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Monday, October 31, 2016

Don't Bet Budget On A Coal Rally

As we get closer to the 2017 legislative session, the budget-deficit discussion rapidly intensifies. So far, though, it has not focused squarely on the deficit itself, but rather various variables that perhaps, maybe, hopefully could catapult the state's finances across the deficit dungeon and onto solid revenue ground again. 

One of the variables that seems to attract the most interest is a rebound in coal production. This is entirely understandable: coal has for a very long time been a very important product in the Wyoming economy, and a critical revenue producer for the state government. 

Today the Casper Star Tribune throws more coal into the engine that drives the rebound hope, boldly reporting that coal is "determined ro rally":

Oil has dominated the Energy Journal for a few weeks, as the price of oil bobbed on news of OPEC deals, Russian doubts and a strong dollar. But this week the story is about coal, and coal's determined rebound. Always an interesting coal company to watch, Cloud Peak Energy will export 1 million tons of Powder River Basin coal to Asian markets between November and February, the company announced Thursday. It expects to have replaced all of its self-bonds by January of next year. In an earnings call, the company's CEO projected optimism in both the coal market and Cloud Peak's outlook going forward.
The Tribune also quotes a report from Hanou Energy, which suggests:
Good news for producers! PRB 8,800 Btu spot prices increased from $9.25/ton in May to $12.25/ton during September. With the power plant “off” season beginning in October, prices have retreated by $0.50/ton since then. Hanou Energy still contends that a strong price recovery could happen as early as spring 2017. Watch the monthly stockpile levels as reported by the EIA closely. Assuming we have a normal winter and $3/mmBtu gas prices, stocks should continue to drop throughout the winter. Maybe the magic 50 million ton number will happen sooner than later. There’s more good news. Bituminous stocks for electricity generation have dropped from a high of 84 million tons at the end of May to 73 million tons at the end of July, the last month reported by the EIA. With the export market heating up and with $3/mmBtu gas prices, Hanou Energy estimates at the end of October bituminous stocks have dropped to 63 million tons. By the end of winter, bituminous stocks could drop to that magic number of 50 million tons. If so, prices should increase substantially for bituminous coal, and, as it has in the past, increase PRB demand and prices.
I am not going to question the credentials of John Hanou, the owner of Hanou Energy. He has more than 40 years of coal-industry experience. However, it is important to put their information in the proper context. Moreover, Hanou's conclusions regarding a pending coal price rally gives Wyoming legislators a false sense of hope that they can "ride out" this crisis and thereby avoid tough decisions on state spending.

First of all, it is not at all surprising that the recent downturn in coal production and coal prices flatten out. That is bound to happen whenever an industry goes through a protracted period of sharp decline. It is also a pattern we can see at the macroeconomic level. Even such disaster-stricken economies as Greece eventually stabilize, though just like the coal industry in Wyoming, the new level of stability is well below their previous levels of activity. 

 In other words, it is not surprising that Hanou Energy or anyone else can identify a stabilization point for coal prices and coal production. Furthermore, it is not surprising if, at that point, we witness a small rebound in production: one reason why stabilization happens is that production costs, prices and productivity have reached a point, well below the original activity level, where the economy is ready to absorb the product at prevailing market prices. Once that point is reached there is a period of "bouncing" - like the springs and shocks of a car going over a bump - before the industry settles at its new, lower level of activity.

Evidently, the Wyoming coal industry is somewhere near that point of stabilization. 

This, however, does not mean that prices will start rising again. There can be a short-term price rally, as the report from Hanou Energy suggests, but here is the important part of that price-rally story that their report omits: with coal at this new, lower long-term level of activity, a price rally will be short-term - and followed by a decline in prices again once the rally is over. 

The key points here, which are absent in both the Casper Star Tribune article and in the Hanou Energy report, are that: 

a) coal production appears to be done declining and has reached a new, lower and long-term stable level of activity; and
b) its price will behave like oil did when it was done declining from $90 to $45 per barrel, namely bounce up and down in the vicinity of its new, long-term equilibrium price.

Let me put this in different words, to drive home the same point from another angle: both the Casper Star Tribune and Hanou Energy appear to assume - at least implicitly - that coal prices and production volumes of recent memory are some sort of natural, long-term equilibrium levels that we obviously, naturally will drift back to. Whatever is keeping us from doing so will be removed, sooner or later. 

This is a false premise. There are no long-term natural equilibria in our economy. There are conditions of economic stability, which can last for several years and, over time, form patterns of long-term growth. However, those patterns are broken more easily than they are established, and "new normals" emerge. The experience with a decline in coal production in Wyoming is a good example of a shift from one "normal" to another. It is therefore a bad idea to pin legislative activity before and during the 2017 legislative session on the idea that we are in some kind of abnormality now.

The following two figures reinforce this point. The first reports the total U.S. electricity production in millions of kilowatt hours and compares it to the share of that production that consists of coal:

Figure 1

As the blue function explains, electricity production kept rising steadily, measured as millions of kilowatt hours, up until the beginning of the Great Recession. Since then, electricity production has been stagnant. 

This is in itself an important shift, but more on that in just a moment. The grey function shows the share of total electricity production that coal has been responsible for. As is evident from the right axis, its share exceeded 50 percent up until the very early 1970s when it experienced what seems to have been the beginning of a long-term decline. However, after the two oil crises in the 1970s, coal made a comeback and remained responsible for more than half our nation's electricity production through the 1990s. 

Since then, coal has been in a relative decline. 

Back now to the stagnation of electricity production. When that happened, almost a decade ago now, the decline in the coal share accelerated and has now fallen to one third of total kilowatt production. 

Before we look at what this means for coal in Wyoming, and for the predictions in the Hanou Energy report, let us look at the same electricity production data from a slightly different angle. Figure 2 reports the kwhs used per $1 of GDP (in constant, 2009 chained prices); it also reports the percentage of GDP growth for the same years:

Figure 2
Sources: U.S. Energy Information Agency; Bureau of Economic Analysis.

The blue function represents kwh per $1 of GDP. After having risen steadily from 1950 it peaks in the early 1970s and begins a slow decline that is still going on. 

The green columns report inflation-adjusted GDP growth. A comparison between figures 1 and 2 tell us the following:

1. Up until the early 1970s, GDP growth was strong, exceeding four percent on many occasions. During this period of time our energy consumption per $1 GDP increased steadily. It was also the period when coal was most prominent in producing our electricity.

2. From the early 1970s to the beginning of the new millennium GDP growth slowed about one percentage point compared to where it was in the 1950s and 1960s. During this period, electricity use per $1 GDP began declining, as did the share of coal in generating that electricity. 

3. Since the beginning of the new millennium GDP growth has shifted down again, now averaging somewhere between two and 2.5 percent per year. During this period, electricity consumption has gone from increasing to remaining largely stagnant. The demand for coal to produce those kilowatt hours continued to decline, but at a faster pace. 

Based on these observations, we can draw two conclusions that are directly relevant to Wyoming and our reliance on - and hopes for a rebound in - the price and production of coal:  

a) The decline in coal production that we have seen in the last couple of years is an in-your-face symptom of a long trend, not a temporary decline that will be followed by a return to the days of milk and honey; and
b) The War on Coal has exacerbated our problems, but is not responsible for the long-term trend. That responsibility lies with sustained trends in the economy, one being the long-term slowdown in GDP growth. These trends unfortunately require too much space and time to be examined here. 

There is a clear message in this, a message that our legislators and other key decision makers should take to heart as we approach the 2017 legislative session: 

Think of the downturn in coal as a permanent phenomenon; do not let temporary price fluctuations lead you to believe that the days of free-flowing milk and honey have come back.

Any substantial increase in coal production would have to be related to exports to Asia. With China in an extended and rather big macroeconomic adjustment period, and with Japan in perennial stagnation, how realistic is that?

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