Coal-fired opportunities are powering back up, almost in spite of climate change concerns. Savvy players from NRG to the Tennessee Valley are taking notice. Sitting in the cross-hairs of emerging climate change regulation and lingering real estate troubles, the prospects for coal were thought to be much blackened. Judging from the recent activity of some quite-smart money, not all is what it first appears. Rather, deals are getting done despite the need to juggle risks ranging from environmental risk to particularly knotty due diligence issues. These risks are not being ignored of course, for the most part....but rather, are being managed through some quite artful legal-ese. With transactions ranging from toe-in-water supply arrangements to full-boat M&A, coal deals are using legal terms to power forward.

Coal companies appear to be in the process of reinventing themselves along with the legal rules by which they operate. Commodities demand in both metals markets and power markets, including related arbitrage, sit behind coal deals. These deals are playing out, despite existing tight regulatory control under the Clean Air Act and the promise of more regulation to come under impending climate change legislation.

Playing a large part in this reinvention narrative is one particular region of coal production, known as the Blue Gem Seam found along the Kentucky-Tennessee border. To understand, keep in mind that coal has more than 1 use. In addition to its use in the energy industry, coal is quite prominent in the production of “silicate metals”. These are used in the production of everything from lubricants to solar cells to specialty steel.

The Blue Gem coal is one of three coal seams in the world that are best suited for production of silicate metals and is sought after globally. As a result, it benefits from a premium price and less price volatility than other types of coal. Globe, Elk hem, DuPont and other manufactures of silicon metal are likely be targeted as buyers for Blue Gem coal.

Along with its outsized promise are large-scale due diligence concerns. The Blue Gem scene is ripe with high quality coal, small operators, and much tradition. While you might think of coal production as a heavily regulated industry fraught with barriers to entry, this is not always the case. Joining large-scale denizens like NRG Energy (more on this later), are small local operators as well as wildcatters. The region is blessed with allegations of illegal mining by unemployed wildcatters simply seeking to make a living, who may be operating in seams owned by a particular company.

Large players are often limited in their abilities to directly penetrate this space for several reasons. Small players play an outsized role in Blue Gem coal production. In contrast to the image of Big Energy and Big Coal, small legitimate operators are quite common because this coal seam is often too shallow to accommodate the heavy machinery used by big coal companies. Second, they may prefer to keep owner-operators involved (with earn-outs and milestone payments) as they best know the landscape, in all senses of that word. As a result, they pursue different deal strategies, each with their own risk management to boot.

Large companies are getting into the Kentucky region by creative deal-making. Consider the distribution attempt by Consolidated Services to lock-up all of LeeCo’s property rights in the area. On June 19, 2008, Consolidated Services, a Delaware-based corporation, bought a 50% in privately owned LeeCo. LeeCo leases coal on approximately 650 acres with an estimated 860,000 tons of surface mineable Blue Gem coal, of which 60-90% is estimated to be recoverable. The owners estimate there’s a lot more where that came from, stating there are 4.5 million tons of deep coal deposits.

CSI acquired the development rights to all rights which LeeCo has or obtains in the future. In the agreements LeeCo assigns their put options on Appalachian tracts and also assigns 50% of their currently owned real estate. In an effort to transfer the properties Lis Pendens needed to be released evidencing Consolidated Service’s desire to hold the property in an unencumbered fashion.

This agreement stands as proof of another phenomenon of Blue Gem Coal. As noted above, it’s often mined by small operators, lacking much of the scale typically found in Big Energy or Big Coal. Take the Consolidate/LeeCo document – lacking the legal formality and anonymity of defined terms, the owners/sellers are simply referred to as “David” and “Pat” in the agreement. Perhaps reflective of this home-style trend, painfully little risk management is put in place in these arrangements.

Outright acquisition is always an option, as seen in the May 2009 purchase of coal leases by Canadian-based North American Gem from Lonesome Pines Leasing. On its face, this deal looks to be a Canadian coal company taking advantage of a weak U.S. economy to expand into the U.S. market. In truth, driving this transaction is the transformation of Blue Gem coal reserves to silicate metals.

Likewise, in July 2009, Foundation Coal Holdings Inc. was acquired by Alpha Natural Resources in an all stock transaction. Foundation’s footprint is in more traditional, power-production oriented coal, though of a cleaner variety thought to reduce pollution control costs. It is seen by Alpha as supplementing Alpha’s own earlier focus on metallurgical coal. Interestingly, Foundation had previously been owned by a particularly smart-money group, the Blackstone Group and First Reserve Corp. They took Foundation public in a 2004 IPO.

Spot market prices are drawing smart money to the opportunity because prices are expected to increase with the rising demand for silicate metals, among other things. The limited supply and great demand creates the ability for North American Group to set a profitable price for Blue Gem coal on the spot market. The coal leases North American Gem acquired establish Canadian-based NAG as a coal producer with the ability to enter into long-term supply contracts, such as the one recently entered into between Tennessee Valley Authority and Alliance Resource Partners.

While all of this upside is promising, the parties have not forgotten the impact of impending regulation. Part of the North American Gem transaction involved commitments to incorporate environmental controls that keep the companies compliant with increased regulatory burdens.

Leasing instead of buying is always an alternative route and certainly is so in coal supplies, as it provides the “acquirer” with particular legal flexibility. As proof, consider the August 2009 agreement for the supply of coal between the Tennessee Valley Authority (TVA) and Alliance Resource Partnership. This agreement, looks to lock in long term supply arrangements, and pricing, for high quality coal. At the same time, it includes both termination rights and unique reps meant to give TVA ultimate control in the face of increasing climate and pollution regulation. In the agreement, it states that the source of the coal is particularly sensitive for Tennessee Valley Authority and they would only accept coal from certain locations, detailed in the contract. According to the agreement the price of coal delivered from an alternate source (therein defined) shall be reduced, if necessary, to account for TVA’s economics. Also, the terms price coal based on the type and the delivery date out the next 3 years. From seller Alliance’s perspective, it has now secured sales commitments for several years to come.

An interesting side note has been a coal-centered drama playing out all year, around major power generation player NRG. This company has been much in the news due to its targeting in a heated (and recently abandoned) takeover battle by Exelon. Less well known about NRG: it plays a major role in Appalachia and particularly in Blue Gem country. To wit, it released its 2009 communication to investors indicating that their coal portfolio company, Alden Energy Inc., is a producer of Blue Gem coal located in the central Appalachia region of the United States. (For more on the battle between Exelon-NRG, please read the recent Westlaw Business Currents articles on this topic, included in the Related Resources to the right).

Producers are set on finding the next, new gem. This is particularly striking, as coal seemed a lot less promising not that long ago. President Obama, in his campaign promises, in describing the proposed cap-and-trade program, exclaimed “if somebody wants to build a coal plant, they can — it’s just that it will bankrupt them, because they are going to be charged a huge sum for all that greenhouse gas that’s being emitted.” Likewise, in September 2009, EPA Administrator Lisa Jackson announced that the EPA will be looking “closely” at 79 permits filed for new mining projects in Appalachia. With strong risk-handling and possibly stronger profit incentives, coal companies are clearly thinking otherwise.