The end of coal?

Face it. Even putting a question mark on that headline is just a technicality. As long as the world needs steel, there will be a cyclical market for metallurgical coal. But when it comes to the business of mining, moving and burning coal for energy, its demise is no longer a matter of if, but when
By John Greenwood

Better days: Brule mine near Tumbler Ridge, one of a bundle of steelmaking coal mines bought by Walter Energy for $3.3 billion in 2011; by 2014 they were idle

It had been a brutal quarter for Teck Resources Ltd. (TSX:TCK.B) and Don Lindsay, the chief executive, speaking on a scheduled earnings call with analysts in late October was doing his best to put a bright face on things. Although the company had just announced a $2.1-billion quarterly loss, due primarily to a $1.5-billion writedown of its coal assets, Lindsay insisted that Teck, one of the world’s biggest metallurgical coal producers, was holding up well in the face of withering market conditions. Sure, the company, which also mines zinc and copper, can still find buyers for its bonds and, no, there are no plans to sell more shares and dilute existing investors. And so it went until the end of the call when Lindsay—perhaps mindful of disclosure rules—acknowledged that at least in the eyes of some, Teck had its back against a wall.

Some of the questions, he said, were based on the assumption “what if the [commodity] cycle is dead” and prices for coal stay low “forever.” But such fears are overblown, Lindsay told the analysts. “I’d point out that when we deal with large institutions such as banks and other companies that are involved in long-term investments… they don’t believe that the cycle has disappeared.” In other words, you analysts need to get a grip.

It is unclear whether Lindsay’s lecture put anyone’s fears to rest but the fact he felt the need to deliver it at all was a testament to the level of desperation in the industry. Commodities have taken it on the chin, none more than coal, and an accumulating tally of exits, closures and cutbacks in the sector reflects it. But Teck is the bluest of blue-chip Canadian coal producers. Small wonder that when Listed went looking for coal executives to give their take on market conditions, we didn’t get many takers. No one wants to be the bearer of bad news.

Prices have fallen so far that half the world’s coal isn’t even worth digging out of the ground, according to a recent report by Moody’s. After soaring as high as US$139 a tonne in 2011, thermal coal has dropped more than 70%; metallurgical coal, meanwhile, fell from US$330 a tonne to US$75 at the end of last year. What’s more, for a big chunk of the industry, things are unlikely to improve. The world is facing “a long, slow secular decline” in thermal coal used for generating electricity, Moody’s said. Translation: Prices are unlikely to recover, ever.

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Oversupply is the immediate culprit. After growing at breakneck pace since the turn of the century, China’s economy is running out of steam, and that has hollowed out global demand for virtually every commodity, especially coal. Worldwide consumption of coal peaked in 2013 at 7.8 million tonnes (about half of that in China); in 2014 it fell 0.9% and was down as much as 4% last year.

It’s not just the cycle. The situation for coal power is exacerbated by the rapid decline in the cost of renewable energy such as wind and solar and which are now cost-competitive.

And then there’s the long-term thorn in the industry’s side: burning coal is the single-biggest contributor of greenhouse gases into the atmosphere. And there is a widening consensus among not just scientists and environmentalists, but policymakers, the public, business leaders, insurers, shareholder groups, investment funds, even central bankers, that if anything’s to be done about global warming, it must start with the elimination of coal as a power source.

This realization was manifest in the just completed COP21 climate meetings in Paris and the resulting Paris Agreement, approved by 195 countries, including Canada, the U.S. and China, the world’s biggest greenhouse gas emitter. The agreement’s underpinning is a collective pledge to act to hold the rise in average global temperatures to less than 2°C above pre-industrial levels. The pact only becomes binding on member states once 55 parties who produce more than 55% of global greenhouse gases have ratified it. But the market in many ways already reads it as a done deal, acknowledging that the shift to lower-carbon economies and societies is inevitable.

Some jurisdictions, of course, such as Ontario, have already abandoned coal power. But many more have recently announced timetables to join them, including the United Kingdom, New York State and the province of Alberta. In November, Alberta premier Rachel Notley unveiled a climate plan, promising to limit greenhouse gas emissions from the oilsands and to phase out altogether the province’s coal-fired power plants by 2030. Critics have taken her to task, but the plan won broad support from both environmental groups and industry.

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On the flip side, China’s coal consumption is still massive and will be for some time. Likewise, India intends to increase its coal generation and domestic coal production significantly to deliver growth for much of its remaining underdeveloped population. Those trends mean that while there was a net drop in global coal production in the past two years, overall coal production may continue to grow modestly until the full transition takes hold. Or not: in December the International Energy Agency cut its 2020 forecast for global demand by 500 million tonnes (about 5%). According to IEA’s senior analyst Carlos Fernández Alvarez, there’s no doubt that coal is on its way out. “The question,” wrote Alvarez in a 2015 report, “is how fast it will happen.”

EXPERIENCED PLAYERS WILL tell you that all commodities are about booms and busts, up-cycles and down-cycles. If you can muster the discipline to sock something away in the good times, you’ll likely make it through the hard times. No one knows when the current cycle will turn but what seems certain is that it has a while to run yet.

Historically, the reason for coal’s popularity as a fuel was that it was plentiful and cheap. Cheaper than natural gas, cheaper than diesel, cheaper than any other fossil fuel. Coal was what drove the industrial revolution back in the 18th century and it’s still used around the world today for the same reason. But the cost advantage is disappearing.

Partly, that has to do with widening recognition of coal’s detrimental impact on the environment and human health. That reality was rarely acknowledged a decade ago, now it’s a cost that is being factored in.

On top of that, a number of technological developments in recent years have eroded or even eliminated coal’s prized position as the cheapest fuel. Not that long ago setting up solar panels was a rich man’s hobby, a niche business that couldn’t exist without government subsidies. But thanks to major improvements in efficiency, it’s now competitive with coal in many parts of the world. Solar electricity generation globally has grown at an annual rate of 50% for the past decade, the fastest of all energy sources, according to the Canadian Solar Industries Association. The numbers for wind are impressive as well. Canada ranks seventh in the world for total installed energy capacity, according to the Canadian Wind Energy Association. In 2015, wind supplied about 5% of electricity demand, enough to power three million homes.

But right now the biggest threat to coal is natural gas. Thanks to the fracking revolution in the U.S. and the huge amounts of previously inaccessible hydrocarbons that have been unleashed, natural gas prices have plummeted to the point where it’s more competitive than coal. In terms of emissions as well, natural gas is superior. In the U.S., many coal-fired power plants have already been converted to natural gas and other countries are going the same route.

Indeed, after China, a big part of the coal story is unfolding south of our border. The U.S. is a giant as well, the world’s second-largest producer and consumer. But the industry has fallen as fast and hard as anywhere. In the past five years, U.S. electricity generation from coal has tumbled from 50% of the total to just 34% in 2015. Even more ominous from an industry perspective was President Barack Obama’s decision in January to impose a three-year moratorium on new leases for coal mined from federal lands.

The fallout from all of this has been devastating. Take Peabody Energy Corp., the country’s biggest producer. As recently as 2012 Peabody, based in St. Louis, Mo., had a market value in the billions with shares changing hands at US$1,000. But after hemorrhaging thousands of jobs and slashing billions of dollars of operating costs it fell to US$2.15 a share in early February. A giant question mark hangs over its future.

Arch Coal Inc. is just behind Peabody in terms of size but it’s a few steps further down the road in terms of evolution, having filed for protection from its creditors in January. It joins fellow behemoths Walter Energy Inc., Alpha Natural Resources Inc. and Patriot Coal Corp. In fact, more than one quarter of U.S. coal production is now in bankruptcy, according to the Wall Street Journal.

The situation in Canada is not much better. Former major producer Sherritt International Corp. (TSX:S) hived off its coal business and sold it for $946 million back in 2013—a move that Sherritt must be feeling pretty good about today. Half of those assets went to Westmoreland Coal Co., a U.S. producer that has been quietly snapping up struggling competitors as part of a bet that coal will come back into fashion.

Under the guidance of chief executive Keith Alessi, Westmoreland built a reputation as an efficient operator and a slasher of costs. But Westmoreland’s bet is a long way from paying off. After trading at more than US$40 in August 2014, the company’s shares were languishing at around US$6 when Listed went to press. Recent news from the company has done little to bolster confidence. In October, it announced Alessi’s departure as chief executive, effective the end of 2015. He was replaced by Kevin Paprzycki, the former CFO.

The lion’s share of Canada’s coal is produced in the western provinces, mostly B.C. and Alberta where where, with closures, roughly a dozen operating mines now produce something below 65 million tonnes, roughly split between metallurgical and thermal coal. Nearly all the metallurgical coal is exported—we’re the world’s third-largest supplier, according to Natural Resources Canada—while the thermal coal is burned for power generation, primarily in Alberta and Saskatchewan.

If there’s any silver lining, it’s that the Canadian coal industry is less dependent on thermal coal and less burdened by debt than its counterpart south of the border, according to Robin Campbell, president of the Coal Association of Canada. That’s given players more time to batten down the hatches—more rope to play with—but the mood is still grim.

“You’re seeing some closures and you’re seeing some projects put on hold,” says Campbell, who adds that the last time he remembers the market being this negative was back in the 1980s. “If this goes on for a couple years… there’s no company that can withstand that pressure.”

Because so much Canadian coal is exported, the fallout also extends to the three major export terminals on B.C.’s coast. Ridley Terminals, in Price Rupert, owned (and technically still up for sale) by the federal government, operated at about 25% of its 18-million-tonne capacity in 2015. North Vancouver’s Neptune Bulk Terminals, meanwhile, 46%-owned by Teck, ran at 50% of its capacity. And Westshore Terminals, in Delta, which handles coal from Teck as well as U.S. producers, recently cut its 2016 volume forecast by about 20%.

While admitting the big negative driver is global demand, Campbell still reserves some of his blame for politicians here at home. “I think at the end of the day in Canada and particularly in Alberta, when people see the costs [of climate change rules] versus the benefits, you’re going to see that people are going to want to go back to coal-fired generation.”

One of the few industry chief executives who agreed to give us his take on the industry was David Turnbull of Hillsborough Resources Ltd., a Vancouver Island producer that boasts the closest operating mine to the West Coast in North America. A producer of thermal coal, Hillsborough is owned by Vitol Group, a privately held Swiss trading company. But the day we spoke to Turnbull, he informed us the mine had just been put up for sale.

“We have a number of people who are interested in purchasing it,” he says, declining to elaborate. Conditions in the market may be depressed “but it is a cyclical business,” he adds.

At one time, coal-fired generating stations dotted all of western Canada, but they’ve been disappearing, completely gone in B.C. Turnbull is confident that coal is not going away as a power source. “There’s over seven billion tonnes used per year,” he says. “It may be a business that’s changing, but there’s still a lot of coal being used, whether people like it or not. The world is continuously changing. Some places will use more coal going forward and some places will use less.”

As for the decision to sell Hillsborough, it isn’t about pessimism, Turnbull insists. Rather, Vitol simply regards the company as a non-core asset that could be more valuable to someone else. “It was a strategic decision.”

IN TERMS OF economic impact in Western Canada, coal is dwarfed by the oil industry, but it is nonetheless a powerful force with strong public support, especially in regions where it’s a major employer. For instance, in Tumbler Ridge, a town in northeastern B.C. built by the province more than 30 years ago to provide accommodation for workers at local coal mines, it’s the lifeblood of the community. In towns in the Elk Valley in southwestern B.C., home to several massive coal operations, it’s a similar story.

People in producing areas may recognize there’s no solution for softening world demand, but there is widespread discontent with politicians like Notley who are legislating change. But they’re in a losing battle there, too.

“I definitely don’t see the government backing down,” says Ben Thibault, director of the Pembina Institute’s electricity program. “People increasingly understand the pollution issues. There’s strong public support for closing coal plants.”

It gets even more interesting on the capital markets side, where institutional investors such as big pension funds are scrutinizing their holdings through a responsible, risk-adjusted lens, jettisoning companies that fail to pass muster. In many cases, clients demand it.

Sustainalytics is a research firm focusing on responsible investment, analyzing companies based on ethical, environmental and governance performance. Founded in Toronto back in the 1990s by Michael Jantzi, the company now boasts offices around the world. According to Jantzi, the investing public has come to the realization that burning coal to generate power needs to stop. “For a lot of longer-term investors, the industry has become a pariah,” he says.

Proponents argue that with the right technology, dangerous emissions could be reduced or even eliminated, and that the carbon dioxide could be stored cost effectively under ground, through so-called carbon capture techniques. But carbon capture has never been commercially viable “and even the cleanest-burning coal plants are not nearly as efficient as a natural gas plant,” says Jantzi, adding that investors are taking this into account when they make decisions.

“All these things led to the consistent downward trend in the share prices of coal companies,” he says. “What we tell our clients is that there is no question we are in a down-cycle, but that this is a spiral that the industry may not be able to come out of.”

From an investing perspective, the final nail in the coffin for coal may be new U.S. securities regulation. In November, Peabody settled with the Securities and Exchange Commission to end a two-year investigation into the company’s disclosure around what it knew about new climate change rules and how those rules might hurt its business. As part of the settlement, Peabody agreed to beef up the quality of its disclosure.

As far as the SEC is concerned, the case has nothing to do with whether coal is bad for the environment. The regulator simply wants companies to communicate what they know about risks they face. Canadian companies are also required to disclose risks related to environmental legislation and climate change, though analysts point out the rules are vague compared to the U.S. version. Still, the direction is clear. As policy makers introduce stricter emissions rules, coal companies will find themselves under greater pressure and with less room to manoeuvre. If they fail to disclose to investors what they know is coming, they will be penalized by regulators. That, in turn, will open the door to shareholder lawsuits, something no company chief executive wants to face, especially one whose business is already on life support.

These are not baseless concerns. Mark Carney, Governor of the Bank of England and chair of the international Financial Stability Board, set the energy industry on edge when he argued in a recent speech that, “parties who have suffered loss or damage from the effects of climate change [could] seek compensation” from carbon extractors, emitters and their insurers. In December, Carney also named Michael Bloomberg to lead a related task force that will develop voluntary climate risk disclosure guidelines.

ON FEBRUARY 11, Teck announced its fourth quarter and full year results for 2015. The news included another writedown and for the quarter the company posted a net loss of $459 million, bringing the total loss for 2015 to $2.47 billion.

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CEO Lindsay, speaking on a call to analysts (Teck declined our request for an interview), once again did his best to be upbeat. “We were pleased with our operating performance in 2015, meeting our guidance, reducing our costs and raising nearly $1 billion,” he told his audience. “However, the commodity cycle continues to provide us with a very challenging environment.”

The best news is that compared to its global peers, Teck is a strong player with rock-bottom production costs and the balance sheet strength to withstand ongoing market turmoil—at least in the medium term. According to a Feb. 7 report by Sasha Bukachevka, an analyst at BMO Capital Markets, “while Teck’s cash generation remains under pressure as metal prices have been looking for a bottom for some time now, we believe its balance sheet is well positioned to withstand an extended pricing downturn.” In the event prices stay where they are now, the company will meet its obligations and continue to hum along.

There are many moving parts to this story. For instance, Canadian producers continue to benefit from the lower loonie and they’re also getting help from the B.C. government which plans to give them breaks on their power bills. All that might come as too little, too late for thermal coal miners and others that have already shut down, but not Teck. “[We] have a plan to navigate an extended low price environment and emerge even stronger,” Lindsay assured listeners on the February call, “ready to take advantage of the next up-cycle.”

Photography: Coal Association of Canada

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