal Inc.'s outstanding shares are held by groups classified as hedge funds.

Atkins said despite a "pop in the markets" there are few large greenfield projects launching in the coal space, as "any cash that hits the balance sheet" is flowing back to shareholders. While typically returning value to shareholders is considered positive, he said, he worries that investors looking to get their money back may be pushing management away from investing in future projects.

"I think what you're setting yourself up for is, as an industry, you're capital constrained," Atkins said. "It's a capital-intensive industry. There's a pretty short-term perspective that these companies are taking."

Large producers have been upfront about their plans to funnel cash flows to investors.

Peabody President and CEO Glenn Kellow said in October that "too often" the sector has defaulted to volume growth rather than returning cash to shareholders, something that will not be Peabody's default position. Peabody, freshly restructured in bankruptcy court after taking on large amounts of debt in years prior, recently enacted a $500 million share repurchase program and in the third quarter voluntarily repaid $300 million of debt.

Arch is also buying back shares and paying dividends to shareholders with excess cash flow, just a few months following that company's bankruptcy reorganization. CEO and Director John Eaves said the company does not want to do any mergers or acquisitions unless it would not impair the company's cost structure, but also noted that the company already has a "tremendous organic growth profile" and is continuing to work on projects from a permitting and planning standpoint as it primarily focuses on dividends.

"Given where we are in the cycle, we just thought returning cash to shareholders makes the most sense right now," Eaves said on an Oct. 31 call. "We'll continue to look at the business environment, the markets, and make a decision at that point, but [we are] very comfortable with what we've done thus far on the dividend and the share repurchase."

One of the largest coal companies not forced to file for bankruptcy, Cloud Peak Energy Inc., took a number of other measures to restructure, including getting away from self-bonding of coal sites and reducing its leverage. CEO Colin Marshall said the company is "waiting for the next shoe to drop" in the form of improved domestic prices, which he said will then put the company in a position to make decisions about what do with the capital.

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A towboat floats near a barge being filled with coal by a dock facility in Illinois.

S&P Global Market Intelligence

"We've given ourselves a position where we're under no time constraints and that was what we wanted to do," Marshall said on a recent earnings call. "Because obviously, the whole coal business has gone through a fair old step change, and now maybe some stability is coming to it."

In addition to not bringing on much new production through greenfield projects, Atkins warned if there is a significant issue with an expensive piece of equipment or a geological issue stops or slows production, finding the capital to replace that production could be difficult.

He noted that "banks are not even in the mix" when it comes to new financing in the coal space, and non-banks are mostly only providing refinancing for debt holders instead of funding new development. Part of that is because, despite much cleaner balance sheets after bankruptcy reorganizations, banks and other large lenders must consider the credit history among a class Atkins said may have "not yet earned back their spurs."

"I sort of see this not as a short-term issue, but a longer-term problem that if it is not corrected in some fashion, could certainly lead to some problems in the medium term," Atkins said. "You've got some very fragile capital markets out there as far as the coal space."

Atkins said investors felt a "sort of sense of whiplash" from coal markets in 2017. A couple of sustained quarters of stability in pricing and cash flow similar to the last half of 2017, however, could get long-term investors "sticking their toe back in the water" toward the end of 2018.

As for Ramaco, Atkins said after several bumps in getting production started in 2017, Ramaco is "looking forward to 2018" as the company substantially increases production. Analysts had recently lowered price targets on Ramaco due to operational concerns the company faced in 2017.