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Thursday, January 26, 2017

Last days of coal on planet earth

World Energy Outlook 2016

Could cutthroat competition prolong the coal industry crisis?

The global coal market is suffering from excess capacity and low prices. Although many mines have been idled or closed, the effect on markets has been more than offset by expanding production from lower cost producers which effectively impeded the market from finding its way back to balance. Prices bottomed out in early 2016 and have recovered since then but, given the dire financial situation of many coal companies in late 2015, the price recovery has only just started to lift producers out of the red. The majority of Chinese coal firms still remain unprofitable and the future of the fifty US coal companies that are under bankruptcy protection is uncertain. Producers targeting the international market are now largely covering their cash costs, but profit margins remain slim (with the exception of coking coal).

The answers as to why coal companies keep on churning out coal despite losing money are many

The answers as to why coal companies keep on churning out coal despite losing money are many. Much has to do with the cost structure of the industry in which the bulk of the costs are variable rather than fixed. As long as prices exceed the variable costs, operating assets contribute to service liabilities or take-or-pay obligations. Additional debt, unless lenders pull out, can keep companies going for a long time, despite increasing the companies’ liabilities and thus worsening the situation. Another part of the answer lies with market expectations. Like other extractive industries, the coal industry is used to business cycles with extended boom-and-bust periods. Many company executives believe that current losses will be more than offset once the market tightens and that keeping assets operational will pay off in the future.

Competition in the coal industry leads to producers cutting prices in the hope that their rivals will have to exit the market. Economic theory suggests that this triggers an adjustment process in which excess capacity is shed and only the most efficient producers survive. However, collective over-optimism in the industry is capable of delaying this adjustment. This notion is not incompatible with a general expectation in the industry of decline; it simply means that the industry consistently acts as if it expects a better outcome than what turns out in the future.

The coal industry is often a major employer. High unemployment in a coal producing country could trigger a downward spiral in wages (or other employee benefits), as a low income is preferable to unemployment if chances of finding a new job are slim. This effect lowers the cost base and gives companies additional headroom to stay in business and further cut prices. As well, the costs of closing a mine or transferring it to care and maintenance may be significant; as long as the mine is just able to cover its variable costs, the company may want it to keep producing.

These potentially detrimental effects of too much competition are difficult to counteract; market-based mechanisms, such as price floors and scrappage bonuses are unlikely to have the desired effect. The Chinese are tackling the problem through direct intervention: in the period to 2020 up to 1,000 million tonnes per annum of coal mining capacity is to be shed. Successful implementation of these measures underpins our projections for China, while the outcome for many other regions rests on market forces restoring a broad market balance by the mid-2020s. Failure to reduce excess capacity or delays in the process, whether market led or administratively managed, could significantly prolong the current industry crisis and leave coal prices at rock bottom for much longer than is projected in the New Policies Scenario.

First published by the International Energy Agency, November 2016 (pages 220-221)