Thermal Coal Settling At US$70/t

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By Andrew Nelson

Xstrata and Rio Tinto have reportedly settled thermal coal contracts with Japan’s Chubu and the prices are around the expected level of US$70 per ton. While this is a US$55 per ton discount to current financial year contracts of US$125 per ton, it is still an US$8 per ton premium to current spot prices. Given the recent deterioration in spot pricing, this should be considered a good outcome for producers.

If thermal coal prices ultimately settle at US$70/t, there could be some significant upside for Australian coal producers because of falling costs. And there’s a good chance of this, says BA-Merrill Lynch, given the major coal producers and consumers involved will likely make these deals a benchmark. For the record, BA-Merrill Lynch and Citi are expecting an ultimate benchmark of US$70/t, Macquarie is expecting US$75/t, but is more than happy with US$70/t, while UBS is actually sitting at US$60/t.

Conclusion: the first indications are coal prices this year won’t be as dire as feared by some.

Analysts at Citi believe a price of US$70/t will give producers a healthy margin given the view that thermal coal median production costs could fall around 10% to $US30/t this year as lower mining costs and exchange rates impact.

However, with JFY09 benchmark coal prices now being settled, the major risk for coal company earnings will come from lower sales volumes, of which there is a real likelihood. On BA-Merrill Lynch’s current volume assumptions, which have already been cut by 15-30% in recent months, the broker estimates the market is factoring in at least a further 10-20% cut to FY10 coal volumes.

That said, Merills admits this may be an overly pessimistic assumption, as base load requirements for coal-fired power remains relatively high and stable, even in a global economic downturn. The broker says it is still starting to see value in Australian coal equities.

The broker stops short of saying it is bullish and reminds that it continues to expect negative news on metallurgical and thermal coal demand. There is no question this  will continue to weigh on the market’s valuation of coal equities in the near term. UBS also thinks the thermal coal market will continue to suffer from volume destruction as producers of metallurgical coal are trying to sell more volumes into the thermal market. Macquarie and Citi are also in step with this view.

This expectation of diminishing demand sees Macquarie make earnings downgrades of 5-10% for the independent Australian coal producers. For Macarthur Coal ((MCC)), the broker has made additional modelling adjustments to the proportion of thermal coal sold given its understanding that the company is now ‘sold out’ of thermal coal, which implies guidance of 1.2mt has been reached.

Given Gloucester Coal sells all of its thermal coal to traders and is thus priced off the spot market, Macquarie makes no earnings changes, while its earnings forecasts for BHP Billiton ((BHP)) are reduced by just 1%.

On the other hand, Centennial Coal ((CEY)) and Felix Resources ((FLX)) are really the major independent suppliers of Australian thermal coal to Japan. The broker notes the vast majority of Australian thermal coal is sold into Korea and prices there are yet to be settled, leaving downside earnings risk in place. Still, Macquarie does prefer Felix.

UBS notes its Korean economist has recently reiterated a 2009 GDP forecast at minus 5%. While the broker expects modest increases sequentially in 3Q09 and 4Q09, its outlook on Korean economic production highlights the likelihood for weak demand for thermal coal. Still, based on US$10/t better than expected coal pricing, Centennial and Macarthur appear to be the cheapest based on FY10 PE multiples of about 5-6x.

Given Centennial sells thermal coal primarily into the export market, which is holding up better than coking coal, the Buy is maintained. However, Macarthur is still a Neutral primarily due to the continued poor outlook on steel production, which has caused customers to cancel shipments in past months. But the stock still offers the most upside to a recovery in coal demand, says the broker, given its large discount to valuation.

Felix Resources remains BA-Merrill Lynch’s preferred Australian coal exposure, with the broker citing a large, low cost and low risk thermal coal expansion. It also notes good M&A appeal as the company is seen as both a buyer and seller of assets, it has a strong infrastructure position plus a strong balance sheet.

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