Date: Thu, 20 Nov 1997 19:15:13 GMT Server: NCSA/1.5.2 Last-modified: Wed, 22 Oct 1997 18:36:49 GMT Content-type: text/html Content-length: 12287 A Brave New World: Coal in a Deregulated U.S. Power Market

Tayeb Tahir Presentation
CoalTrans '97
Istanbul, Turkey


A Brave New World: Coal in a Deregulated U.S. Power Market


Good Morning.

I have been invited here today to tell you about the effects of electric industry deregulation in the U.S. on the coal industry.

That's a little bit like being asked to tell you about the expected effects of a hurricane that's approaching a shoreline. We can't predict exactly what will happen or which trees or houses will remain standing, but we have a pretty good idea that nothing will be the same when it's all over.

It is clear that deregulation will have a profound impact on the way electric power is generated, transmitted, bought and sold in the United States.

It's also clear that as a result of these changes, the coal industry itself will undergo massive changes that parallel the shifts in natural gas markets in the 1980s and electric power markets of just a few years ago. Nothing less than a whole new world ... a brave new world of coal, if you will ... is being formed as we speak.

In this brave new world, those who can reshape and reposition themselves to take advantage of the new structures and dynamics will see increased opportunities; those who remain static are likely to find themselves on the sidelines.

I like to think that companies like my own are in the former group ... and I will be telling you a little about how we are positioning ourselves for this new world.

As I said, it's difficult to predict precisely what the industry will look like in a few years, after the hurricane has subsided somewhat.

But you can be sure that we are doing our best to anticipate those changes and how they will impact our future. Our educated guesses are informed, to a great extent, by our observations of the recent upheavals and outcomes in the natural gas markets and in the electric power markets.

And today, I will be focusing on changes in three key areas that I think are of interest to all of us.

First is coal's increasing importance in a deregulated market. As the principal fuel for electricity, coal will see expanded opportunities in both physical and financial markets.

Second are structural changes in the energy industry. Deregulation is accelerating ongoing structural changes in both electric utilities and coal companies.

And third is the transformation of coal into a commodity. Coal will soon be bought and sold much as natural gas and oil are—as commodities that can be priced and hedged in the financial markets. This is a huge departure from the long-term, fixed price contracts of the past.

First, let's look at coal's increasing importance. Coal is the least expensive fuel for generating electricity. It is also, already, the principal fuel for electricity. Coal currently generates about 56 percent of the electricity used in the U.S.

We think it is safe to expect that, as electric utilities rise to the challenge of competition, they will be seeking more efficient and lower-cost power generation. We think it is also safe to expect that coal will become even more preferred in this scenario, playing an increasingly important role in a deregulated market.

This increasing importance is being driven by several forces.

First, coal companies are extending their value chains to encompass a much broader spectrum of energy activities.

In the past, coal companies focused on core mining activities such as extraction and transportation. Today's companies are looking to extract more than coal; we need to extract value all along the energy supply chain.

So you're likely to see coal companies that have a much broader reach all along the energy value chain, from the fuel source to the customer. We are essentially vertically integrating our businesses so that we can protect and expand our interests all along the value chain. At Zeigler and EnerZ, for example, we're long on coal, but we are extending our reach to leverage our existing fuel relationships. I'll talk more about exactly what we're doing in just a few moments.

Going back to our list of factors that are driving coal's increasing importance, I think it's important to acknowledge the increasing ability of power marketers to access information. In the past, it was difficult for power marketers to access the information needed to support fluctuating coal prices. But that information is becoming increasingly accessible, which is making it much easier to consummate coal deals at a rapid pace. We're not looking at minute-by-minute prices just yet, but even monthly fluctuations seem like the speed of light compared to the old long-term pricing.

Third, utilities are linking their power generating and fuel procurement functions, which can only increase their focus on coal as a low-cost generation fuel. Until recently, the bulk power marketing arms of most utilities were disconnected from their fuel procurement functions. Deregulation, or should I say competition, has helped them see the advantages of linking these functions. They now see the relationship between the cost of fuel procurement and how they generate revenue within and outside their franchise areas. With the fuel source more closely factored into that equation, coal has obvious advantages.

Fourth, contract terms are getting shorter. In the past, it was not unusual to see even 15 to 20-year contracts. Today, there's a lot more spot coal being traded, and the new demands of deregulation will mean much shorter terms.

Fifth, innovative delivery mechanisms such as coal tolling and coal by wire are growing. Coal tolling allows utilities to lease their excess capacity to a third party, who burns fuel and sells the generated power to whoever wants to buy it. And coal by wire is just what it sounds like. It's a lot cheaper to burn the coal near the mine, and transmit that power to a far-off utility customer, than to transport the coal to that far-off customer in the first place. This is one of the creative delivery mechanisms we're seeing, and I'm sure there will be more.

And sixth and finally, financial markets are developing that will revolutionize the way coal is bought and sold. The New York Mercantile Exchange, or NYMEX, is preparing for coal to be traded as a commodity, so it can be priced and hedged in the marketplace. NYMEX has already started the process to launch a coal futures contract that will lead to real-time pricing of coal by early next year. As you might imagine, the availability of this financial market will act as a powerful facilitator in the convergence of gas, power and coal trading.

What this means to a company like ours is that we can backstop our financial trades with the commodity itself from our own mines. We can apply our power trading skills directly to coal trading.

All of these forces are combining in a synergistic manner to increase coal's importance as a power-generating fuel. And as you might imagine, they are also helping to fuel major structural changes in the coal and electric power industries.

We are already witnessing a massive reshaping of industry structures, both in the coal arena and in electric utilities. The Energy Policy Act of 1992 resulted in a new opportunity, allowing the sale of electric power directly to wholesale customers. This is resulting in a reshuffling of the marketplace. Major players are dismantling and reassembling themselves in more efficient and creative ways that will position them for the new market dynamics. A key result of this restructuring is that larger players are commanding an increasing market share, while smaller players are fighting for a smaller piece in niche markets.

Electric utilities are also redefining themselves as they look for ways to serve not a group of captive customers, but a competitive marketplace made up of customers who will soon have the power to choose where they purchase electricity. Mergers, acquisitions and restructurings are rampant.

Zeigler Coal Holding Company is positioning itself for this new world through many changes, including the formation of EnerZ Corporation. With EnerZ, Zeigler has created a "virtual utility": a mechanism that will make it possible to buy and sell electric power and its underlying fuels, and also to purchase rights to assets owned by other companies so that we can assemble the best of the deregulated world. Some of these purchases may be linked to hard assets such as coal inventories; others may be tied to contractual rights, to other generating plants, or even to generating stations owned by Zeigler. The potential is limitless, and we are looking at as many possibilities as we can, expanding our operations all along the energy value chain.

The third and final area of change brought about by deregulation is the transformation of coal into a commodity ... indeed, a transformation of electricity and all of the underlying fuels that generate electric power.

Just as natural gas and oil have become commodities, coal will be traded as a commodity, with pricing fluctuating daily and even hourly, and with coal prices tied much more closely to other fuels. While coal is closely linked with electric power, it will have more in common with the way natural gas and crude oil and refined products are traded.

This has many practical implications for how coal is inventoried and stored, transported, and used. Again, we don't know exactly what the shoreline will look like when the hurricane is past, but we expect it will look very different.

The result of all these changes is that coal trading will integrate with power and gas trading in a much more complex and sophisticated market. Deregulation will allow coal to substitute for other fuels, as utilities look for low-cost generation means. And finally, coal mining and coal-fired generation assets will increase in value. These assets will increase in value because they will operate in new deregulated structures.

Please keep in mind that the value of the assets is determined by the type of people who own and run them. Those who can efficiently combine financial trading skills with the operation of the physical assets will not only thrive in the new marketplace but will also increase the value of these assets. Of course, our own company fits this description.

What will this industry look like three years from now? Who will the winners—and the losers—be? The answers to these questions are worth a great deal to those who can guess correctly. We can find some parallels if we look at the massive changes in the natural gas markets in the 1980s.

Those who transformed themselves became key players in the industry, while those who remained static are no longer around. Those who plan to succeed require not only significant financial resources, but also a high tolerance for risk and a diversified portfolio of hard and soft assets. In addition they need a cultural change in their organizations; an attitude of irreverence for the status quo and the ability to maneuver in an ambiguous marketplace.

No one can anticipate precisely what this industry will look like over the next few years. As various industry players look for the right answers, innovative solutions will emerge. One thing is certain: those who can rise to the challenge of coal as a commodity business—those who can both reduce cost and enhance value—will have a prominent place in this brave new world.