By Taylor Kuykendall

DEBTORS' COMBINED MOTION FOR ENTRY OF (A) AN ORDER ESTABLISHING BIDDING AND SALE PROCEDURES FOR THE POTENTIAL SALE OF CERTAIN MINING PROPERTIES AND RELATED ASSETS AND GRANTING RELATED RELIEF AND (B) ONE OR MORE ORDERS APPROVING THE SALE OF SUCH PROPERTIES

This is the fifth article in a multi-part series looking at the state of the U.S. coal industry. Part five considers whether a smaller more consolidated coal industry could better withstand future market challenges.

If you became familiar with the U.S. coal industry just a few years ago and had not revisited it until recently, there is a good chance you might not recognize the vastly changed sector.

It is not just that the industry is shrinking, though it is, the sector is also seeing old familiar faces fade into bankruptcy, new and bold players emerging and some are even being tempted away by the fuel's greatest competitors, natural gas.

"The United States coal industry will be significantly smaller in five to 10 years as the American coal markets will shrink further from the 1.2 billion ton per year level, prior to the election of Mr. Obama, to our predicted 700 million tons per year by 2018," said Murray Energy Corp. spokesman Gary Broadbent. "Further, a study by McKinsey and Co., which was just released, shows that the coal industry, as a whole, taking all producers together, is now bankrupt. Indeed, all coal companies together currently lack $45 billion to fund their debts and employee and reclamation liabilities. Only three of America's leading coal companies are currently demonstrating positive cash flows, and two have large debt levels. As such, we expect much more restructuring to come."

Chiza Vitta, a Standard & Poor's analyst, told SNL Energy it is difficult to say when a coal market rebound could come and many of the new faces and restructuring that are going on in the industry has not yet proved itself out. As a result, investors are cautious.

"The markets have really painted the sector with a broad brush and valuations have fallen," Vitta said. "To be sure there's been some impairments, but on the equity side you see 80% reductions in valuations across the board, and in my opinion there hasn't been much of a differentiation between the stronger players and the weaker ones. … As sales and restructurings slow down and there's consistency, some comfort will come back and investors will be comfortable investing in the space again."

One of the greatest constants through the changing face of the sector has been Peabody Energy Corp., which has dominated the sector by production for more than a decade.

Peabody too, however, has changed vastly. While country singer John Prine may have lamented the damage the miners did in Paradise, Ky., the company long ago spun its union-laden Appalachia assets into Patriot Coal Corp., a company now being picked apart by up-and-comers in the sector via the bankruptcy court. Peabody recently sold its New Mexico and Colorado mines off to Bowie Resource Partners LP.

With assets in the Illinois Basin and feet firmly planted in Wyoming's Powder River Basin, Peabody is one few large U.S. coal companies that have kept itself off both the bankruptcy and penny stock rosters. In a recent earnings call, Peabody President and CEO Glenn Kellow noted every one of the company's U.S. mining assets were EBITDA and cash flow positive and despite "undoubtedly difficult, if not unprecedented times for the coal sector," Peabody is banking on future opportunities in global coal markets.

"We have an unmatched portfolio with access to some of the best markets," Kellow said. "… We have significant advantages from our diverse operations, particularly in the PRB, Illinois Basin and Australia. … We believe that long-term global coal demand is favorable, even though its effects have been masked by near-term industry headwinds, and Peabody continues to take necessary steps to improve our operations in business and we recognize that there is more to do."

Trimming and shifting

Moving south down the list of top coal producers, it does not take long to encounter signs of trouble.

Arch Coal Inc. has reported production of 99.8 million tons of coal in the first three quarters of 2015, the second highest of any producer. While more than three-fourths of Arch's production in the period came from its single Black Thunder mine in the Powder River Basin, the company is also heavily invested in Appalachia. Arch skipped hosting a call with investors in the quarter, instead focusing on debt negotiations as the company warned in early November that it could commence a bankruptcy proceeding.

Arch noted that markets are expected to remain weak in 2016. What a potential bankruptcy could mean for the second largest producer in the coal space is not yet known, but peers that have already resorted to the courts to fix their balance sheets may offer a hint.

Patriot survived just a few years after Peabody spun out its Central Appalachia assets after a crash in coal prices — particularly hard-hitting for those in the metallurgical coal sector — dried up revenues for a slew of companies that had piled up debt in anticipation of growing markets in China and India and other markets for steelmaking coal. The company fairly quickly returned to the bankruptcy court, this time to dissolve Patriot and sell its assets.

Alpha Natural Resources Inc., the fourth largest producer in the U.S., and Walter Energy Inc. similarly suffered the price hit, but both are seeking to reorganize in the courts and return stronger, better able companies. In court filings, Alpha Chairman and CEO Kevin Crutchfield referred to the reorganization as a "breathing spell."

"The unprecedented changes facing the coal industry run deep and are occurring at a frenetic and unpredictable pace," Crutchfield wrote. "… The U.S. coal industry as currently structured is unsustainable."

A part of that structure change will come from Alpha itself. Though it shut down many of its Appalachia properties before filing for bankruptcy protection, now it seeks to off-load even more of those operations it says "in many if (if not all) cases, pose a burden" on the company in a bankruptcy auction.

Cloud Peak Energy Inc., the third largest producer in the first three quarters of 2015, is already different than many of its peers. The company only holds property in Wyoming and Montana and is a major player in the sector with just three large surface mines. While the company's assets produce primarily coal with a lower heat value, the company was built without building much debt and Cloud Peak is significantly less leveraged than many of its peers.

However, the company said it is seeing the market for coal fall faster than producers have been able to hold off production. The company has trimmed millions of tons to account for the decline in demand, but anticipate if prices hold or decline, more cuts could be in the works even in the Powder River Basin.

"It will always be slow because people want to try and keep their mines open and they'll do lots of crazy things to manage their costs," Cloud Peak President and CEO Colin Marshall said on a third-quarter earnings call. "So I think it is going on, it's just not gone to the point that supply has been less than demand. And that's the issue with pricing."

“ I think there are still a lot of unknowns in terms of how much of an effect the new regulatory environment will have on production. Regardless of where that ends up, coal will certainly continue to be one of the top, if not the top, fuels for electricity generation though it will fall from where it is today. ”

 Chiza Vitta, analyst, Standard and Poor's

Diversification away from a pure-coal asset portfolio has been tried by a few producers. CONSOL Energy Inc., which still is the seventh largest coal producer, has made a high-profile move toward natural gas while still experimenting with innovative contracts that leverage its ability to provide coal or natural gas to its customers.

Among the coal assets CONSOL Energy held was a Pennsylvania complex that produces high-Btu coal the company is using to market to customers. While its coal production was significantly reduced, the company has taken up a focus on quality.

"Since our coal is 13,000 BTUs per pound, it travels very well," CONSOL President and CEO Nick DeIuliis said on an Oct. 27 call. "People often forget to take into account BTU adjustments when comparing the different basins. … If you follow up what's happening in the domestic metallurgical coal markets and the weakness of a lot of suppliers, it's given us more opportunities. That's why we're building our position domestically."

A potential rebound in metallurgical coal prices would most benefit companies like Alpha or Walter who already have a big stake in those assets. Vitta said overleverage and sort of circular contribution to an oversupply problem really hurt those companies. The timing of a recovery could be the difference between the return of some of met coal giants, or their fragmentation or absorption into other companies.

"I think most people agree in the longer term, Chinese demand will come back since they are such a large consumer of coal, that picture might get better now," Vitta said. "By no means do people think necessarily prices will get back to where they were before, but the combination of hopefully … a reduction in supply and the continued upward long-term demand trend for metallurgical coal will mean that companies can once again be profitable producing met coal."

Emerging and growing

Murray Energy, one of the most vocal opponents of the Obama administration and regulations it sees as significant threats to the coal industry, meanwhile, is expanding. The company is still betting on coal, scooping up CONSOL's longwall mining operations in West Virginia and even expanding into international coal properties.

Murray Energy's strategy, which Broadbent said is still employed today, involves buying only high-heating value, longwall minable reserves with low-cost transportation located near base load generating power plants. While the company's finances are private, its ability to expand upon its strategy with the CONSOL acquisitions suggests the strategy is working.

The options for adaptation to the diminishing coal market are few. Broadbent said Murray Energy has positioned itself for international growth, but repeated a statement of Founder and CEO Robert Murray saying that under currently depressed coal prices "the export market is not a panacea" for coal producers. Broadbent said there will be a pivot in the sector to export markets, but "not to a significant extent."

Broadbent said what the industry needs is pro-coal president and an immediate stay of the Clean Power Plan. Neither, however, may be enough to reverse the coal industry's decline.

"Unfortunately, no president will be able to fully reverse the damage that has already been caused by Barack H. Obama and his radical administration, as once these coal-fired power plants are closed, they will never come back," Broadbent said. " … Our court system is far too slow to assure the checks and balances from the judicial branch over the executive branch that the fathers of our Constitution envisioned, and the Obama administration uses this to the fullest, destroying the jobs and family livelihoods of our coal miners in the process. This is an absolute tragedy for America."

Other companies such as Blackhawk Mining LLC are scooping up the pieces of its bankrupt peers, building a larger and more diverse coal mining portfolio. New players such as Royal Energy Resources Inc. are even looking at the distressed market with wide eyes.

"It's been the wrong time for a long time to invest in coal, but now we've got this great opportunity at the bottom of the market," Royal Energy President Ronald Phillips told SNL Energy in a prior interview.

Vitta said that many producers "have finally accepted it's a depressed market" and as there are "more asset sales and more supply come off" things will begin to shake out, with those making the best investment decisions able to emerge on the other side of the downturn with potential upside.

"I think there are still a lot of unknowns in terms of how much of an effect the new regulatory environment will have on production," Vitta said. "Regardless of where that ends up, coal will certainly continue to be one of the top, if not the top, fuels for electricity generation though it will fall from where it is today. … The restructuring and capacity that could come off will shift the landscape. … Some producers just have assets that will not be profitable."

Standard & Poor's Ratings Services and SNL Financial are both owned by McGraw Hill Financial Inc.