Thermal coal producers in North America are subject to several intractable pressures; the COVID-19 pandemic is only the most recent. With more investors citing ESG factors in restricting capital to the industry, many of the world's largest banks and asset managers are no longer financing new thermal coal projects. Some are even liquidating their holdings, which has contributed to declining share prices in the past year and widening yields on debt securities. As such, we view capital structures as increasingly unsustainable without some indication that new capital will emerge for refinancing in the next few years.

Credit Quality Declining For Coal Producers

Coal's share of domestic electricity generation fell below 50% in 2004 and currently stands at less than half that level. Its use is likely to continue declining in favor of cleaner and increasingly cheaper alternative fuels such as natural gas and renewables. Over the past year, equity prices among thermal coal-producing issuers S&P Global Ratings rates have decreased 60%-90%, and in most cases, debt is trading below par in the 50%-85% range. While much of this has to do with COVID-19-related headwinds, operating conditions were already deteriorating for the sector before 2020. The advent of widespread hydraulic fracturing more than 15 years ago made cheaper, cleaner natural gas widely available and began the slow secular decline of competing thermal coal. This led to a spate of bankruptcies in 2015-2016 that facilitated financial and operational restructurings, which provided an initial boost to those that shed obligations and emerged with more conservative capital structures. Nevertheless, the attrition continued, with producers that were able to tap the seaborne coal markets (especially for metallurgical [met] coal) as a lifeline faring best. With this as a backdrop, the back half of 2019 brought with it 30% and 9% price declines in seaborne met coal (used for steelmaking) and seaborne thermal coal (used for electricity generation), respectively. Subsequently, prices have dropped even further as customers have deferred orders and opted to pay their way out of contracts, as shelter-in-place mandates and other consequences of the pandemic have slowed economic activity, making exports uneconomic for all but a few producers. In recent months, anemic thermal coal demand has been further compounded by the precipitous drop in prices for competing natural gas, which fell to a 21-year low of $1.42 per million British thermal units in June.

In the past two years, four coal companies we rated have defaulted. This most recent round of defaults consisted largely of companies that did not restructure back in 2016 and subsequently succumbed to the aforementioned sector headwinds. Of those we continue to rate, only Alliance Resource Partners L.P. and Drummond Co. Inc. have ratings above the 'B' category (table 1). While broader industry dynamics suggest ongoing pressure, relief from the subset of pandemic-related headwinds might be forthcoming. We are forecasting a recovery in economic activity in 2021, with 5.2% real domestic GDP growth reversing the anticipated 2020 GDP contraction. However, it is unclear to what extent coal companies will share in such an economic resurgence. Certainly, compared with 2016, many issuers that have filed for bankruptcy recently are finding it more difficult to reorganize and emerge and, in some instances, are being relegated to liquidation.

Table 1

Refinancing Risks Move To The Fore

In large part due to the collapse of the industry in 2016 and weaker investor sentiment, coal producers shifted to profit-oriented financial policies with lower leverage levels from those more geared toward growth. Subsequently, buoyant economic and industry conditions in 2018 enabled large shareholder distributions and share repurchases that had a limited effect in supporting equity prices but preserved little capital to protect credit quality in the event of a sharp downturn (see "U.S. Coal Producers Fire Up Shareholder Returns," published Feb. 13, 2019). Nevertheless, the weighted average maturities for all the coal companies we rate still exceed two years, a key benchmark for us. The only company with a notable maturity in the next two years is Peabody Energy Corp., which has $459 million in senior notes due March 2022 (about 34% of total reported debt). Despite the fact that most of these companies stand free of major maturities until 2024 (charts 3-9), access to new capital has waned dramatically since the beginning of 2019, and the shift in the coal sector's standing in credit markets (chart 1) has prompted us to revisit our stance on the sustainability of their capital structures--a defining factor for our 'CCC+' rating.

Chart 1

Generally, investors have limited appetites for funding growth projects in the coal sector; however, another key catalyst to our expanded approach of assessing capital structure sustainability has been the building groundswell of investors eschewing investments based on ESG considerations. Various ESG-related announcements over the past couple years (table 2) culminated with BlackRock Inc., the world's largest fund manager, stating in January that it would begin divesting actively managed investments in companies with more than 25% of revenue from thermal coal. Debt and equity prices have fallen as capital has left the sector, and this accelerated as financial performance began to decline. As expectations recalibrate, debt offerings have been downsized or restructured in favor of higher levels of security, and this has translated into more diverse capital structure components, including equipment leasebacks, municipal bonds, and securitization facilities. In our view, if things remain as they are, coal-producing issuers might not be able to roll over enough of their maturities when they are due. Certainly, they are unlikely to be in a position to settle their pension, asset retirement, and other nondebt obligations in addition to their debt. As such, even if it has more than two years to maturity, we might view a capital structure as unsustainable without some indication that a pool of capital will emerge for refinancing in the next few years.

These refinancing concerns would not be alleviated simply by short-term improvements in operating performance. Even with a return to higher levels of profitability, associated increases in cash flow would only make distressed exchanges of deeply discounted debt more likely. Ultimately, the specter of investors receiving less than they were promised in such an exchange would continue to weigh on ratings until, and unless, credit markets also began to reflect improving prospects in trading levels closer to par.

Table 2

Weakening Competitive Positions Are A Prominent Factor In Rating Outcomes

As thermal coal producers lose ground to natural gas and renewables in power-generating plants across the U.S., their competitive advantage relative to other mining companies has suffered. For our purposes, key dimensions of this decline include growth prospects and access to markets. Coal is the most abundant fossil fuel in the U.S., and most producers we rate have assets with mine lives in excess of 20 years. However, demand, particularly domestically, is steadily waning. The U.S. Energy Information Administration estimates that U.S. coal-fired power plants accounted for about 966 million kilowatt-hours of energy produced in 2019. That corresponds to an average annual decline of about 6% from the peak in 2007, even as total energy production remained relatively flat during that period. While coal-fired energy production started to decline, coal-fired generation capacity rose until 2011, when it reached 318 gigawatts, with about two-thirds utilization. Since then, utilization has fallen to slightly below 50%, despite a concurrent 28% reduction in capacity. Even with technological advancements in coal-fired electricity generation, dozens of proposed coal-fired power plants have been canceled across the country, amid unfavorable economics and increasing recognition of the social costs of carbon emissions. As the industry shrinks and competing fuels become cheaper, the scale, scope, and diversity, as well as the levels of profitability coal producers can expect, will diminish, further weakening overall competitive positions for those producers that do not adapt.

Nevertheless, coal remains the leading fuel for power generation globally (chart 2). Absent the shale revolution that made competing natural gas so plentiful domestically, growing economies in Asia continue to source increasing amounts of thermal coal from seaborne markets. In theory, there is an opportunity for domestic coal producers to contribute to the close to 1 billion tons of thermal coal sold internationally. In practice, however, several factors limit the extent to which U.S. producers can participate in these markets (see "When The Cycle Turns: U.S. Coal Companies Seek Pay Dirt In Exports," published Oct. 26, 2018). First, coal is a bulk commodity, and transportation costs are increasingly prohibitive the further it needs to travel--especially over land. Asia is the fastest-growing consumer of seaborne coal, and China accounts for over half of the purchases, but coal production and port capacity are restricted out of the West Coast. Instead, export infrastructure is much more heavily focused in the eastern U.S., which is better situated to serve Europe than Asia. Second, in serving international buyers, U.S. producers could be competing with producers that are closer to buyers. These competitors would have lower transportation costs and would be able to adjust to market conditions and fill orders more quickly. Third, projects geared toward boosting local production, pledges from China and others to reduce emissions, and plans by brokers such as Glencore to diminish their coal footprints could make the seaborne thermal coal market less accessible. These challenges make it unclear whether U.S. producers can get a permanent toehold in the thermal seaborne market or if they will be relegated to the role of a swing supplier--only relevant when supply is tight. A minority of U.S. producers has the geographic and product positioning to replace sales lost domestically with sales to the seaborne market, and when those producers do, they likely do not enjoy the revenue stability and visibility that come with domestic contracted sales.

Chart 2

Prospects Diverge For Thermal And Met Coal

Year to date, we have downgraded all the coal companies we rate, except for Drummond and Warrior Met Coal Inc. Drummond has no reported debt outstanding, and Warrior Met Coal is a pure play met coal company with high quality assets--factors that mitigated but did not insulate these two producers in the ongoing downcycle. Although we continue to assess thermal coal issuers through the lens of slow but steady secular decline, the principal contributor to downgrades year to date has been the pandemic-induced slowdown in economic activity and its effects on coal prices and demand. Among fuels for electricity generation, coal was disproportionately affected, and similarly, we would expect it to benefit the most if economic activity recovers in 2021 as we expect. Indeed, within the overarching trend of thermal coal decline, this would be in line with the year-to-year fits and starts we have seen in the past. We account for the cyclical nature of the industry in our ratings by not only incorporating credit measure fundamentals but also how sensitive these fundamentals might be to changing operating conditions.

As domestic coal demand falls and lower prices squeeze margins, coal producers have been focusing their efforts on their most profitable operations while divesting or idling noncore assets. However, companies highly dependent on thermal coal (table 3) recognize that more needs to be done in the long term. Contura Energy Inc. and Drummond have continued to participate in the seaborne markets while others have increased their efforts in this arena. Another common approach has been to expand met coal operations. While CONSOL Energy Inc. has temporarily slowed its spending in this area until operating conditions improve, Arch Resources Inc. has been forging ahead with its plans to develop its met coal reserves. Alliance Resource Partners L.P. has taken yet another path, actively managing its growing oil and gas investments in-house. Unfortunately, oil and gas prices have suffered along with those for coal, but we anticipate these assets will have better long-term prospects for sustained profitability. The decisions management teams make in handling these transitions will be key to the survival of their companies, and this challenge might prove more difficult in cases where these teams have recently changed.

Table 3

In winters during which a polar vortex causes inhospitably cold temperatures, energy demand soars, and the electricity grid is pushed to its limits. In the pockets of power outages that invariably follow, coal takes center stage, as abundant and cheaply stored reserves fire underutilized coal-fired plants to bridge the gap. Such considerations ensure that coal will remain a part of the domestic energy portfolio for decades to come. However, the coal production quantities required to satisfy this type of demand are likely well below the more than 500 million short tons of thermal coal sold for electricity generation in 2019. So while thermal coal operations could remain profitable, this would require an extended period of ongoing rationalization until demand reaches its new steady state.

Company Maturity Profiles

Weighted average maturities for all the coal-producing companies we rate exceed two years (charts 3-9). However, ratings will face increasing pressure as maturities approach if the sector's standing in credit markets does not improve.

Key considerations include:

• Notable maturities generally start in 2024 and beyond;
• Diminished access to capital reflected in alternative forms of financing is becoming more common; and
• Issuers would not be able to pay their way through maturities and nondebt obligations.

Chart 3

Alliance mines about 74% of its coal from the Illinois Basin, which we believe isn't as well-positioned to address the export market as Appalachian Basin coal. The company has a conservative financial policy and stable rating history. It is taking an increasingly active role in its minerals, oil, and gas investments, which are targeted to contribute 25% of total EBITDA by 2025.

Chart 4

Arch continues to allocate capital toward developing its Leer South mine, which will increase its met coal production. In addition, Arch and Peabody Energy Corp. announced plans for a joint venture that would combine their Powder River Basin and Colorado assets. We would not incorporate the joint venture into our forecasts until after it receives regulatory approval. However, if these efforts are successful, Arch would reduce internally managed thermal production to less than 2 million tons, and, while smaller, the company would become more profitable.

Chart 5

CONSOL's assets are concentrated in its Pennsylvania mining complex in the Appalachian Basin. The basin's high quality thermal and crossover met coal, as well as port access, provide opportunities to sell to the seaborne market, and the company exports 30%-35% of its volumes. Given the difficult operating environment, CONSOL has postponed the development of its Itmann project, which it expects to contribute incremental met coal production when complete. CONSOL's significant nondebt obligations exceed $950 million.

Chart 6

Contura has a 65% interest in the Dominion Terminal Associates coal export terminal, and the company's export revenue accounts for about 55% of coal revenue, predominantly driven by its met coal sales. Contura is the largest producer of U.S. met coal, but its profitability has lagged that of peers focused on met coal. The company expects to improve its profitability as it continues to wind down its remaining thermal coal business.

Drummond Co. Inc. Maturities

BB/Negative/--

Drummond is a private company and does not publicly disclose its financial statements. Drummond has no rated debt. The company's available borrowings are limited to its $250 million revolving credit facility (undrawn) due March 2023. The bulk of its operations are in Colombia, which we consider to be a high-risk jurisdiction, but the company has no reported debt. These operations focus on selling thermal coal to the seaborne market and are advantageously positioned to access the Americas, Europe, and increasingly, Asia, as markets dictate. Drummond's other segments, coke and real estate, represent about 10% of total revenue.

Chart 7

Natural Resource Partners L.P. is unique in that it leases rather than operates a portfolio of mines. The company's business model is characterized by royalty agreements with built-in minimums, nondebt obligations that reside with the lessor, and negligible costs compared with those of a conventional miner. These factors typically diminish operating risks for the company, but royalties are under pressure due to its significant footprint in the ailing Illinois River Basin. The company also has a soda ash segment.

Chart 8

Peabody Energy Corp. has operations in multiple U.S. basins, as well as Australia, which provide proximity to growing thermal coal end markets in the Asia-Pacific region. Peabody would operate the proposed joint venture with Arch that they project would unlock $120 million in annual synergies over the initial 10 years. (We do not include this in our forecasts because it is still pending regulatory approvals). Peabody has $1.2 billion in nondebt obligations, and its $459 million in secured notes due March 2022 represents a maturity slightly ahead of its peers.

Chart 9

Warrior Met Coal produces premium low-volatility and mid-volatility hard coking coal ideally suited for steel making. The company primary sells to end markets in Europe, South America, and Asia. The company's focus on this high margin coal, coupled with a highly flexible cost structure, has enabled it to continue generating high EBITDA margins and positive free operating cash flow.

Related Research

• Research Update: Peabody Energy Corp. Downgraded To 'CCC+' From 'B' On Unsustainable Capital Structure; Outlook Negative, Aug. 14, 2020
• Research Update: Arch Resources Inc. Downgraded To 'B' From 'B+' On Weak Performance; Debt Ratings Affirmed; Outlook Stable, Aug. 12, 2020
• Metal Price Assumptions: Gold Shines, While Slow Recovery Flattens Other Metal Prices, July 1, 2020
• Research Update: Coal Producer Drummond Inc. Outlook Revised To Negative On Deteriorating Cash Flows; Issuer Rating Affirmed, July 1, 2020
• Research Update: CONSOL Downgraded To 'B-' On Weaker Profitability And Unfavorable Long-Term Prospects For Thermal Coal; Outlook Negative, June 26, 2020
• Research Update: Contura Energy Inc. Downgraded To 'CCC+' On Deteriorating Credit Measures And Weak Market Indicators; Outlook Negative, June 2, 2020
• Research Update: Natural Resource Partners L.P. Rating Lowered To 'B' On Distressed Lessees; Outlook Negative, April 13, 2020
• Research Update: Alliance Resource Partners L.P. Downgraded To 'BB-'; Outlook Stable, March 27, 2020
• Research Update: Warrior Met Coal Inc.'s Outlook Revised To Positive On Strong Performance During Market Downturn; Ratings Affirmed, Nov. 22, 2019
• U.S. Coal Producers Fire Up Shareholder Returns, Feb. 13, 2019
• When The Cycle Turns: U.S. Coal Companies Seek Pay Dirt In Exports, Oct. 26, 2018