Spot coal prices in the East are at record levels for the second time in four years. The high spot prices of 2000/2001 did not translate into significantly higher delivered coal prices because the volumes being traded were small. Delivered coal prices of Central Appalachian coal did not increase significantly as a result of the rise in spot prices for Central Appalachian coal. As a result, most coal companies did not see their revenues or profits increase. This led to mine closures to bring production in line with demand. Those closures have in turn created a supply shortage and spiking spot prices. What change in marketplace fundamentals led to such increased volatility in spot coal prices?
Prior to the mid 1990s, the U.S. coal industry was a classic example of a fragmented industry. It was in chronic over capacity with many producers. There were few barriers to entry and significant barriers to exit. It lacked economies of scale and there was little advantage to size in dealing with buyers and/or suppliers. Coal served regional markets with steam coal contracts often written for supply from a specific mine. As a result, pricing was highly competitive after the surge that followed the Energy Crisis of the 1970s. Flat to slightly declining spot coal prices led one trader to describe coal as “interesting as dirt.”
Over the last decade the coal industry has changed, and it is no longer fragmented. The coal industry is much more concentrated today than it was during the 1980s and early 1990s. The 10 largest producers accounted for about 64% of production in 2003 compared with 60% in 1999, 41% in 1994, and only 33% in 1989. During the 1970s, oil producers invested heavily in the coal industry, leading to a dilution of physical coal supply as new mines were developed in the Powder River Basin (PRB). As the oil giants sold their operations during the late 1980s and 1990s, the coal industry became increasingly concentrated. The recent challenge of the Arch Coal acquisition of Triton Coal by the Federal Trade Commission (FTC) on anti-trust grounds is a testament to how some industry observers view the current level of concentration in some markets.
Government mine reclamation regulations, including the requirement of extensive mine planning and the posting of reclamation bonds, limit how quickly mines can be permitted and opened and who is able to develop new mining operations. Other factors such as government restrictions on developing some coal reserves (e.g., the Kaipaworwitz reserves in Utah), the mining methods used (e.g., mountaintop removal), and the high bonus bids now being paid for Federal reserves in the PRB further limit entry into the coal business.
Through technology and consolidation, the coal industry has created significant economies of scale. The large mining companies, particularly in Northern Appalachia and the PRB, hold the best reserves. There are fewer, highly productive mines that are heavily capitalized relative to what was required only 10 to 20 years ago. Mines using longwalls, super sections, and large shovels, trucks, and draglines dominate production and require significant capital expenditures to develop. As more production is tied to larger, more highly capitalized operations, it becomes increasingly important to operate facilities around the clock. This is particularly true of modern coal preparation plants and loadouts that have become coal factories with tight quality control and continuous scheduling.
Large coal companies are better positioned to manage the risks involved in developing new mines. Coal supply contracts are generally for less than 10 years and usually have price re-openers that keep contract prices close to current market levels. Therefore, coal companies must put their own capital at risk in developing new operations. Large coal companies have a greater ability to diversify their operating and market risks across a portfolio of mines, regions, and contract terms. They can also offer buyers coal sourcing flexibility and a full range of risk management instruments (including contracts with put and call provisions). The large coal producers are better positioned to arrange additional services such as coal transportation and ash disposal.
The downside of such large, high productivity operations is that when something goes wrong, significant tonnage can disappear from the supply chain. When continuous mining sections run into problems, the equipment can be redirected within a mine or, even if management decides to mine through a problem, only a portion of a complex’s production is affected. When a longwall runs into a problem, it generally must mine through it and total mine production can take a significant hit as a result. Similarly, longwall operations can be down for weeks during panel moves, resulting in minimal production. Continuous mining operations can move mining equipment from one part of a mine to another with little impact on mine production.
Today, six of the largest 10 U.S. coal producers are publicly traded. The CEOs of these companies generally have backgrounds in business rather than mining engineering. These executives of companies that have become publicly traded in just the last four years must now pay attention to their stock price performance from quarter to quarter. Since costs for labor, supplies, and regulatory filings have been increasing faster than average revenue, coal companies have not seen their profits increase with higher spot prices. However, Wall Street stock analysts have been kind to companies that failed to meet financial targets but reined in production through closed or mothballed operations. Therefore, coal company executives are holding out for higher prices rather than add capacity to relieve short-term imbalances.
Coal suppliers and users also have eliminated most, if not all, of the physical shock absorbers that kept coal supply plentiful and prices flat. Coal suppliers spent the 1980s and 1990s squeezing costs out of their operations. In some cases, wage and benefit packages were cut in order to compete with lower cost operations. In the past small mines provided surge capacity when markets became tight and spot prices climbed. Small operations generally do not have the economies of scale that allow them to compete in today’s marketplace. Many mining operations used to operate only one or two shifts a day over a five-day week. Production at these operations could be increased by adding another production shift or by working Saturdays. However, as small mines have closed and operating mines worked more shifts, the ability of the coal industry to adjust supply to changes in demand has become increasingly limited. Longer permitting lead times (particularly in Central Appalachia) have further limited the coal industry’s ability to add capacity quickly.
Electric power generators are the primary users of coal. They also have wrung costs out of their coal supply chains. One major trend has been the reduction of coal stockpiles held at generating plants. Figure 2 shows both the level of coal stockpiles at the end of each year and the days supply based upon the average consumption for the coming year. Large stockpiles were usually built up prior to nationwide United Mine Worker (UMW) strikes. However, such strikes have become a thing of the past. Today, plant managers are attempting to reduce working capital by drawing down their fuel stockpiles.
Nationally, the power sector ended 2003 with 122 million tons stockpiled for a 43-day supply. Nationally, coal stockpiles reached this level or less two previous times. There was no spike in prices when stockpiles reached 38-day supply at the end of 1997 because supply was in line with use. Prices did spike when stockpiles fell to a 39-day supply at the end of 2000
because use appeared to be growing faster than supply. The power sector pulled down stockpiles by 39 million tons in 2000 before supply responded. Unfortunately, demand growth evaporated in 2001 and the power sector rebuilt stockpiles by 36 million tons during the year. The strategy of minimizing stockpiles is correct because even if low stockpiles force coal plants to purchase in a high priced market, it is generally more cost effective for them to pay the higher prices for a short period than to maintain a large inventory indefinitely. The volume of coal traded at the highest prices has been small relative to the amount of coal locked into lower contract prices.
Today, the coal use in the power sector is expected to continue growing slowly, but coal production in the East has not increased in response to higher prices, according to estimates made by the Energy Information Administration (EIA). Steam coal also is being diverted to metallurgical markets. However, during the price spike of 2000/2001, it took Central Appalachian production nearly five months to increase production after spot prices started to increase in August of 2000. Figure 3 shows how production increased during 2001. This delayed response to a spot price increase is simply another of the structural constraints leading to price volatility.
Price is the one factor that remains to bring use in line with supply. As a result, the coal industry has witnessed two significant spot price shocks during the last four years. These shocks are not so much a result of unique confluence of events as they are of a basic change in industry structure. Coal producers and buyers are like commuters on the highway cruising along at 70 mph with only a couple of car lengths between them. Every lane is full and as long as everything goes smoothly, drivers and passengers arrive home on time for dinner. However, if there is a small accident, traffic can back up for miles and it can take considerable time to re-establish traffic flow. While it takes time to remove the highway congestion, markets relieve congestion with pricing. High prices determine who really needs (and is willing and able to pay for) coal now. Recent changes in coal industry structure almost guarantee periodic price spikes since the physical shock absorbers are gone. Coal price volatility is here to stay.
