Coal Assets & Competitive Advantage Pt. 1

A quick guide for the new coal investor

When trying to differentiate between various coal producers, it all comes down to the real competitive advantage inherent in the coal assets. As you’ll soon see, the various forms of competitive advantage come with important implications such as pricing power, embedded optionality, ability to ramp production, etc. In this article I’m going to cover the basics and explain all the nuances inherent in coal assets, and how the details can help or hurt the bottom line.

I’m going to touch on the following here in Part 1:

• Coal Quality & Marketability

• Coal Sales

• Low Cost Mines

Then I’ll cover the rest in Part 2:

• Transportation Infrastructure & Optionality

• Proximity to Markets

• Port Capacity

• Workforce

---

Coal Quality & Marketability

It all starts with the quality of the reserve base. During the drilling and exploration stage in the life cycle of a coal mine, the primary considerations to geologists and mining engineers are the thickness and geographical extent of the coal seam(s) and the coal quality.

That’s yours truly, logging core somewhere in the Hunter Valley, Australia

Thermal Quality

For thermal mines used in electricity generation, the energy or heating content is obviously paramount. The energy content is contained within the volatile matter and fixed carbon of the coal. We measure heating content in terms of Btu/lb in the US, whereas overseas its referred to as calorific value and measured in units of kcal/kg. Another consideration is ash, which is measured simply as weighted percent (wt%) of the sample. Ash is simply the non-combustible minerals within the coal. High ash leads to slagging and fouling problems in the boiler. Sulfur is important due to SOx emissions. The higher the sulfur content the higher the emissions and flue-gas desulfurization costs. There’s a good summary of US thermal coal qualities in different producing regions on page 43, linked here.

There are entire books written on coal quality but I’m going to move on for brevity, if you want to learn more you can message me and I’ll send you some reading material.

Metallurgical Quality

Met coals have a unique quality in that they swell upon heating, followed by a gaseous release of its volatile matter content. This leaves a hard porous carbon material called coke, which under high temperatures reduces metal oxides to metals. Coke is therefore a fuel and reactant utilized blast furnaces during primary steelmaking. Met coals are differentiated by their volatile matter content and coal rank.

In the US, we have the following coking coals with established specifications for East Coast indexes:

1. Low Vol (LV)

2. High Vol-A (HVA)

3. High Vol-B (HVB)

LV vs. HV are differentiated by volatile matter content, and HVA vs. HVB is determined by coal rank.

Overseas there are three main categories all differentiated by coal rank:

1. Hard coking coals (HCC)

2. Semi-soft coking coal (SSCC)

3. Pulverized coal injection coal (PCI)

PCI is not a coking coal, but it’s still referred to as a metallurgical coal since its used in steelmaking. PCI coals are used for their heat value and are injected directly into blast furnaces without going through the coking phase (since they lack caking properties).

Coking coals are blended together to create a favorable mix specifically for it’s use in the coke oven. Here is a 1 minute video from Suncoke Energy explaining the process. I think the coke battery in this video is the Haverhill Coke Plant up the road from me in Franklin Furnace, OH.

N. American and European coke ovens and blast furnaces were designed to utilize Appalachian coking coal, whereas SE Asian steelmaking infrastructure were designed for Australian blends. It’s important to know that coking coals of the highest quality are a very unique substance that are becoming increasingly geologically scarce throughout the world. The very best coking coals are the backbone of most coking blends utilized for globally for coke production. These reserves will still be in demand 100 years from now, as long as humanity requires iron and steel.

During periods of high demand the high quality coals receive a higher premium relative to lower quality coals. This is because when steel producer utilization rates are high, steel producers can actually save money by purchasing higher quality feedstock. The chemical processes require less material when the materials are high quality. By the way, this quality to cost savings relationship also holds true for iron ore in blast furnace, and thermal coal in electricity generation.

Conversely, during extreme downturns, low quality met coals like HVB will garner the same price in the marketplace as a high heating value thermal coal. Therefore, before investing in a met producer, it’s important to know their quality blend. Are they producing mostly HVA and/or LV or is it a mix of mostly HVB?

Coal Sales

Coal quality is paramount to marketability and most producers have a coal sales team whose job it is to establish relationships and peddle their product. Some producers, on the other hand, use coal trading firms as a third party to procure and organize their sales. The major trading companies I’ve come across in N. America are Xcoal and Javelin. I’ve even heard of Xcoal being referred to as the “OPEC of coal” at an industry conference.

These trading companies are good at offloading volumes but bad at maximizing sales price realizations for the producers. In a cyclical downturn it’s good to have the trading companies as part of your sales “team” since they can place volumes into places and customers that an in-house sales team perhaps couldn’t have penetrated. They’re also fairly sophisticated and often hedge and use derivatives which gives them a level of robustness in a downturn above and beyond what your typical small to medium sized coal producer has. In times of a cyclical upturn however, the supply contracts with a third party trader are often a liability. For example, I’ve seen a producer sell high quality met for $80/ton due to a supply arrangement inked in 2015 or 2016, and meanwhile the trading firm was selling it forward for probably twice that amount in 2017 and 2018. As we’ve seen twice now in recent history, when coal markets begin to rally they often do so quite abruptly. The upside volatility is not captured in fixed-price supply contracts, which are good on the way down but bad on the way up.

Referring specifically for met coal produced in the US, the characteristics of domestic vs. exports sales is important to differentiate and its something I’ve noted previously in my writing.

• Domestic met contracts are for a predetermined volume at a FIXED price, and typically for a years worth of supply. Therefore each year buyers and sellers get to renegotiate their annual supply.

• Export contracts, on the other hand, are for a predetermined volume at a price that is determined by one of the various met indexes. They can differ on exactly how they are calculated but the takeaway is that they are not price-fixed.

This means producers with a mix of domestic and export can hedge part of their future production with domestic contracts and still maintain market exposure with export sales. Export contracts allow producers to see meaningful upside and allow them the optionality of ramping up production in good times to meet demand in the seaborne market. This excess volume allows their mines to run more efficiently (especially the longwall operations which thrive at higher volumes), lower their avg cost per ton, and maximize profit margins.

A good mix of long term domestic contracts along with export optionality is the sweet spot in the coal industry; it allows producers to naturally hedge a significant portion of future production and also capture excess revenue when prices rise in seaborne markets.

Keep in mind approximately 70-75% of US met production is exported in the during a good year. If you’re invested in a producer serving mostly domestic customers you may not be getting the upside price exposure you originally thought. The sales strategy of each producer is somewhat hard to figure out, they don’t often explicitly state the use of trading firms in their financial statements. This is where listening to the earnings calls during the Q&A can have an advantage. Listen to questions about forward price assumptions.If they have no idea where their realizations are headed then they’re probably not operating under many long term fixed-price contracts. If, on the other hand they have very specific guidance, it’s a clue that they have some fixed-price agreements and could therefore be losing premium relative to spot prices in an upside pricing scenario.

Low Cost Mines

At the end of the day, success in the coal industry is determined by the long run spread between price realizations per ton and mining costs per ton (sometimes referred to as cash costs). A mine at the low end of the cost curve has a higher probability of surviving during a downturn. Similarly, a producer with their weight average mining costs at the low end of the cost curve has a higher probability of surviving during a downturn.

In general, high volumes create better economies of scale which then generates low mining costs. Therefore a large scale strip mine utilizing draglines to remove overburden from thick coal seams is going to be much cheaper than a contour mine on a mountainside in Appalachia, on a per ton basis (all else being equal).

Here’s a picture of a dragline and mining strip I took at the Liberty Mine in Kemper County, MS. By the way, that is a small dragline by industry standards.

Similarly, an underground longwall mine is usually going to be much cheaper than a room and pillar operation on a per ton basis. Below is a video demonstrating how awesome longwall systems are:

There’s another video for those interested in room and pillar mining and the equipment involved, linked here.

Besides the cool technology, it’s important to know what sort of mining operations you’re investing in and where the company generally falls on the cost curve for whichever market they’re supplying.

For example, two years ago when Henry hub natural gas prices were in the $2 range and consensus believed (and probably still believes) that US domestic thermal was dead, we all assumed every thermal mine that was NOT a high volume surface operation (think PRB or dragline strip mining) or if underground, was NOT a longwall, would be closed in 10 years. While consensus might be shifting, this is something to keep in mind from a risk standpoint.

In terms of met coal, the 2019 global supply curve can be found here. Look into the financials of each met producer, find out where they likely fit on this curve. The ideal met producer will have mostly high quality High Vol-A and/or Low Vol reserves, and operate some world class, low cost longwall mines.

I should note that longwall systems represent huge capital investments and operators of them do not really have the flexibility of materially lowering their output in a downturn. The engineering and geotechnical implications of slowing a longwall down does not work very well. Longwall systems are like race cars, it doesn’t really make sense to drive them slowly, from a cost and mining conditions standpoint. During the downturn in 2015 and 2016, I recall how a couple large longwall mines continued producing large amounts of met coal, completely swamping the anemic demand in the market at the time. The explanation/rationale was that the producers needed the cash flow to meet their heavy debt obligations. As with anything differentiating, it has its pros and cons which represent risk and reward for the investor.

---

I hope Part 1 provided some good food for thought for the intrepid new coal investor. Part 2 should tie it all together when I cover transportation infrastructure & optionality, proximity to markets, port capacity, and finally workforce.

Feel free to provide me with any feedback necessary to make future articles even better. If you have any questions for me, please leave a comment. Also, please consider sharing this article and subscribing by hitting the buttons below.