The Coal Explosion

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By Greg Peel

Recommended reading as a supplement to this article is “Old King Coal” (Sell&Buyology; 11/02/2008)

“Japanese and Korean utilities are the traditional big consumers of coal, and UBS suggests they are currently in a “state of denial” over what’s going on around them. Both are currently negotiating fiercely to set 2008 prices, but they are now doing so from a much weakened position.”

These lines appeared in the above article published in February. How prescient they seem now. Back in February, the most bullish of coal analysts were pencilling in a 2008 coking coal contract price of US$200/t. Yesterday it was announced that as of April 1, Korea’s Posco – Asia’s third largest steel maker – will pay between 205-215% more to BHP Billiton ((BHP)) for its coal in 2008 over the 2007 price. The equates to as much as US$308.70/t.

As late as yesterday morning, Citi issued a report lifting its 2008 coking coal price forecast to US$285/t while GSJB Were shot to US$290/t. They weren’t far off.

For the Koreans it has been a case of very unfortunate timing. Coal contracts are always renegotiated at around this time each year, and Australia – the world’s largest exporter of coal – has seen its production devastated by floods earlier in the year. Weres analysts note the floods cut Australian exports by as much as 15%, which equates to about 6% of global seaborne supply.

At the same time, snow in China all but shut down that country’s coal production. While China is normally a net exporter of coal, Chinese steelmakers were being forced to bring in lower quality coal from India on spot contracts for as much as US$270/t back in February. Even then analysts expected the snow to melt and the spot price to retreat, but what the bad weather has served to highlight is that China is desperately underpowered, and is going to be needing a lot more coal. At the same time, its transport infrastructure is not up to the task. This harsh reality is also true for Australian coal miners, who are struggling to meet revenue expectations as they can’t get the coal out to sea.

But if it weren’t for such constraints, the coal price would not be where it is. As tantalising as such a coal price is, Australian miners have to be content with taking their places in the queue to actually sell their product. However, infrastructure problems in Australia or anywhere else are not about to be solved overnight, and so it is unlikely the coal price will collapse shortly. Australian coal producers can get used to the idea of 2008 contract prices over US$300/t.

The news is of course, very good for coal producers. That’s why share prices, including those of BHP and Rio Tinto ((RIO)) have had a good run this week. However, many stocks have run very hard in anticipation of such extreme coal price renegotiations, and now that a price has been set analysts have taken to downgrading recommendations for some miners from Buy to Hold. For pure-play coal miners it’s a case of “lock it in”. Macarthur Coal ((MCC)) and Felix Resources ((FLX)) are two to have suffered downgrades. Felix’s share price has run 142% since the January 22 low.

One welcome beneficiary of higher coal prices will, however, be diversified conglomerate Wesfarmers ((WES)). A bit of increased coal income will provide some assistance in dealing with the amounts of debt needed to finance the Coles turnaround.

The next question is as to whether such high prices will be sustained come the 2009 negotiations. The general belief is no – not at these sort of levels – but that prices will remain robust nevertheless. It will depend on steel demand, both from the point of view of a global slowdown and as to whether steelmakers like Posco can pass on the coal price increase into its steel prices. Bloomberg reports Korean analysts as believing it can.

But there is also a small matter of power generation. Thermal coal is not enjoying the same sort of price explosion as metallurgical coal, with analysts expecting only a comparatively modest price increase of a bit over 100%. This takes the 2008 price to around US$110-120/t. While steel demand can prove volatile, the need for further power generation across the globe has become a critical issue. (Refer to the above article.)

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