Commodities | May 09 2013
-Thermal coal under pressure
-Over-capacity now the issue
-Thermal coal surplus for some time
-Coking coal still in demand
By Eva Brocklehurst
Coal mining is in a spot of bother. Planning and executing large mining projects takes a long time. There is always the risk that, by the time supply and capacity are lined up, demand has gone elsewhere. Australia's coal export capacity utilisation has been high, running above 85% over the last decade. Now, with a lift of 100mtpa in export capacity recently, the opposite is true. Macquarie finds the industry is looking very stressed. At the production front it is pressured by sustained low prices and a high Australian dollar. At the port level, capacity is now seeking supply. Macquarie cites Whitehaven Coal ((WHC)), which has indicated there could be 60-70mtpa excess capacity through the coal terminals at Newcastle in 2014, as evidence.
This is a turnaround from when port expansions were being planned and funded in the latter part of last decade. At this time, all the talk was about bottlenecks in export capacity as mine output rose. Many producers were keen to lock in tonnage for further projects. Macquarie observes Wiggins Island had eight coal producers participating in phase 1, underpinned by take-or-pay agreements. These deals formed long-term obligations to use the terminal, with rolling 10-year contracted tonnage. Wiggins Island is at an advanced stage of development and Macquarie believes it will still continue, although one year later than planned because of problems along the way raising enough debt finance. Nevertheless, Macquarie thinks that, for some of the miners involved, it now looks like a burden rather than a blessing.
Where this scenario diverges in terms of the demand outlook, and hence the future prognosis, is with the two main types of coal – metallurgical (or coking) coal, which is combined with iron ore to produce steel, and thermal coal, used for electricity generation. Commonwealth Bank analysts note that China has been critical in determining the fortunes of both types of coal, very much so in the case of thermal coal. Thermal coal demand growth is expected to slow over the next decade relative to the past 10 years, reflecting environmental and regulatory pressure, combined with advances in alternatives, such as natural gas and renewables.
Transition to consumption of thermal coal in China's northwest will disadvantage imports. Coupled with this, the analysts envisage power demand is likely to grow more slowly along the eastern seaboard. Meanwhile, across the Pacific in the US, shale gas and stringent environmental regulation is displacing thermal coal, either putting it out of production or pushing it towards the seaborne market. Coupled with the rise in Australian supply, the issue of surplus looks obvious.
The Japanese fiscal year contract has now settled at US$95/t free on board and the pressure is on for thermal coal producers in Australia, in Macquarie's view. On a cash basis many mines are now barely breaking even and there will be substantial pressure for costs to be taken out of the businesses on a sustainable basis, with potential for asset divestments. Longer-dated projects will be delayed or mothballed. Macquarie suspects that export growth after 2015 is optimistic.
CIMB concurs that international thermal coal prices will remain subdued in order to price into the Chinese eastern seaboard market. European conditions are weak and will exacerbate the over-supply. India is the lone potential bright spot. India offered a bail-out package to Adani Power, which included a temporary increase in tariffs to offset additional fuel costs — in particular, buying imported coal. If this goes ahead, it could set a precedent that future utilities under financial stress could seek higher tariffs. If so, the analysts think it would be a boon for imported coal demand. Nonetheless, CIMB also thinks the writing is on the wall for thermal coal producers in Australia. They will need to either lower costs or shut down. The analysts note producers are using a volume strategy to counter low prices but this is risky and, until some of the supply is closed off, prices are unlikely to recover over the coming months.
Macquarie thinks the impact of take-or-pay contracts will be at the forefront of future coal development. They may be the standard way to fund projects but they have also increased the fixed nature of the miners' cost base. For 2013/14 these take-or-pay contracts are likely to keep Australian exports high, whether they be economic or not. Macquarie thinks contracts for port capacity will be difficult to sell or renegotiate and mines that have over-committed will be left with the cost burden. Much the same is true for the new railways. Existing rail contracts would feel some downward pressure but the value of an incumbent asset against a new development is widening. Take-or-pay contracts for new projects are likely to be much less attractive.
In terms of coking coal, the outlook is rosier. Commonwealth Bank analysts expect modest growth over the coming decade, underpinned by pig iron output and a shift towards larger, higher quality blast furnaces in China. The key to the growth outlook is the extent to which China's Shanxi province increases production, and at what price new capacity enters the Chinese coking coal market. The analysts prefer premium coking coal because of relative scarcity and medium-term supply/demand fundamentals. More of Australia's premium coking coal mines are in the lower half of the cost curve, as against thermal coal. In the short term, the analysts expect premium coking coal prices to drop from US$183/t in FY13 to around US$169/t in FY14.
Goldman Sachs expects a gradual recovery in metallurgical coal prices out to 2017. The broker believes that, as the marginal buyer in the spot market, Chinese consumers have taken advantage of depressed seaborne prices by increasing import volumes so far this year. This has not tightened the market and supply has been surprisingly resilient. The re-balancing will be more gradual than the analysts previously expected. Prices are expected to be around US$164/t over 2013 to run to US$180/t in 2014 and to US$195/t by 2017.
Global steel production is accelerating relative to 2012 and Goldman expects seaborne demand for coking coal to rise. The analysts note that the supply response to low prices has been counterintuitive. Many loss-making mines are avoiding production cuts and chasing productivity gains instead. The analysts think Australian producers will deliver over 22mtpa of incremental capacity by 2017. This will be fed into a market that is already well supplied, and where demand is set to grow at around 2% annualised average over that period. Nevertheless, Goldman agrees the industry fundamentals remain attractive for metallurgical coal because it is more scarce and the threat of substitution from scrap or Direct Reduced Iron (DRI) is limited.
CIMB finds the coking coal market is struggling at spot prices below US$150/t free on board for premium hard coking coal. While steel production has been strong in Asia in early 2013, steel prices and margins are seen falling and a production response is considered inevitable. CIMB sees China continuing to over-produce, noting that in the first quarter steel production reached 191mt, which is an annualised rate of 768mt. Meanwhile, Europe's steel industry is struggling with over-capacity. In such an environment, Chinese and Indian buyers, the main participants in the spot trade, have been successful in keeping prices down, taking advantage of the suppliers' need to maintain sales volumes. As producers bring on more tonnes CIMB believes prices will continue to remain under short-term pressure.
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