The theme of the coal industry
The coal industry is capital-intensive. It heavily depends on both factors of production, labor and capital. Highly capital-intensive industries tend to offer what economists call “economies of scale.” A large mining company can share resources between different mines. As a result, large mining companies are generally better at capital allocation.
Kevin Crutchfield, CEO of Alpha Natural Resources (ANR), the second-largest American coal producer (KOL) by revenue, has called for meaningful consolidation in the coal industry to create value. With producers cutting down production and idling mines, speculations of consolidation are circulating in the news. Let’s see if the current environment is conducive to industry consolidation.
Bad memories of consolidation
Major coal industry players are still paying the price of untimely consolidation in 2010–11. All major coal producers went on acquisition sprees in 2010 and 2011, when floods in Australia left a supply-side gap. Coal prices reached new highs. But it looks like markets had a different plan. Right in the beginning of 2012, natural gas prices hit bottom, taking thermal coal prices and demand on a downhill ride. Production in Australia recovered, creating oversupply in seaborne met as well as thermal coal markets.
Leverage is a time bomb
Consolidation happened in 2010–11, when coal prices were high. Expecting the rally in coal prices to continue, major American coal producers—including Peabody Energy (BTU), Arch Coal (ACI), and Walter Energy (WLT)—acquired other coal producers, particularly those producing metallurgical coal. Most of these acquisitions were funded by debt, heavily leveraging acquirers’ balance sheets. When coal prices started falling, leverage (as measured by debt to EBITDA[1. Earnings before interest, tax, depreciation, and amortization]) started rising exponentially.
Since most coal producers have been burning cash for a while now, it’s unlikely that they’ll be able to meet the debt repayment obligations. However, they’ve ensured that no significant obligation matures before 2018. Meanwhile, they’ve built up significant liquidity to survive the downturn. So leverage looks like a time bomb, waiting to explode.
In the next few parts of this series, we’ll look at what expensive acquisitions did to some of the largest US coal producers.