By Taylor Kuykendall

This is part one of a three-part news series in which SNL Energy analyzes the global metallurgical coal market that surged, busted and might still be seeking a bottom. While U.S. coal operators struggle under the weight of regulations, low natural gas prices, transportation issues and more, some of the first coal companies to seek bankruptcy this year have been those that invested heavily in met coal just before prices took a dive.

The first part of the series looks back at the optimism many in the sector held for the future of the market. The second part considers which company might be the next to fall. The third part looks at when a met coal recovery could happen and what that recovery might look like.

Jack Porco, president and chief commercial officer of Xcoal Energy & Resources, a top metallurgical coal marketer, declared 2014 "annus horribilis," or horrible year, for the met coal market. Then, he issued a warning that may have been hard for the already distressed industry to believe — "we haven't hit the bottom yet."

It was likely tough news to swallow given that many producers found months of low met coal prices had already decimated much of their balance sheets. Those in attendance at that March industry conference were already speculating about which companies might suffer the first and worst hangovers as met coal prices came off of their highs.

Among the publicly traded coal producers, Walter Energy Inc. looked to be in the worst shape at the time. The company's strategy as a pure-play metallurgical coal producer made it especially exposed to ongoing weakness in the market.

BB&T Capital Markets analyst Mark Levin said at the same conference that a commodity cyclical company should probably not let its net debt to EBITDA ratio get over 3x to 4x. At the end of 2014, Walter was reporting a ratio of 195.0x. Among major producers Patriot Coal Corp. beat Walter to bankruptcy court earlier this year as it retreated to reorganization for the second time since 2012.

After Walter filed for Chapter 11 protection on July 15, rumors swirled about which company might go next. At the end of 2014, Arch Coal Inc. had a higher debt to EBITDA ratio than Alpha Natural Resources Inc., but one key difference was that Alpha had debt that would mature sooner than Arch's. Now, of the public producers with debt to EBITDA ratios higher than 10x at the end of 2014, only Arch remains out of bankruptcy court, though the company has insisted it has significant liquidity and has made numerous efforts to provide relief to its debt position.

Because most of the companies suffering right now produce metallurgical coal for steelmaking as well as thermal coal for power production, the reasons for distress are complicated and vary by company. While weakening demand caused by increased reliance on natural gas price and greater pressures have crunched much of the industry, a large amount of the sector's stress can be traced to the rush to take on debt to buy metallurgical coal assets at a time when the market was surging on the promise of rapid economic growth in Asia and weather conditions in Australia had temporarily dazed one of the biggest global met coal suppliers.

"In our opinion, the problem for U.S. coal did not start with the weak natural gas prices of 2012. Rather, we'd argue the problems started with a wave of M&A during the previous year," Jefferies LLC analyst Peter Ward said in a March 2014 note. "In two decades covering the mining industry, these were some of the most regrettable transactions we had ever seen."

Fresh met coal properties in hand, many coal companies looked like a sure bet to some on Wall Street. Only a few months into the acquisition frenzy, however, demand for met coal tanked and oversupply steadily pushed down the price of the fuel.

What happened?

At the top of the market, the global met coal benchmark price was $330/tonne and left plenty of room for profitable margins. The latest settlement is at $93/tonne and some in the industry say it might not have bottomed yet.

Bennett Hatfield, the former CEO of Patriot, saw firsthand the devastation metallurgical coal markets wreaked on U.S. producers. While at Patriot's helm, he navigated the company through a drawn out bankruptcy only for the company to file again just a few weeks after his departure from the company.

In an interview with SNL Energy, Hatfield said a "calamitous oversupply" in the met coal industry "threw everything in a different direction."

"Everyone was looking at Asian growth and particularly the growth in China. I don't think anyone saw the dramatic change coming with respect to the slowdown in growth of the Chinese economy. … Everyone was doing forecasts that there was going to be huge demand for steel and iron ore and coal and so forth. … We all thought India and China were going to continue to grow," Hatfield said.

The Wall Street Journal reported early in 2015 that China's economic growth had slowed to 7.4% in 2014, "a level not seen in a quarter century." That stall in economic growth, along with other factors leading to an abundance of global metallurgical coal supply is more than many companies can bear.

In commodity markets, it is not uncommon to see cycles of stronger and weak demand, but confidence in metallurgical markets and eagerness to participate in those markets means many companies took on more debt than they could handle. It is tough enough to mine coal when it is hard to fetch a good price, but compounding that issue was that many companies also had big payments outstanding on what was supposed to be a herd of cash cows.

"If they were only charged today with trying to meet the market price for their product, they'd have a much better chance for surviving without reorganization," Hatfield said. "But, when you have to do that with the debt load and the huge interest charges, it's just almost insurmountable."

What were they thinking?

In a recent interview with SNL Energy, Chiza Vitta, an analyst with Standard & Poor's, said metallurgical coal assets looked very attractive in 2011 and producers were banking on prices remaining close to those near-term peaks.

"A tremendous amount of investment was made," Vitta said. "A lot of money was spent, which had the effect of levering these companies up so they had really high interest costs and debt burdens. As things got tougher, they were in a position where it was very hard to get out from under that."

“ They weren't controversial moves. ”

 Ben Hatfield, former CEO, Patriot Coal

The rush to make the big bet on the metallurgical coal market included multiple transactions, some larger than others. Among the largest was Alpha's $8.5 billion acquisition of Massey Energy, Arch's $3.4 billion acquisition of International Coal Group, Walter's $3.3 billion purchase of Western Coal Corp. and James River Coal Co.'s $475 million acquisition of International Resource Partners.

All of those acquisitions were made in early 2011 or late 2010, when the market was near its peak. Of those transactions, only Arch has managed to stay out of bankruptcy court.

James River sold much of its assets to Blackhawk Mining LLC and Patriot is looking to the same company to buy substantially all of its assets. Betting big on metallurgical coal may clearly look like the wrong move now, but at the time of the acquisition flurry, most coal companies had no shortage of supporters.

"They weren't controversial moves," Hatfield said. "If you look back at the press coverage in 2011, Alpha was generally heralded for their growth by adding on Massey and similarly, Arch and ICG was a combination that was widely complimented in terms of investor reaction and analyst reaction. None of us saw the changes coming in the market that have befallen the industry since then."

Alpha touted the purchase of Massey as a "transformational" transaction that made it one of the largest metallurgical coal companies in the world. Analysts were also quick to praise the transaction and the new found exposure to metallurgical coal markets.

"In our view, this is a truly transformational deal for Alpha, as it will make it the [third] largest met coal producer in the world," a 2011 note from analysts Jeremy Sussman and Lucas Pipes, from what is now known as Brean Capital LLC, said. "As we wrote in [a previous piece], 'we believe a combined company of Alpha and Massey would be a 'must own' in the coal space, accounting for roughly [one-third] of total U.S. met coal production.' As the global met markets have tightened significantly since then, this holds even truer today."

In the second quarter of 2011, Alpha executives gathered for an earnings call with analysts in which CEO Kevin Crutchfield said the company was working through a transaction that though it had lots of "moving parts" would prove to offer an "extraordinary amount of opportunity." When Stifel Nicolaus analyst Paul Forward asked about some "pretty ugly macro data points that are spooking the markets," including the market for metallurgical coal, Crutchfield was optimistic, especially about what he called second tier metallurgical coal. He also warned that "my crystal ball is as good as anybody's at this point."

By the first quarter of 2015, Alpha had seemed to have lost a lot of optimism in the metallurgical coal market.

"While there are some encouraging signs coming out of Europe, the met coal market globally remains challenged as global steel capacity utilization declined during the first quarter. … In the first quarter, Chinese GDP grew at 7%, its lowest rate since the first quarter of 2009," Crutchfield said.

While awaiting the market rebound, since 2010, Alpha had slowly grown the percentage of coal mix that went into metallurgical coal markets. In its 2012 annual report, despite declining metallurgical coal prices, Alpha wrote it was expecting demand for its product to grow worldwide and noted that a central tenant of its 2012 repositioning plan was positioning itself as a leader in the metallurgical coal market. In 2012, metallurgical coal was 19% of the company's shipments, but tonnage does not tell the whole story — by 2013, the company was reporting 47% of its revenues came from metallurgical coal.

"Metallurgical coal is the most profitable element of our business and we have the largest metallurgical coal reserve base in the United States. … With the most flexible logistics network, an outstanding reputation in the international marketplace and a broad range of metallurgical coal products, Alpha is well positioned to capitalize on new opportunities and is well protected from customer and country risk," Alpha wrote in its 2012 annual report.

Bracing for a recovery that never came

Alpha Natural Resources A Jan. 31, 2011, investor presentation from Alpha Natural Resources exemplifies the assumptions metallurgical coal producers had for the future of the market. While significant investments on the supply side ensured production would ramp up, demand would fall quickly as growth markets slowed.

Alpha was not the only optimist operating under the belief metallurgical markets were ready to spring back. In its 2009 annual report, Patriot told investors they were preparing for the global economy to return from recession and it was positioning itself to take advantage over that with significant expansion of its metallurgical platform.

"We have plans in place, for example, to significantly increase our production of metallurgical coal from our 2009 level of 5.4 million tons to more than 9.0 million tons over the next two years," Richard Whiting, then Patriot's President and CEO, wrote in a letter to investors attached to the 2009 annual report. "With a strong metallurgical market and improving thermal market, as well, we expect to be back on a growth trajectory sooner rather than later."

Prices initially improved after 2009 and even hit record highs in May 2011. In the meantime, Patriot was able to take advantage of a market that was increasingly willing to pay a premium for metallurgical coal, particularly when major flooding in Australia caused a significant supply disruption.

Analysts also expected more business with China. In an April 2011 note, UBS Investment Bank predicted a strong market for met coal.

"Social policy housing units and the economy are expected to continue to grow," analysts wrote. "This will likely result in continued demand for met [coal] tons from the seaborne market when combined with the apparent met quality degradation. The market remains tight and is expected to remain in deficit through 2013."

In 2012, after metallurgical coal prices peaked, Patriot was forced to idle several of its metallurgical coal mines. Whiting was still waiting for the rebound.

"We do see sunnier days ahead in global coal markets," Whiting wrote in a letter attached to the 2011 annual report. "As I write, metallurgical coal pricing remains strong by historical standards, with further margin expansion on the horizon as demand returns. … Temporary market conditions aside, the long-term fundamentals of our industry remain strong."

Walter's enthusiasm to expand its metallurgical coal presence was just as clear in its 2010 annual report when referring to the purchase of Western Coal.

"This is a transformative transaction at a time when global demand for metallurgical coal is surging. … Our combined production capacity and geographic footprint leaves us extremely well positioned to benefit from favorable sector dynamics driven by increased steel production in markets such as China, India and Brazil," states the report. "Bottom line, this is the right transaction at the right time."

Walter found in 2010 that the market's global supply-demand dynamics were "squarely in our favor." Investors agreed for some time. In a few months surrounding the peak of the metallurgical coal market, Walter shares — which traded for pennies in the weeks leading up to bankruptcy — hovered well over $100 per share.

In its 2013 report, Walter acknowledged that global supplies of metallurgical coal were growing and even expected the first half of 2014 to be "challenging." The company also forecasted supply growth to slow and was touted its "stronger, leaner" profile.

“ Everyone was looking at Asian growth and particularly the growth in China. I don't think anyone saw the dramatic change coming with respect to the slowdown in growth of the Chinese economy. … We all thought India and China were going to continue to grow. ”

 Ben Hatfield, former CEO, Patriot Coal

"Despite curtailing production at several mines in 2013, we grew met coal production overall through productivity improvements," Walter noted. "We have carefully allocated capital to continue to grow our key met mines so they will remain cost-competitive and ready to expand production coincident with the anticipated improvement in the business cycle."

Recapping 2014, Walter CEO Walter Scheller wrote to investors that company employees were sharing in the "pain" shareholders were feeling after a year that "was certainly not the year we hoped for." Scheller noted the ongoing supply problem and largely attributed the pain to slower growth in China.

"It is likely that the metallurgical coal industry in 2015 will have to struggle against many of the same headwinds as in 2014. … Predicting when this market will turn more in our favor has been difficult for analysts and company management teams alike. … We will retain our focus on our key metrics and make the decisions necessary to weather this challenging environment," Scheller wrote in Walter's 2014 annual report, released just a few months before the company filed for bankruptcy reorganization.