Questions on the Obama Administration’s Moratorium?

In announcing a moratorium on federal coal leasing last week, Interior Secretary Sally Jewell articulated it largely as a tool toward managing climate change.

Jewell noted that the federal lease program had not been reviewed in 30 years. She said that when reviews were finally undertaken the Interior Department realized market conditions had changed and that the program needed adjusting to align current policy with market realities.

WILL THIS CREATE COAL PRODUCTION PROBLEMS?

Peabody Energy said there would be no immediate impact on coal production. The company added that it is well positioned today, with a 20-year supply of Powder River Basin coal. Peabody executives added that they think the moratorium is misguided and that federal policy on climate change should be directed to technology investment, not federal lease reform. Cloud Peak Energy, another important Powder River Basin producer, said it saw no immediate impact. Its criticism was that the action is just part of the Obama administration’s agenda to keep coal in the ground.

Jewell put the impact of moratorium and the state of the nation’s coal resources succinctly: “There is plenty of coal.”

IS THERE PLENTY OF COAL?

From a technical standpoint, the U.S. has at least 100 years worth of coal resources. It’s a different story from a financial standpoint.

The Energy Information Administration says the Powder River Basin has eight billion tons of coal in active mines. If you think the region will produce about 400 million tons per year, then you have a 20-year supply.

However, having reserves under contract in active mines does not mean the coal can be mined and sold at a profit. For example, there are almost two billion tons of 8400 BTU coal under active production in the Powder River Basin. This coal has lower heat content than the more abundant 8800 BTU reserves in the region. Cloud Peak, Alpha Natural Resources, Peabody and Arch Coal all have some low BTU reserves. All are reducing production becasue pricing is weak, very weak.

Alpha, the only pure-play low-quality coal-reporting entity shows in its last posting that its Powder River Basin margins at best are $1.40 per ton with revenues at $11.40 per ton and costs between $10 and $11.40 per ton. Today the spot price for 8400 BTU coal is in the low $8 per ton range. To the degree there is any profitability, it is from the temporary and fading impact of existing coal contracts. Utilities and state public service commissions will be hard-pressed to grant fuel adjustments and new capex investment in a low-price natural gas environment that is liberally salted with declining prices for solar and wind.

You would think that coal executives would start talking about these issues as a way to prepare the market for supply reductions, higher prices and to set the stage for an early termination of the moratorium. But no, they are so busy managing the anti-Obama ideology machine and blowing smoke at state regulators, investors and bankruptcy courts that they are forgetting about their margins.

The coal industry has no plan to bring coal companies back into the real world. Maybe this moratorium during a down market can focus on questions of price and supply and begin some process of discipline that the coal industry is incapable and unwilling to bring about.

WHAT ABOUT THE NEED TO GROW COAL RESERVES AS PART OF THE INDUSTRY’S VALUE PROPOSITION TO INVESTORS?

Historically speaking, coal companies have touted the size of their reserves to investors as evidence of growing, vibrant companies. This strategy has benefitted companies by increasing their valuations when coal reserve levels and coal prices rise simultaneously. And federal leases awarded at below-market prices are always good for a stock price bump.

The truth now: Cheap coal reserve awards from a rubber stamp Department of Interior are at least temporarily in limbo. If Cloud Peak’s prescription is to be followed, then the lease processes would simply continue and the government would agree to flood an oversupplied market. One can understand Cloud Peak’s consternation at the temerity of a government that asserts its ownership rights.

The coal business is an extraction and depletion business. The moratorium puts a crimp in the reserve growth thesis and should prompt changes in the industry’s business model. Under existing SEC rules, coal companies have great latitude in how they present reserve valuations. We remember circa 2010 when one coal company told its investors that 2015 Powder River BAsin coal prices of $30 per ton were possible. Others were trying at the time to sell the investment community on $125-per-ton export prices off the West Coast. These speculative numbers fueled acquisitions and coal reserve prices. Today the spot-market domestic price of Powder River Basin coal is less than $10. Newcastle benchmarks hover around $50 per ton and are expected to drop to the low $40-per-ton range over the next seven years.

SHOULDN’T MARKET CONDITIONS FORCE REALIGNMENT, AND SHOULDN’T THE FEDERAL GOVERNMENT JUST GET OUT OF THE WAY AND LET IT HAPPEN?

Jewell referenced two prior moratoriums, one in the 1960s and one in the 1970s. If you go back further, to the time of Teddy Roosevelt, you see that speculation was rampant and Congress found it should not feed such market frenzy.

This moratorium for the time being will curb coal industry enthusiasm for imprudent speculative initiatives that include large-scale exporting of coal to non-existent Asian markets. Most of the coal reserve frenzy during the past few years has been driven by the expectation of exporting coal off the West Coast. This initiative, rather than building value and revenue, has resulted in the opposite: depleting value and revenues alike. Cloud Peak, for example, the coal company with the highest market share of West Coast exported coal, has recently temporarily terminated its export operations. Peabody invested heavily in the MacArthur mine in Australia and is now saddled with $5 billion in debt it cannot repay. One has to wonder about Peabody’s commitment to technology investment when they decided to throw years of future profits into more coal mining without a viable plan for the survival of the company.

Perhaps the Department of Interior can take two lessons from the larger financial trends. First, the country needs fewer mines. The coal industry is in structural decline and yet it will not sufficiently cut production to meet demand. Second, pushing the coal industry into a smaller size is economically wise and serves to do something the industry itself won’t do. Coal companies mine coal. They are poor investors and bad students of market dynamics. They also seem to be off their game in the political arena. Having scored a major battlefield win by killing federal climate legislation, they managed to lose the war in the marketplace as their stocks have proceeded since 2010 to crash.

The moratorium is a policy hiatus that comes at a time of energy-decisions crossroads for the U.S. As markets and policy move, the coal industry should end up with smaller, fewer companies mining less coal. Its has chosen a painful path of bankruptcy and liquidation, and out of this should come lower debt levels, modest margins and less speculation on exports. We would be surprised and delighted if the industry also moved to cooperate with regulatory efforts and programs to help the workers and communities hurting from the plant and mine closings.

We assume the coal industry will not embrace any of these trends until they must. Some companies are even looking at acquisition strategies, past this period of bankruptcy and insolvency toward a time when they have a more coal-supportive president, presumably one willing to wage a war on wind and solar energy.

In the end, the moratorium is an opportunity for the U.S. to set a course for the next several decades. In the 1980s President Reagan decided to flood the nation’s markets with cheap coal to drive down prices and protect the country from Mideast oil-market risk. From a financial standpoint, the decision worked. That business model between the government and the coal sector has run its course. What the next one will be is up to how the problem is analyzed and how the policy process is managed.

Tom Sanzillo is IEEFA’s director of finance.