Coal. The mere mention of this word sends shivers down the spine of any environmentalist. The concept of burning coal for energy dates back millennia, and its abundance in the earth ensures that were current global consumption levels to remain static, there would be enough known reserves to last at least two centuries. As such it is the cheapest way to produce electricity, but burning coal is also the fastest way to load the atmosphere with greenhouse gases.
If you think that environmental concerns have led the world to begin reducing its dependence on coal, think again. Nothing could be further from the truth. Providing power to the developing economies of China and India alone in the next decade is going to provide a challenge for suppliers to even meet the growing demand.
And that's before you start talking about steel production.
Coal can generally be divided into two categories - thermal and metallurgical. Thermal coal is used for firing power plants. Metallurgical coal is used to fire the blast furnaces driving the process of turning iron ore into steel. Metallurgical coal can then be divided into "premium" hard coking coal, less preferred semi-soft coking coal, and finally "low vol PCI" coal which is of a lesser standard again, being "low volatility" and used for "pulverised coal injection".
Last year Australia exported 250 million tonnes of coal - 45% thermal and 55% metallurgical. Australia is far and away the world's biggest exporter of coal, with daylight second and third before Canada sneaks in ahead of the US. The world's greatest importers of coal to date are Japan, Korea and Taiwan. The reaction here might be: what about China? China is also blessed with an abundance of coal.
Which is another reason movements in the coal price in recent years have failed to excite when compared to oil, iron ore, base metals and uranium. But the global dynamic is beginning to change. As of 2008, China is expected to become a net importer of coal. And India, which is about to begin an ambitious plan to provide electricity to every citizen, has no useful coal to speak of.
While such changes in the supply/demand dynamic have been gradual, suddenly coal has been thrust into the spotlight given recent events. For all of 2007 in Australia, one coal producer's set of quarterly results after another highlighted the same problem - we have the coal, but we can't get it to our customers fast enough. When we get it out of the ground, there aren't enough rail cars to load it on to, and there are traffic jams down the line. Once it does get to port, then we all have to wait our turn to get the coal loaded onto a ship.
Then just to make matters worse, it rained. It rained in Queensland, it rained in WA and it rained in the NSW Hunter Valley, and then it rained some more. Pits were flooded across the country and production at some mines shut down altogether. It will take months to return to full production. But it will take years to construct the infrastructure required to meet global demand.
Over in China, it snowed. And then it snowed some more, shutting down coal mines and electricity supply. The snow will eventually melt, but the snow has also served to highlight what is a fundamentally deeper problem in China - the country needs more power plants to keep up with electricity demand. It didn't snow in South Africa, but South Africa has also come to realise as its mining industry has been forced to shut down periodically that it, too, is short on power generation, and will be for some time to come.
The Chinese snowstorms also brought attention to the fact China is suffering the same problem as Australia. It doesn't have sufficient rail infrastructure to avoid supply bottlenecks anyway. India has been watching, and has decided that when it builds all its new "ultra-mega" power plants they will all be located on the coast - next to ports. And when Australia completes its port upgrade plans currently on the table - around 2010 - demand for Australian coal will have already risen beyond the new throughput capacity. And rail constraints still won't have been alleviated.
With the amount of supply disruption going on in the world, spot coal prices have shot up dramatically these last months. Things will settle down again, but resource analysts are beginning to realise that the fundamental supply/demand story in global coal is set to reach a tipping point in 2008. From 2004 to 2007 the price of coal increased by roughly 50%. Analysts now expect that prices are likely to double in 2008 alone.
Even in the time of Mao Zedong, China was a voracious producer of steel. For some reason steel production was seen as a highlight of a triumphant communist regime, even if it didn't always find a use. When China began to properly industrialise in the early twenty-first century, steel production continued as a significant industry, and so China began madly exporting steel to the world. This led to cyclical fluctuations in the global price of steel, as China cycled from under- to overproduction. But in the last year or so China's steel exports to the developed world have fallen dramatically in percentage terms. China's domestic economy is now the substantial driver of the overall economy, led by a property and infrastructure boom.
From 2004 to 2007 the global iron ore price has risen 120%, including the big 71.8% jump from 2004 to 2005. Negotiations are currently underway between Australia and China to set the 2008 price, and increases of at least 50-60% are forecast. Iron ore and coal are the two main inputs to steel production, but while China boasts large coal reserves it can't say the same about iron ore. That's one reason why the Chinese are very worried about a possibly merged BHP Billiton (BHP) and Rio Tinto ((RIO)), which would control the majority of the global seaborne iron ore market.
Until recently, China hadn't been as concerned about the supply of coal. Indeed it has been a net exporter. But it has taken the current severe snowstorms to alert the world to the fact that China is desperately underpowered. Half of its provinces are experiencing rolling brown-outs. China has initiated an ambitious program to build several nuclear power plants in the next decade, and has also become serious about renewable energy. But both these sources will only be a drop in the power supply bucket. China needs to build more coal-fired power plants, and quickly, lest its economic progress be stalled.
The Chinese government has now banned all coal exports, at least until March. If the ban is lifted, it still remains unclear as to whether China will return as a net exporter once more, or will remain a net importer as it has recently become. China produces 2 billion tonnes of coal per year. Annual global trade in coal represents less than 1% of that figure. But the Chinese government may decide to continue with the ban.
China is increasing its coal production capacity, and forecasts are that supply could increase in 2008 by as much as 26%. Demand is only expected to increase by 20%. However, the increase in production might still prove fruitless given China's rail infrastructure is not up to the task. And furthermore, the additional coal produced is of a lesser and lesser quality, such that higher quality coals would still need to be imported for blending.
As far as steel production is concerned, industry expansion continues at a rapid pace in China. In 2005-06 steel exports increased by a third. They increased again by a third in 2007. As the US and Europe are staring down the recession barrel there has been concern the subsequent drop-off in demand for Chinese steel would put a dent in Chinese economic growth, flowing right back to demand for commodities such as coal. But the truth is that most of China's exported steel is now directed to the rest of developing Asia. Exports to the US account for only 8%.
Indian crude steel production is targeted to increase by 60% by 2012. Citigroup analysts believe this is an unattainable goal, but that does not detract from the fact that, either way, the growth in India's demand for metallurgical coal will be "tremendous". India has basically no "met" coal of its own. On the thermal coal front, India intends to follow China by powering its economic growth with coal-fired electricity.
India's other plan for 2012 is to substantially increase its power generation capacity. Half of the new capacity will come from ten corporate-built "ultra-mega" power plants (I think that means "big"). As India is already feeling the pinch from current thermal coal supply disruptions, six of these plants will be designed to run on lower quality coal imported from Indonesia. Indonesia is emerging as the world's biggest exporter of thermal coal as Australia, China and South Africa all suffer from supply disruptions. Reports suggest the current coal stockpiles at Indian power plants are averaging only 9 days when 30 is considered safe. Just how quickly Indonesia can increase its thermal coal exports will be a critical factor in the market.
But there is one small problem. Apart from Indonesia's coal being of a lower quality that requires blending, Indonesia, too, has grandiose plans to expand its own electricity generation capacity. It is, after all, the world's fourth most populous country. To that end, there is a proposal in front of Indonesia's Minister of Energy for 50% of coal to be sold domestically. This would create big problems on the global supply side.
Back in the already developed world, the realities are yet to hit home. 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. Furthermore, Japan had set itself an ambitious plan to expand its already substantial nuclear energy capacity, however a recent spate of earthquakes has put the frighteners through all involved. The end result is that Japan is looking to increase its coal-fired capacity, and thus its imports of coal.
The contribution from North American exports is waning as both the US and Canada deal with rising costs, infrastructure challenges, and environmental considerations which are constraining thoughts of production increases.
The only flipside to the global demand/supply situation is the case of Europe, which saw a sharp drop-off in demand for coal imports in the last quarter of 2007. In the third quarter, imports registered a 22% decline year-on-year. This is not because Europe saw its economy dramatically slow in that time, but because of the increase in the number of gas-fired power stations recently commissioned. Europe has been the leader in carbon reduction and subsequent trading, and the additional cost placed on coal makes gas a much more economical option.
Which brings us to the subject of carbon costs. Outside of Europe, plans for carbon trading are still being formulated and an internationally generic system is a long way off. In Europe however, Phase 1 of the European carbon trading scheme has been in place for a few years now. It was not a great success, as the carefree issue of industry exemptions led to the price of carbon offsets actually collapsing down to not much. But Phase 2 came into force in January, and apart from sorting out the exemption situation, Europe has also stepped up the level of reduction requirements. The result is that the offset price which had fallen to nearly zero has now leapt up to US$23 per tonne of carbon. It is likely the European model will form a framework for many other national schemes, and as such the traded price of carbon in Europe will offer a benchmark elsewhere.
But despite this additional cost to be borne by coal producers and consumers, Citigroup analysts for one do not see the global demand thesis changing much as a result. It will certainly take many years before alternative forms of energy become mainstream. Nuclear energy will still only be a small substitute despite the number of reactors being planned across the globe. Renewables are still not ready to be providers of base-load power. Gas is clearly an alternative that could make a mark in the medium term, but there is a lot of infrastructure that needs to be built within a high cost environment. You only have to consider the long delays surrounding the great PNG gas project to know that this is not an overnight solution either, whereas for developing countries power is a very immediate issue.
And there is a lot of effort been thrown into somehow producing "clean" coal, but at the moment this concept appears to be right up there with cold fusion - everyone talks about it but no one's actually done it. Coal-to-gas or coal-to-liquid conversion, on the other hand, is very real and under development, and this process does significantly reduce carbon emissions. What it doesn't do, however, is reduce the demand for coal.
There are other sources of coal being developed across the globe, from Russia to Kazakhstan and Mongolia, from Mozambique to Columbia. Developed countries such as Russia all suffer from the same infrastructure constraints. Developing countries not only suffer from such constraints, but are reducing coal exports as domestic demand rises. Vietnam, for example, has been increasing its exports but now its domestic demand is rapidly rising. Undeveloped countries are pretty much at the beginning of talking about infrastructure, which will need to be built in far-flung places at great cost.
Analysts agree that while there is potential around the globe, we are once again in no way talking about an overnight fix.
Finally, the cost of producing coal (or any commodity) has been exponentially rising in past years, and analysts were quite shocked by some of the cost increases revealed in the most recent round of Australian coal producer quarterly reports. It is well understood that everything from labour, to skilled professionals, to equipment, and right down to even truck tyres is becoming more and more scarce and more and more valuable. This is not a situation that is about to change in the foreseeable future. Those costs impact on the bottom lines of coal producers, but are pretty quickly passed on. Coal is very much a "consumer staple" and not a "consumer discretionary" product.
And so to price.
The average price for thermal coal in 2007 was US$55/t and for metallurgical (hard coking) coal US$95/t. UBS is expecting 2008 prices to rise to US$100 for thermal and to US$170/t for hard coking. Citigroup is predicting US$100/t and US$200/t respectively. JP Morgan (ever the conservative voice) has pencilled in US$70/t and US$140/t. GSJB Were (often the frontrunner) has US$125/t and US$200/t. Macquarie has forecast US$88/t and US$150/t, but suggests "significant upside remains" to forecasts.
Analysts tend to be conservative in general in their forecasting, as it's always more heartening for investors if price predictions rise rather than fall. But witness late breaking news from Citigroup that small volumes of thermal coal were traded at US$125/t last week, up US$30 from the week before, and coking coal has traded at a whopping US$270/t, up US$70. While immediate prices reflect current supply disruption issues, it is clear the buyers have become somewhat desperate. For the likes of Japan and company, currently in contract negotiations, this news is not good.
For those invested in coal producing companies, the news is all good, and appears will remain so for the foreseeable future.
Of the Australian coal companies listed in the S&P ASX 300 index, analysts lean towards Buy ratings for all of Centennial Coal ((CEY)), Gloucester Coal ((GCL)), Macarthur Coal ((MCC)) and Resource Pacific ((RSP)). Coal & Allied ((CNA)) is little covered individually as it is a subsidiary of Rio Tinto. Those brokers placing Hold or even Sell ratings on Australian coal companies are focusing on short term issues of flooding and infrastructure constraints. The Buy raters take these problems on board, but have put their faith in the rising coal price.
BWN Price at posting:
0.0¢ Sentiment: Buy Disclosure: Held
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