As if domestic life weren't bad enough for U.S. coal, Congress is calling for an investigation into royalty payments made by companies exporting from the Powder River Basin.Â After the pummeling U.S. coal has taken in the wake of the emerging natural gas leviathan, exports were supposed to be coal's lone bright spot. Indeed, 2011 exports surpassed levels we haven't seen since 1991, and the Energy Information Agency predicts that 2012 exports may break all previous records. But if this investigation turns up evidence of foul play, the responsible parties may have undermined their one remaining growth opportunity.
Roughly 43% of U.S. coal originates on public lands, the majority of which are in Wyoming and in Montana's Powder River Basin (PRB). Companies pay the government royalties for the coal they extract from public lands.
Between declining domestic coal demand and Asia's ravenous energy appetite, coal producers are rushing to export coal, particularly to Asia in deals that can double or even triple their margins, according to analysts. The cheaper they can do it, the better. PRB coal is the cheapest in the U.S. to produce. A December 2012 Reuters investigation found that some companies operating in the PRB may be cheating the federal government, and therefore taxpayers, out of a portion of the royalties they're due.
The royalty on coal mined from public lands is 12.5%. The $6 million question is: At what point along the value chain do companies fix the price they use for royalty calculations? Lately, the price companies fetch for coal sold in Asia is 10 times higher than the domestic price. Clearly, companies will pay far lower royalties if they use the domestic price for their calculations.
American taxpayers subsidizing Asian growth?
But Sen. Lisa Murkowski, R-Alaska, and Sen. Ron Wyden, D-Ore., cry foul, and they have said as much in a letter to Secretary of the Interior Ken Salazar demanding an investigation. They expect companies to pay royalties on their actual net revenues. Arguably, doing otherwise amounts to a U.S. taxpayer subsidy for industrial rivals like China.
Reuters' investigation fingered Peabody Energy (NASDAQOTH: BTUUQ ) , far and away the largest PRB miner in the business. It also took a hard look at Arch Coal (NASDAQOTH: ACIIQ ) and Cloud Peak (NYSE: CLD ) , both of which have deals with Kinder Morgan Energy Partners (UNKNOWN: KMP.DL ) to export PRB coal starting in 2014 on a very meaningful scale.
In consultation with various experts, Reuters found that Peabody, Arch Coal, and Cloud Peak could owe a combined $100 million in back royalties. Looking forward, the accounting difference could figure in the billions of dollars if the industry succeeds in its efforts to ship 150 million tons of coal through the Pacific Northwest.
Sen. Wyden and Sen. Murkowski's letter says: "If any violations of the law have occurred, companies should be required to cure any gap in royalty payments and, if misconduct has occurred, civil penalties should be levied."
Disappointingly, all three companies Reuters investigated "declined to explain how they book Asian coal sales, and their securities filings give only a partial picture of how miners operate in volatile energy markets." Shareholders should expect and demand transparency in this regard. I struggle to imagine a legitimate reason for keeping such accounting standards a secret.
The great giveaway
This isn't the first threat to the federal leasing program under which companies have access to the PRB. In response to an April 2012 request from Rep. Edward Markey, D-Mass., the Government Accountability Office (GAO) is conducting an audit of the program. The issue is that the government may be foregoing staggering sums of money by offering noncompetitive federal mining leases instead of putting them up for auction. One analysis estimates the government's losses at $29 billion over the last three decades. The GAO audit is ongoing and its outcome unknown, but the issue itself is significant enough to have sparked its own term: "The Great Giveaway."
It's not clear where all of this is headed, but it's worth noting that there is a precedent. Marathon Oil (NYSE: MRO ) used a similar accounting system in the 1970s to calculate royalties on natural gas exports to Japan. Ultimately, a federal court ordered Marathon to pay its royalties on the basis of overseas value, and levied a $10 million fine to bootÂ (not adjusted for inflation).
The stakes in this game are high. Investors should monitor the progress of the various investigations I've described, as well as the extent to which U.S. coal remains dependent on exports to keep the industry afloat. Furthermore, they should watch for companies that may choose to increase transparency and get out in front of this issue. If indeed the tides are turning, as it appears they may be, then a winning corporate strategy might well be to accept the new reality and work artfully within it.