High hopes end with some harsh reality

Every day at 8.30am sharp, management at Solid Energy would gather for morning prayers at the company shrine.

The small room was dominated by a huge gleaming slab of coking coal, etched with phrases from an early foreign exchange hedge contract. The dozens of executives stood facing it, arms by their sides, palms turned towards the slab in unison.

It was always a brief, uplifting affair. The CEO would begin with a chant: "Every day in every way, we expect coal prices to rise."

The executives would respond: "And rise they shall."

CEO: "With wood pellets and lignite we will rule."

Response: "Nothing bad will happen."

CEO: "Our big ideas are worth squillions."

Response: "Yes, probably more."

CEO: "Gentlemen, make it so."

And with that they would shuffle out shiny-cheeked into the morn.

Those days are gone now, self-actualisation having proved unsatisfactory as corporate strategy.

Chalkie wasn't there of course, but reckons something like this might have happened. How else to explain Solid Energy's remarkably optimistic outlook despite contrary experience, market scepticism and the old saw of sod's law?

Last week's announcement of job losses, suspension of underground mining, hefty write-downs and slashing of investment was surely belated acceptance of reality, rather than simply "the impact of the extremely challenging global coal market" - the company's official line.

For example, rewind a couple of years and the chasm between the views of Solid Energy and market analysts was obvious.

In their statement of corporate intent, 2010, Solid Energy directors estimated the company was worth $3.5 billion.

In November 2010, analysts from Forsyth Barr and Macquarie totted up the numbers at $1.6b and $1.7b respectively.

That's quite a big gap.

At least in part it was due to analysts valuing the company's think-big projects at zero, compared with the board's estimate of $1.3b.

A year later Solid Energy had pulled in its horns and valued itself at $2.8b. The view from Forbar last November was unchanged at $1.6b. Macquarie didn't publish another valuation.

Granted, these calculations are always a bit subjective and rely on numerous assumptions, but there's something seriously amiss when the answers are so far apart. Chalkie recalls professional investors reacting to Solid Energy's 2010 projections with mocking scorn, particularly the company's heroic view of future coal prices.

However, CEO Don Elder placed a different emphasis on prices at the press conference last week, recalling the dark days of the global financial crisis.

"When coal prices dropped in the GFC they dropped 60 per cent or so, from US$300 a tonne-plus, to US$126 a tonne," he said. "But the New Zealand dollar dropped from a high of 88c down to about 52c very quickly afterwards.

"Today, while spot prices are still up around US$170 a tonne . . . the New Zealand dollar is still at 81c; as a result our prices in New Zealand dollars today for spot cargoes are 20 per cent below the deepest prices in the GFC and there is a risk that will continue for some time.

"This is much worse than the bottom of the GFC."

Well, yes, in a way it is. But if you take a wider view of prices, it's clear the US$300 level sticks out like Paul Reynolds in a popemobile. (Reynolds, Chalkie should explain, is very tall.)

Even when prices slumped to US$126, they were still double the norm for the previous several decades.

In context, "much worse than the bottom of the GFC" is way better than it used to be. Having said that, underground mining is expensive and risky, so the hits on Spring Creek and Huntly East announced last week should be no surprise, except, maybe, to Solid Energy.

As a joint venture with US company Cargill, Spring Creek's figures are publicly available and they show it has not made a profit since 2008. No wonder Cargill's stake changed hands for a token $1 when Solid Energy bought it out in February - oh, and $40 million of assumed debt.

It probably did not help, financially, that production was cut significantly between November 2010 and last May while major safety work was done. Perhaps the explosion at the Pike River mine on November 19, 2010, reinforced the safety focus.

Overall, Solid Energy says it has spent about $200m upgrading Spring Creek in the past few years, money that looks wasted in light of the suspension of operations at the mine.

As an aside, it is interesting to note Spring Creek Mining Company's comments on coal price risk in its report till June last year. "Export coal prices can fluctuate significantly," it said, "ranging from US$129/tonne to US$300/tonne for export coking coal over the last two years."

But "the company's exposure to commodity price risk at balance date is minimal due to the fact that all export coal held in inventory has been sold at contracted rates".

At Huntly East, Solid Energy said in June 2010 that "current levels of productivity are insufficient to sustain the mine's long-term viability".

Less than a year later it began work building a $40m ventilation shaft to develop and extend the mine, expected to increase the workforce from 160 to 230 people - and presumably boost productivity.

Last week work on the shaft was stopped and further investment cancelled as mine staffing was cut from 234 positions to 171.

Turning to the company's alternative-energy investments, it seems what began with such high hopes will end with some harsh reality. Chalkie reckons the Nature's Flame wood-pellet plant in Taupo was built after a "Field of Dreams" analysis session at an off-site meeting in a Rotorua hot tub. As a plan, "build it and they will come" can work, but it has risks.

Certainly, the anticipated export demand did not happen and the plant needs those sales to be economic. Cue $30m writedown and "idle capacity which looks likely to remain for some time".

The lignite briquette plant at Mataura in Southland is at least on a domestic scale to give the concept a test run, but it seems to have suffered some teething problems.

Production was due to have begun by now but looks still several months away. And amid rumours of budget blowouts, the $25m plant mentioned in 2010 has become a $29m one in current reports.

In the context of Solid Energy's overall business these are not big deals, but it is worrying that the company has struggled with them.

Management has made much of the huge potential of ambitious projects such as coal-seam gas, underground gasification and the conversion of lignite to briquettes and urea - the company has acquired about 3800 hectares of land in Southland for that.

Question marks over the execution of smaller projects don't instil confidence in Solid Energy's ability to deliver on these grand plans.

That is not a good look for a wannabe listed company.

As an antidote to over-optimism, Chalkie reckons every company should have at least one miserable sonofabitch at senior level asking the hard questions.

Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.