Foundation Coal Holdings(NYSE:FCL) is the fourth largest coal producer in the U.S. in terms of tons produced. The company's 13 mines in Wyoming, Pennsylvania and West Virginia yielded 71.8 million tons of coal in 2007. Steam coal, which constituted over 92% of the coal used worldwide in 2004, accounted for 97% of FCL's sales volume and 89% of its $1.49 billion revenue. Almost all of these sales were made to electric utilities in the United States.
Coal is the predominant source of electricity worldwide, accounting for roughly 40% of electricity produced in 2005. World Coal Institute expects global demand for coal to rise by 40% over the next 20 years, primarily driven by China's energy appetite. However, coal is not a scarce commodity, and as a result the company faces stiff price competition. Even though coal prices jumped by 160% between July 2007 and July 2008, FCL, due to its long-term supply agreements with electric utilities and steel producers, did not benefit from the increase. In fact, in the first quarter of 2008, FCL's net income fell by 74% compared to the year before because of an 11% rise in cost of production.
Foundation Coal Holdings accounted for 6% of US coal production in terms of volume. The company sold 73.6 million tons of coal, of which 71.8 million tons were produced in its own mines. The company's coal reserves are estimated to be around 1.6 billion tons; at the 2007 production levels, the reserves have a life of 22 years.
Almost all of the company's sales were made to electric utilities. Steam coal, primarily used in electricity generation, made up 97% of the production volume and 89% of the company's revenue. Metallurgical (Met) coal, used for steel production, accounted for the other 3% of volume and 11% of revenue. The company engages in long-term price contracts with electric utilities and steel producers for the sale of coal; 79% of the company's revenue in 2007 came from contracts with life of 1 year or more. Due to these contracts a change in the spot price of coal does not directly translate into a change in FCL's revenue, and thus insulates the company against short-term price fluctuations.
FCL operates through 13 mines, which are located in the three major coal producing regions in the US: Powder River Basin (PRB), Northern Appalachia (NAPP) and Central Appalachia (CAPP). PRB coal, while less expensive to extract due to its proximity to the surface, has a lower heat capacity (8800 btu/pound) than NAPP or CAPP coal (12500 btu/ton). Moreover, due to its distance from major markets the PRB coal is also more expensive to transport. Hence, in 2007, PRB coal commanded a much lower average price ($12.5/ton) than NAPP or CAPP coal ($70/ton). PRB accounted for over 70% of the company's production volume and slightly less than 32% of the company's revenue in 2007.
FCL's revenue in 2007 was $1.49 billion, up 1.3% from the year before; and, its net income was $32 million, up 3.2% from the year before. On the other hand, operating margins fell from 28% in 2005 to 22% in 2007. This can be explained by the fact that FCL's depreciation expenses shot up by 20% during the same period, to $1.13 billion in 2007. Being a very cash-intensive business, FCL has been able to maintain a high leverage -- in fact, in 2007, 72% of FCL's operating income was used to pay interest expenses. 
Coal is the predominant source of electricity worldwide, accounting for roughly 40% of electricity produced in 2005.. In the US, coal accounts for 50% of the electricity produced, and the US Dept. of Energy expects it to rise to 60% by 2030. China is the world's largest consumer of coal, with over 2.6 billion tons consumed in 2007, and demand is expected to rise to 3.0 billion tons by 2010.. China generates 80 percent of its electricity from coal, and thus demand for the commodity is heavily tied to the country's GDP growth.
On the other hand, coal is abundant in supply all over the world, and the US has enough coal for another 250 years. The price of coal is determined by its heat capacity, sulfur content and proximity to markets or consumers. Generally, coal from the same region fetches a very similar price, and coal producers make most of their sales locally. Thus Foundation can do very little to distinguish its coals in the market, and must compete in terms of price, making it difficult for them to maintain high margins.
As a form of energy, coal faces most of its competition from natural gas, a cleaner burning source of power that contributed about 20% to US electricity production. Oil also competes with coal for electricity generation, but its high price and concerns of peak oil has induced utility companies to shift away from it. In 2005, oil contributed around 10%, down from nearly 20% in the 1970s, to US electricity production. Both Oil and natural gas prices have risen rapidly since 2002. Oil jumped from $23/barrel to $143/barrel, while US natural gas rose from $3/thousand cft to $8.4/thousand cft between Jan 2002 and July 2008.
Between 2008 and 2012, 29 new coal power plants with capacity of over 15,000 MW are expected to be completed in the US. Even though the price coal has also risen, it is still considered to be a much cheaper source of energy than natural gas and oil. The price of CAPP and NAPP coal increased nearly 160% over the last year, rising from $55/ton in July 2007 to around $140/ton in July 2008. However, Foundation has not been able to benefit from this rise since 79% of its sales are made through long-term contracts. In the first quarter of 2008, FCL's revenue rose by 4.5% compared to the first quarter of 2007, while net income fell by 74%, because of an 11% rise in cost of production.
Generally, coal from the same region has similar attributes and hence fetches the same price. This means coal producers are subject to stiff competition and are vulnerable to price cycles. Strong demand for coal leads to higher prices as suppliers cannot adjust production levels quickly. However, once the prices are high, the abundance of coal brings a lot of new mines into operation which increase supply and drive down prices. On the other hand, when the prices reach a low level, many mines are forced to close down due to shrinking margins, which in turn, increases prices again. These cycles can be triggered by transportation problems such as strikes, extreme weather conditions, or by rising prices of other energy commodities.
As a result of these cycles, coal producers see their margins shrink or expand between one period and the next. Foundation's operating margin has shrunk from 28% in 2005 to 22% in 2008. However, long-term supply contracts with coal users such as electric utilities offer short-term insulation from these cycles. In 2007, 79% of Foundation's sales were made through contracts with a life of one year or more. However, while price of coal jumped by 160% between July 2007 and July 2008, Foundation's was not able to benefit from the surge because of these contracts. In the first quarter of 2008, its revenue increased by only 5.4% while its volume remained stable.
Coal is one of the dirtiest forms of energy production. Its burning releases pollutants that contribute to environmental problems such as smog, acid rain and global climate change. Governments around the world are being pushed to adopt policies to reduce environmental degradation. Regulations, such as the Kyoto Protocol and the Clean Air Act mandate emission caps through cap-and-trade systems of trading carbon credits and have increased costs for coal users.
Moreover, the Energy Policy Act of 1992  offers subsidies to competing renewable energy sources, and 20 US states have mandated targets for use of clean energy. For example Pennsylvania plans to obtain 18% of its energy from clean sources by 2020. However, while other sources of energy, such as wind energy and solar power, are cleaner than coal, they are also much more expensive, which limits their adoption. Renewable energy sources collectively contributed less than 8 percent to US electricity production in 2005.
Regulations such as the Clean Air Act Amendments of 1990, by imposing restrictive standards on carbon and sulfur emission, drove down coal prices in the 1990s. However, over the years, they have forced coal power plants to adopt technologies to reduce the harmful impact of coal. In 2008, these measures have become more common and has resulted in a renewal of the coal power industry, illustrated by 15,000 MW of new power plants being built between 2008 and 2012.
Sulfur scrubbers, which reduce sulfur emissions by 95%, offer an example of such technologies at work. The advent of these scrubbers have made the NAPP coal, which has a high sulfur content relative to heat capacity, more marketable. The price of NAPP coal has jumped by 160% between July 2007 and July 2008. The NAPP was FCL's most profitable sector, and accounted for 71% of the company's operating income in 2007.
Foundation Coal, being a commodity producer, has no way to distinguish its product from those of its competitors. The company operates as a price-taker in a competitive environment against other coal producers in the US.
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