Reliable Invisible 

By: Bill Reid
Managing Editor


Peter B. Lilly

    “I take great pride in the fact that Americans are able to give so little thought to electricity,” said Peter B. Lilly, COO – Coal, CONSOL Energy, Inc. in presenting the keynote address to the Eastern Coal Council’s 24th Annual Conference and Exhibition held at the Meadowview Conference Resort and Convention Center, Kingsport, TN. “It is a credit to the power companies, to the fuel suppliers, and to the equipment manufacturers that this very valuable product is provided so reliably and so invisibly.”
    Lilly supposed for the moment that we didn’t have coal and reviewed the role of solar, wind, and nuclear power which could not supply sufficient electricity to replace coal. He also pointed out that relying on gas as a base fuel for electricity would also be a difficult proposition.
    Assuming a base load gas plant of 300 megawatts, it would be necessary to build about 1,000 combined cycle gas plants to replace existing coal fired capacity that would consume an additional 14 quadrillion Btu’s of gas. That means the U.S. would have to increase its annual supplies of natural gas by 70%. Despite gas prices peaking near $10.00 per Mcf and increased gas drilling, overall supply declined slightly in 2001. Power generation accounts for one quarter of all U.S. gas consumption and according to EIA, gas had an 18.5% market share of the power generation market in 2002. Lilly feels that the growing use of gas for power generation will be interesting. 
    Gas in storage is well below the five year average for storage at this time of year. A month ago it was at historic low levels. Spring and summer are the traditional periods when a lot of natural gas that is produced is placed in storage for use during the winter heating season. Even if gas projections meet the five year average for the next five months, we are likely to be 20% short of normal gas storage levels going into the winter heating season.
    “We can’t ignore the importance of solar, wind, or nuclear as potential sources of electricity,” said Lilly. “But neither can we dismiss the value to us of the existing fleet of coal mines and coal fired power plants.”
    On the subject of the financial condition of the power generation industry, Lilly noted:
· In two years, this has become an important concern for coal suppliers. The financial health of customers is a surprisingly new issue created by the deregulation of the generation side of the electric utility industry. 
· Utility customers were gold plated customers. Ability to pay were issues never heard of.
· NRG Energy which operates a number of coal fired plants has filed for bankruptcy. 
· Others are undergoing significant restructuring.
· At least half a dozen are searching for new CEOs.
    This has created a dramatically different market environment for fuel suppliers with cash strapped power companies intent on redefining normal stockpile levels and allowing inventories to decline to levels well below historical norms. Current coal inventory levels seem to be approaching the low point of 30 days burn that was seen in 2001 just prior to the run up in coal prices and this is likely to produce another price spike if there is a hot summer.
    Lilly provided a review of the coal industry. From the late 1800’s to the 1960’s, independent mining companies existed with mining assets sometimes controlled by steel companies. Coal was one of several raw materials necessary for making steel. Over time, this backward integration into raw materials supply proved costly and the steel makers began to sell their assets in coal and iron ore.
    In the late 1960’s and early 1970’s, the oil companies moved to buy coal assets. CONSOL Energy, for example, was bought by Conoco in 1966. The model was built around hydrocarbons. Oil companies were in the hydrocarbon business with oil and natural gas and could see that all hydrocarbons were valuable. By the mid-1980’s, the oil companies began to realize that the oil and gas markets were very different from those of coal despite the fact that they were all hydrocarbons. Today most oil companies have exited the coal business.

Eastern Coal Council

    Some electric utilities also integrated backward into fuel in the 1970’s. As was the case for steel, the idea was to own coal mining assets solely to provide fuel for the companies’ power plants. The mines were captive and many costs were pushed down into the fuel component and passed along to the electricity consumer. Deregulation made that model difficult to sustain and most power generators disposed of their coal mining assets. 
    Today, Lilly sees two viable models for coal production assets. The dominant model is the pure mining model but coal mining companies are finding it difficult to earn their cost of capital as a single commodity producer unless they reach a very large size. This is what helps create the pressure to consolidate. According to Lilly, there already has been considerable consolidation in the industry. Merrill Lynch reported that the top ten coal producers in 1980 accounted for 33% of U.S. production. Today, the top ten producers account for 65% (68% according to NMA). The top five producers today account for about half of total U.S. coal production.
    “But more consolidation in the industry is likely in my view, because of the cost of capital and long investment horizon of new coal projects,” said Lilly. “Aggregation with other metal mining properties probably on an international basis is a possible scenario. The core competency in this model is mining. It is mining that binds the model together.”
    Lilly said that a second model is possible as well. Here the core idea will be to create a new energy producing company, not built around hydrocarbons as the oil industry did but built around electricity. However this is not a simple backward integration model of the regulated utility industry. It will be the aggregation of power, coal, and natural gas assets – linked, yet independent. 
    “Coal and gas while providing fuel to in-house generating assets will nevertheless not be captive to the generation. They will stand on their own, each marketing the fuel they produce to the market at large, as well as to their generation partner.
    “I see the power-coal-gas model as a very powerful one capturing value all along the production chain, maximizing the value of each component part, serving an enormous and growing market,” said Lilly. 
    “As a principal provider of fuel to generate electricity, I believe the coal industry must play a key role in encouraging the expeditious cleanup of our existing fleet of power plants,” said Lilly, in supporting President Bush’s Clear Skies Initiative. The power generation industry in America has made enormous progress in reducing emissions from coal fired plants with more than $50 billion spent in the last 25 years to control emissions. In the last three decades there was an average reduction of 56% over the combination of five of the six pollutants regulated under the Clean Air Act. During that time, energy use rose 41%, economic output increased 158%, and coal use nearly tripled. “But there is no doubt in my mind that until power plant emissions fall to even lower levels, we will not be able to convince Americans that coal’s role in energy production should increase,” said Lilly, who outlined the Clear Skies Initiative.
    “We need to provide this new standard, provide a reasonable time for compliance, and provide plant operators the assurance that this is and will be the law of the land,” said Lilly. “Let’s give to plant operators the regulatory certainty that will allow the prudent investment in technology, investments that are not being made today because of the current chaos of regulation.” 
    America faces various challenges such as the threat of terrorism and the need to revitalize the economy. “As America faces these challenges, there in the background invisible, yet working, stand the industries like coal,” said Lilly. “An industry I’m very pleased to be a part of.” cl



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