Commodities | Mar 18 2009
By Andrew Nelson
Now that the first contract coal settlements are starting to trickle in, it becoming obvious that last year’s high levels will not come close to being maintained. The first agreement in thermal coal that was struck last week by Xstrata and Rio Tinto with Japan’s Chubu Electric (see our previous story Thermal Coal Settling At US$70/t), is a clear illustration of this.
At US$70 to US$72/t, last week’s contract pegs in a drop of 44% on last year’s US$125/t. It also increases the likelihood that agreements between other Asian utilities and coal producers going forward could come in at even lower levels.
The commodities team at Barclays Capital suggests there are several dynamics at work here. First, coal demand remains extremely weak. This is borne out not only by lower sales, but also by consecutive double-digit falls in the industrial production of major consuming economies.
The second factor is that Asian utilities can purchase lower-grade material, which can be mixed with semi-soft coking coal and pulverised PCI. The team believes both of these are in large surpluses.
And in a surplus market, notes Barclays, buyers can always turn to the spot market if contract terms are unfavourable. Working together, these factors have undoubtedly strengthened the bargaining position of coal buyers. But there is some upside though.
Currency movements, such as a weaker AUD, may well lessen the pain for producers in certain countries, making it easier to live with lower prices. At least for a while.
So the question for investors is: How will the coal miners fare?
In short, not as bad as it looks. While contract prices have fallen by 44%, the Australian dollar has also weakened by some 30% against the US dollar. Barclays points out this means that for a producer who has locked in current AUD weakness by entering into monthly AUD/USD forward contracts, its revenues from annual contracts would not fall by quite as much as implied by headline prices.
Barclays finds that by using historical annual contract prices and rebasing them from the fiscal year into the calendar year, the fall in contract prices would translate into only a 21.5% fall in USD revenues/tonne for CY 2009. However, it only implies a meagre 0.1% drop if exchange rates were fixed according to the current AUD/USD forward curve.
It looks just as good when factoring in profit margins, says the team, given they would only shrink to 50% from 51% if you assume constant operating costs in local currency terms. However, the reality is that costs are lower and this should support margins even further.
As an example, the team from Barclays points out that while the one year forward Brent price has fallen from an average of US$83/bbl to US$53/bbl from October 2008 to last month, prices have not really changed in Russian ruble terms.
Barclays notes that these are both examples of how recent currency depreciations have led to price strength relative to US dollar-based forward prices, which gives rise to hedging opportunities for local producers who have the bulk of their costs denominated in local currencies.
