Material Matters: Coal Market Updates

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 – Falling global coal output to improve market balance
 – Goldman Sachs outlines key factors in met coal market
 – Thermal coal outlook reviewed
 – Natural gas displacing coal in US
 

By Chris Shaw

Major mines in the US, China and Australia are delaying and cutting back production, signalling to Standard Chartered a global reduction in coal output is now underway. If this process continues, and it may given many producers in Australia for example are generating cash losses that could drive mine closures, the demand supply balance will be tilted away from oversupply to a more balanced market.

Shorter-term, Standard Chartered suggests demand is likely to pick up ahead of the Pacific region re-stocking period in coming months. Interest from China and India in particular should improve, helping offset what is likely to be still lacklustre demand from the Atlantic Basin.

For China in particular, total coal output is expected to remain below 3.65 billion tonnes this year as major producing regions lower output. Standard Chartered expects as long as domestic prices remain at a premium to imported coal, interest from Chinese buyers should increase.

In India, weak rainfall in the current monsoon season suggests there could be a shift to coal fired power generation to offset a shortfall in hydropower output. Indian buyers are likely to have a preference for South African and Indonesian coal over Australian coal in the view of Standard Chartered.

Based on the above scenario, Standard Chartered is forecasting quarterly prices for API2 thermal coal of US$88 per tonne in the September quarter and US$92 per tonne in the December quarter this year, rising to US$98 per tonne for the first two quarters of 2013. 

Similar price moves are expected for API4 coal, while Newcastle coal price forecasts for September and December stand at US$95 per tonne and US$100 per tonne respectively, rising to US$105 per tonne in the March quarter next year. 

Looking more closely at the metallurgical coal market, Goldman Sachs has lifted its long-term price forecast by 21% to US$200 per tonne to reflect supply/demand and cost inflation trends. This compares to an estimated average cost of production in Australia of US$150 per tonne.

Short-term Goldman Sachs sees little scope for price gains, as the seaborne market is more exposed to lower GDP growth economies and this implies lower rates of demand growth. At the same time the supply side is improving as Queensland mines return to pre-flood output levels. This suggests prices in coming months will remain around cost support levels in the absence of any significant supply disruptions.

Longer-term the outlook remains more favourable in the view of Goldman Sachs, as met coal remains geologically scarce and there is limited threat from alternatives such as scrap metal (secondary steel production from scrap metal does not require met coal in the process). As well, the supply side is regularly exposed to weather-related disruptions. 

Goldman Sachs suggests the relatively concentrated met coal industry structure and the need for higher prices to induce new projects supports the view profit margins should remain attractive over the medium to longer-term. 

A long-term price of around US$170 per tonne is seen as enough to induce new large scale met coal projects, though the price varies according to the market in the view of Goldman Sachs, as examples, the inducement price in Australia is estimates at around US$165 per tonne, compared to US$206 per tonne in Indonesia and just US$124 per tonne in Russia.

At the same time, the expectation is that seaborne demand is likely to grow at a slower rate relative to the growth rates seen over the past decade. This means diminished scope for periods of sustained price increases, something expected to force a focus on volume growth and margins. A significant driver of the met coal market will continue to be China, as it is a net importer of material thanks to limited domestic resources. 

In terms of differentiating between met coal producers, Goldman Sachs suggests the key criteria investors should look at are production growth profile, cost profile and stakeholder management. Cost profile is becoming more relevant as productivity in both the Australian and US coal sectors as continued to decline in recent years as input cost inflation has risen. 

Applying this to Australian-based met coal stocks under coverage, Goldman Sachs continues to rate BHP Billiton ((BHP)) and Rio Tinto ((RIO)) as Buy, while coverage of Whitehaven Coal ((WHC)) is currently suspended.

Turning to the thermal coal market, the latest market data suggests Chinese thermal coal inventories at power plants rose to 24 days of consumption in mid-August, up from 21 days at the end of July. Macquarie suggests this pick-up is a reflection of lower daily consumption thanks to sluggish demand growth.

At the same time, Macquarie notes Chinese raw coal production cuts are starting to impact, as July output was down 2% relative to June. This trend is expected to continue through August. With Chinese customers also deferring some orders and defaulting on some contracts, coal prices in China are expected to stabilise in coming weeks in Macquarie's view.

Deutsche Bank is less optimistic with respect to the sustainability of a price recovery in the thermal coal market. This reflects not only worsening demand statistics from China but the expectation of an increasing surplus in the market in coming years.

As Deutsche notes, a growing surplus is likely as the current pricing environment has not had any appreciable impact on medium-term plans for expansion of existing projects and the bringing on line of new mines. 

This is more than enough to offset recent positive signs such as lower inventories at Chinese ports and power generators, as Deutsche points out inventories in both cases remain at levels that would have been regarded as record highs prior to March this year. 

With US natural gas prices seeing large swing throughout the current injection season, Barclays has looked at just how fast is the rate at which natural gas is displacing coal in the US market.

The regression analysis undertaken by Barclays suggests coal displacement is not as sticky as might have been thought. Coal displacement is estimated to have averaged 3.6Bcf/day so far this year, reaching a peak of more than 9Bcf/day in April when gas prices averaged less than US$2.00/MMBtu. 

Coal displacement levels have since pulled back to their lowest levels for the year in July, this as the natural gas price rallied above US$2.50/MMBtu. 

A supportive factor for the market has been a steady decline in the gas storage surplus, Barclays noting since the end of April the storage overhang has fallen from 880Bcf to around 487Bcf. 

But with coal displacement remaining sensitive to the natural gas price on a weekly basis as well as a monthly one, Barclays doesn't expect natural gas storage to remain on pace to finish the current injecting season at 4Tcf or lower without prices dropping below US$3/MMBtu for at least September and October. 

In India, Macquarie notes the Auditor General has tabled a report on the allocation of coal blocks, as there is an argument in favour of competitive bidding for new projects rather than free allocation, and the potential for this to deliver windfall gains to private companies.

The report suggests there has been a probable loss of as much as US$34 billion as a result of free allocation of coal blocks but in Macquarie's view this estimate is inaccurate.

All mines already allocated but where operations have not started without reasonable cause can be de-allocated. At the same time, Macquarie notes all captive coal-based power producers have been asked to sell power the competitive bidding processes. 

The impact of the report has been to dampen sentiment towards the sector, with Macquarie taking the view fresh approvals by the Ministry of Coal will reduce current uncertainty.

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