The most troublesome challenges facing risk management professionals can relate to market trends or changes that count against a counterparty, regardless of how well-established, or how professional, the counterparty is in its chosen activities.
Today’s coal market is in a state of rapid change, pressurised by an onslaught of substitutes and the effects of climate policies. The US is particularly notable for the decline in its coal production, likely to fall by 15-20% as 2019 draws to a close, compared with the last quarter of 2018. The phenomenal success of its shale gas industry has delivered abundant and cheap feedstocks to US thermal power generators and heavy industry. Indeed, the fate of the US Environmental Protection Agency, and climate policies in general, have become largely irrelevant to the US coal industry’s future, because of the impact of cheap gas. US coal producers have consequently suffered the fallout, with Ohio-based Murray Energy Holdings being the latest high-profile US coal mining group to file for Chapter 11 protection (in October 2019).
Elsewhere, new coal-mining projects, such as Adani's Carmichael mine in Australia, have encountered funding issues, as banks and insurers increasingly turn their backs on the fuel. And in Europe, the UK and France are committed to removing coal entirely from the wholesale energy mix, while Germany is devising strategies to reduce its use of coal and lignite. These developments also in turn create the risk of a downturn in availability of trade finance to support wholesale coal transactions. While China is significantly advanced in its diversification efforts, its voracious appetite for international coal also appears to be easing as it focusses on domestic production. The transition process has so far barely touched South Africa, a world-leading coal producer which is dependent on coal for its own power generation market and industry, or Indonesia, which appears keen to direct more of its reserves to domestic use in the medium-term.
So, from a credit perspective, should we now be downgrading our risk appetites for coal producers and traders, if a worldwide shift towards gas and LNG, renewables and carbon-reduction strategies is gathering force and now threatening their businesses?
Much clearly depends on the current financial position of the coal company concerned. The bankruptcies and failures mentioned above shows that some are already closer to the edge than is comfortable, with many companies having amassed debt and other liabilities in a surge of consolidation in the mid-2010s. However, throughout the long history of the wholesale fossil fuels market, traders and producers have proved themselves adept at developing strategies to adapt and survive in the face of changing conditions. Key among these strategies is diversification, either within a region, or into another commodity. For those whose balance sheets can survive the current "run" on coal, there is a clear and pressing motive among coal producers to diversify beyond their own frontiers or into other commodities to reduce concentration risk.
Origin Energy, one of Australia’s most prominent miners, is also active in LNG production and export, giving it a cushion to absorb the impact of any long-term decline in global coal demand. Its model could be replicated by US operators to improve liquidity, alleviate credit risks and ultimately to protect credit ratings.
But, what about the risks to coal traders’ credit-standing caused by new regulatory burdens forced, directly or indirectly, onto operators from Emission Control Areas (ECAs), carbon emissions trading systems and so on?
COP 25 in Madrid broke up this month with no agreement, and so the immediate pressure on Asian authorities to devise methods of reconciling climate targets with coal use, has been lifted. But, assuming the eventual imposition of new targets in Asia, coal producers, traders and end-users can move quickly to adapt technological solutions to coal-fired emissions to protect their businesses and credit ratings. Methods of “clean coal” use through carbon capture, and capture of flue-gas emissions at combustion sites in power and industrial plants, must be subsidised or supported in some way by coal traders, miners and end-users alike, as these will markedly improve the risk profiles of all coal counterparties. The technology already works, but methods of applying it to large plants economically, and on a worldwide scale, are yet to be perfected.
While conditions in gas and LNG markets have been disadvantageous to coal producers, that may not always be the case. Final investment decisions (FIDs) for new LNG production projects have slowed in recent years, meaning that growth of LNG demand may outstrip supply in the post-2022 market. New LNG from Mozambique, Papua New Guinea, Nigeria and others may add to supply, but if they do not meet all the demand growth in Asia and Europe, a reliable coal “back-up” will once again be needed.
“Know-your-counterparty” remains the key principle for credit risk analysts active in commodity trading, but it is becoming increasingly complex in the case of coal market participants. For some, the damage being caused by the evaporation of certain sources of coal demand, particularly US power generation and industry, could have left insufficient time to adapt. But, for those still standing in the coming years, the key to understanding the risks attached to coal traders and suppliers lies in an appreciation of how they can adapt and survive in the face of a now rapidly-changing global market.