"Met coal is the product that will save the coal industry." "You can't make steel without coke". These are sentiments (motherhood statements) that are rarely challenged. Do they reflect the current situation?
A recent Seeking Alpha article argued for a recovery of the met coal market in general and SunCoke Energy (NYSE:SXC), the major coke producer, in particular. I note that since that article was written (15 October), the SXC share price has fallen from $6.34 to $3.47.
Of particular note to Peabody Energy (NYSE:BTU) investors, it has been suggested that its Australian metallurgical coal assets will be a jewel in the crown for BTU "when met coal recovers".
I confess that, while my gut feel is that innovation invariably finds a way to solve a problem, I've always assumed that coke was an essential part of steel making, and hence we will be using metallurgical coal for a very long time.
So I was surprised when Seeking Alpha member Jay14150 indicated to me the challenges facing coke manufacturers. Anyone following the dramatic fall in the stock price of SunCoke Energy, down steadily from $19.72 a year ago and down dramatically in the past months to $3.47, must wonder what is going on. Since SXC is the largest independent producer of coke in the Americas, such a precipitous fall is of concern, although in a situation that parallels many other coal-related stocks, analyst opinion seems still optimistic that things will turn around. It is certain that with SXC under such dire (terminal?) threat, this means that met coal is also under attack. This has played out with bankruptcy for major U.S. met coal producers, Walter Energy and Alpha Natural Resources, and it is relevant to Peabody Energy's Australian met coal assets.
In the past SXC has been seen as pretty secure, as it has long-term contracts with major steel manufacturers, who make steel using a blast furnace (e.g. U.S. Steel (NYSE:X)). However, while SXC is putting on a brave face, these "take-or-pay contracts" seem to be falling apart.
The steel industry is changing
Almost all commentary about steel production focuses on the commodities downturn and the switch from a construction to a services economy in China. This is clearly a significant aspect of the decline in the steel industry's fortunes, and this goes to "business as usual" supply and demand issues. A recent article discusses the challenges faced by U.S. Steel.
Are there structural issues in play, which will have a longer-term impact?
There is no doubt that some formerly profitable markets for steel are undergoing substantial change. One needs to look no further than the automotive industry and the substitution of steel for aluminum in automotive body panels. This is planned for the Ford F150 in 2017 and will be followed with new models from GM (NYSE:GM) and Chevrolet. Indeed the list of cars incorporating aluminum panels is long already. This is not helping steel, as body panels have been a highly profitable area for steelmakers. In a twist that shows just how fast things are changing, some suggest that car bodies will end up being made from carbon fiber, so that Aluminum panels are not where the revolution ends.
However, there is more to the story than this.
Steel, like just about every other industry in this time of immense change, is being reinvented. The loss of the panels market is being substituted by the use of steel in smart frame constructions. Moreover, combining smart design with construction foreshadows huge new markets for steel especially in the building industry.
There is more to say about this, but of relevance to this story, I don't think the market for steel is about to disappear.
Making steel without coke: dramatically cutting coal use in steel making
The surprise for me is that for many years now there has been an emerging revolution in the steel making industry that heralds a switch from blast furnace (coke requiring) steel making to more nimble Electric Arc Furnace (EAF) steel construction. I was amazed to learn that the most recently constructed blast furnace in the U.S. was built in 1965!! And the cost of refurbishing a blast furnace can be $100s millions!
On the other hand, EAF plants, which are not powered by coke (derived from met coal), are booming. Nucor (NYSE:NUE) is the company which has led the transition from blast furnaces (needing coke) to more nimble EAF micromills. NUE is North America's largest recycler of scrap steel and the largest steel company in the U.S. The company also produces Direct Reduced Iron (DRI), which takes iron ore and makes it available for steel making in an EAF facility.
Gas is used in the DRI process rather than coal. In the U.S., 65% of steel is now made in an EAF, which means that coke isn't involved. And today the trend is going even smaller and more nimble with new EAF-based micromills as being developed by Commercial Metals Company (NYSE:CMC).
Comparing the fortunes of NUE (current share price $40.30, 12 month high $50.70) and CMC (current share price $13.69, 12 month high $17.76) with X (current share price $7.98, 12 month high $27.68) and AK Steel (NYSE:AKS) (current share price $2.24, 12 month high $6.17) reveals very different trajectories for the nimble versus the traditional companies.
Of course the U.S. steel industry operates in a mature economy where there is a balance between new build and retiring obsolete materials. Iron doesn't decay and so it can be reused indefinitely. Steel is the most recycled material in the world, with a claim that 81% of steel is recycled in the U.S. The high figure of 81% comes from the U.S. iron and steel website. Others sources indicate a lower figure, but it is well above 50%. 65% of new steel production in the U.S. is composed of recycled steel.
The recent Paris climate agreement puts major pressure on CO2 emissions and traditional blast furnace steel production results in up to 12 times the amount of CO2 that a modern Electric Arc Furnace produces. This does not auger well for met coal in the long term.
Coke ovens and blast furnaces closing in Europe too
The U.S. transition from blast furnace to Electric Arc Furnaces is also happening in Europe. The 98-year-old Redcar coke ovens and blast furnace have closed after no buyer was found to keep the facility operating. This closure is but one of a number of traditional big old facilities.
Making steel using Electric Arc Furnaces
Electric Arc Furnaces are usually thought of as using recycled steel rather than iron ore and coke (which is what blast furnaces use), but this is a generalization that while partly true, is not the whole story. The EAF furnaces are favored because they are inexpensive to construct, are really flexible with short cycle times (less than 60 minutes) and are able to make steel of specific character in small batches.
Blast furnaces by contrast are slow, use huge amounts of input energy, and are inflexible. You make big batches and this means large inventory in a world of just-in-time manufacture (reduced inventory, short lead times). With a blast furnace, a run is a big deal and takes a long time. With EAF, you just turn on a switch and turn it off when you want to stop. This is a major reason for blast furnaces going out of favor. Of course the huge refurbishment bills of a blast furnace are also a key disadvantage over an EAF.
Recent advances in EAF technology mean that Direct Reduced Iron can be used to supplement use of recycled steel. There are many signs that the US steel industry is switching from blast furnace produced steel to EAF production.
A lot of work is being done to address sustainable production and emissions reductions in steel making, with the goal of reducing or minimizing use of coke. For a sense of the research and commercialization in the space, see a 2013 report from the Ernest Orlando Lawrence Berkeley National Laboratory.
There were 119 EAF plants in the U.S. in 2009, which do not use coke in the manufacturing process. Possibly the industry-changing transition has been planned by U.S. Steel to replace a century old blast furnace in Fairfield, AL, with a substantial $230 million Electric Arc Furnace facility. In news just in, U.S. Steel has deferred the construction of the Electric Arc Furnace, citing weak demand in the oil and gas sector and low steel prices.
A recent report from the Boston Consulting Group, which focused on sustainability, suggests that dramatic changes are in train to adopt more recycling in steel production, with between 50% and 70% of global steel being constructed from scrap in electric arc furnaces by 2050, compared with less than 40% today. The major driver is China's increasing adoption of Electric Arc Furnace technology. This report was written before the Paris climate summit reached a goal of substantially less than 2C and preferably 1.5C global temperature increase. This more aggressive goal (previously 2C, with pledges at 2.7-3.5C) requires dramatic reductions in CO2 emissions and steel with 27% of manufacturing CO2 emissions is a prime target for change.
China steel making
No manufacturing story is complete without factoring in China, and the steel industry is no exception. China has fueled the massive rise in met coal use through construction of blast furnaces (which also use large amounts of thermal coal) with massive steel output. A major factor in this was the virtual absence of scrap iron in China as the building revolution took hold. In 2015, scrap iron accounted for just 8-11% of the input iron in Chinese blast furnaces. Scrap usage in blast furnaces can be as high as 20%, So China could incorporate substantially more scrap into its existing blast furnace steel making without adopting EAF technology.
There are signs of growing interest in scrap iron in China. This will have consequences for the growth of the EAF steel making in China. Goldman Sachs estimates that by 2040 there will be a dramatic scale-back of iron ore required due to slow down in construction and dramatic increase in the role of recycling in the steel industry. One report suggests that China may reach 20% recycled steel by 2020.
By 2030 it is estimated that China will have scrap at 30-39% of input iron for steel making. This requires adoption of EAF technology on a significant scale, with ~130 million tons less iron ore needed in steel making (assuming the existing steel making capacity continues, although this probably won't happen). It is hard to get data on this, but it seems that EAF technology is being adopted in China, although its significance in total production is currently small. Given the need to reduce CO2 emissions, I suspect we may see dramatic changes away from blast furnace steel making (and hence coke requirement).
Virtually 100% of input iron can (is in the U.S.) be sourced from scrap in an Electric Arc Furnace.
There are signs that the big heavily indebted Chinese steel producers may be getting into trouble. Will we see nimble EAF-based producers, like NUE in the U.S., have an increasingly important role in China too?
Are there parallels between thermal coal decline and met coal decline?
A report just out by Wood MacKenzie states that 65% of world coal production is operating at a loss. This is the fifth year of decline in coal prices. Coal production is being cut back dramatically and at least 34 million tons of coking coal production have ceased in the last 21 months.
Citi indicates that prices for both thermal and coking coal will continue to fall in 2016 and 2017, notwithstanding further falls in production.
The factors confronting met coal are not unlike those challenging the thermal coal industry.
Thermal coal is facing a combination of problems. Polluting health effects and emissions of greenhouse gases are causing intense pressure on the industry. Added to that, new cost-effective ways of energy production are taking over. First, in the U.S., there is the emergence of gas. But closely following this is the emergence of renewable energy (solar PV and onshore wind) to substitute for both coal and gas (and nuclear) power. Coal is not winning the economic war and that is even before you add in costs of CCS (Carbon Capture & Storage), which will have to be adopted if use of thermal coal is to survive. The only significant CCS project, SaskPower, is increasingly in hot water as to costs of operation and the ability to keep the plant going, while the Kemper CCS plant has failed.
In the case of met coal, the health and environmental (greenhouse gas emissions) negative factors that pertain to thermal coal also apply. With the emergence of specialized steel making with Electric Arc Furnaces, there is an attractive solution that doesn't need large quantities of coke (met coal).
This story was triggered by a chance comment about met coal and got a life in trying to make sense of the emerging SXC disaster. Having only scratched the surface of the steel industry story, a few things are clear.
i) China has dominated steel production and its switch from construction to services economy is creating havoc with overproduction of steel. This is a classic economic cycle story, which will resolve itself. China, having started with no scrap steel is a blast furnace (coke requiring) story, but this may change.
ii) Steel production is changing in two ways: firstly the nature of the steel products is shifting; this is a story for another article. Secondly the way that steel is being made is becoming more flexible and is moving away from coke dependency to coke independence (EAF technology). This is a structural change that suggests that coke and met coal companies may be heading into long term rather than temporary decline.
I conclude that it is a brave investor who sees an early recovery or indeed a long term future for coke stocks like SXC or for coal companies with strong exposure to met coal (e.g. BTU). Do your homework, but be careful about stranded assets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article results from a most stimulating collaboration with Jay14150, who has spent nearly 30 years in a manufacturing environment. I acknowledge detailed input from Jay14150. We have reviewed recent information and tried to accurately report the current situation, but investors should do their own research before making investment decisions.