Regional Report – China: Facing a new reality

Amy Gibbs and Daisy Jackson, JLT Specialty Ltd, UK, explain how China’s cooling demand for coal will affect international miners and explore the impact of the slowdown in Chinese coal import demand.

Recent proposals from China to reduce imports of lower-grade coal and political commitments to tackling pollution are indicative of a broader shift in the Chinese Government’s stance towards coal consumption.

China’s change of direction

Despite abundant coal reserves, in 2007, China’s insatiable demand for coal finally outpaced considerable domestic supply, forcing the country to import coal. In 2013, the country’s imports reached 330 million t of coal – nearly one quarter of global supply. Yet while coal has fuelled industry, Chinese demand for coal imports is set to recede.

The 12th Five-Year Plan, issued in 2010, highlighted protection of the environment as one of its three core pillars. It aims to reduce pollution, increase energy efficiency and guarantee a stable, reliable and clean energy supply. There are also strategies in place to produce at least 15% of energy from renewable sources by 2015, to further develop the fledgling unconventional gas industry and to lower coal usage from 69% to below 65% of total energy use. Meanwhile, an agreement was signed with the US in June 2014 to work towards lowering carbon levels.

Ramping up domestic production

Domestic coal output in China rose to 3.7 billion t in 2013, accounting for nearly half of total global production. Meanwhile Beijing aims to put 860 million t of new coal production into operation by 2018 – eclipsing India’s coal output. Plans to build new rail lines will also accelerate domestic output and will keep costs down as coal mines at a distance from large industrial towns can transport coal from mine to market. With these new developments, a sizeable proportion of the thermal coal market currently supplied by international exporters will increasingly be controlled by domestic suppliers.

The build-up of domestic output capability, while cleaner forms of energy are developed, will start reducing Chinese demand for imports. In the long term, coal usage will decline, as the government delivers on its commitment to reduce pollution. International coal miners and traders, already experiencing cost pressures as coal stays cheap, will be forced to confront the reality of reduced Chinese demand. Alternative, sustainable markets must be found to fill the demand gap. Without new buyers, mining firms will start to feel the pinch, potentially leading to further cuts in workforce, mine closures and delays in investment.

Challenging political risk landscapes

Slowing Chinese imports adds to the challenging operating environments already faced by mining investors in several of China’s key coal suppliers: Australia, Indonesia, Mongolia and South Africa. Political risks, in a variety of forms, have impacted balance sheets and investment plans alike.

Australia

2009 was a watershed moment for Australia’s coal mining industry, as values of exports to China jumped from AU$ 508 million in 2008 to AU$ 5.6 billion. Previously, coal exports had centred on the industrial demands of Japan and South Korea for high quality thermal and metallurgical coal, but construction booms rapidly increased China’s dependence on Australia’s high quality coal. Today, China imports over 59 million t, accounting for 52% of Australian coal exports. It costs Australian miners around US$ 80/t to produce coal. Cooling demand will therefore have a considerable impact on the domestic Australian mining industry, as well as the broader economy, of which mining contributes 4.2% of GDP. Coal is predicted to deliver AU$ 18.3 billion in public revenues in the next four years, helping to fund crucial infrastructure and public projects. A prolonged drop in export revenues could therefore leave local governments struggling to make up shortfalls, with potential political repercussions for investors in the form of increased tax, legal and regulatory risks.

Indonesia

Indonesia has been China’s primary supplier of coal, with Chinese demand underpinning a mining sector worth 17% of GDP. It costs Indonesian miners around US$ 42/t to produce coal. The country currently exports around 70% of its coal output (in excess of 420 million t in 2013), made up of both thermal coal and lower quality brown coal; 30% is retained for domestic consumption. A litmus test for the general state of the industry, Indonesian coal miners have already been cutting costs and reducing output since 2012 to cope with reduced Chinese demand. Leading firms, such as PT Bumi Resources and PT Adaro Energy, have seen share prices drop and have been forced to freeze hiring, while production forecasts have been readjusted. Smaller firms have halted production entirely in some cases. Alongside the impact of the export ban, which will not be lifted immediately by Indonesia’s new president, gaps in infrastructure have also made the operational environment more challenging from a cost perspective.

Mongolia

Mongolia will also be affected by China’s cooling demand. The country relies heavily on mining exports and 90% are transported across the border to China. However, Mongolian coal exports fell 20% to 17.3 million t in 2013. In addition, foreign direct investment (FDI) fell by 54%, on account of increased government interference in the mining sector, which contributed to a drop in export earnings of US$ 800 million. When combined with low coal prices, this fall in investment and earnings has dented Mongolian GDP growth and will leave large gaps in public finances. The likely consequence will be a further increase in the risk of renegotiation of contracts, licence cancellation or increased taxes as the government looks to secure revenue streams.

South Africa

For South African miners, the greatest concern – even if alternative export markets are found – will be the risk of strikes and subsequent business interruption. The coal industry is vital to the economy and employs around 74,000 workers. In the aftermath of the platinum industry strike, in combination with the declining influence of worker unions, the threat of wildcat strikes is rising – especially if mining firms have to cut workforces, delay pay increases or put investment plans on hold.

Shifting export markets

The main advantage that Indonesian, Mongolian and South African mining investors have over their counterparts in Australia is that, in the future, a share of coal stocks that previously would have shipped to China can be sold domestically. Indonesia’s coal demand will jump up 29% to 90 million t this year and into 2015. President-elect Joko Widodo has plans for a number of high profile infrastructure projects; coal will underpin the manufacture of raw materials and help the national grid keep pace with increased demand. Indonesia’s geographic situation also allows it perfect access to diversify to India, Vietnam and South Korea. Similarly, Mongolia and South Africa will continue to see their domestic coal consumption levels increase, in part due to increased demands on power supplies and as further foreign investment helps mature their economies with industrial development.

Australia is, without doubt, set to face the greatest challenges in adjusting to decreased Chinese demand. Domestically, the country’s demand for coal, as has occurred in the US and in Europe, has dropped on account of concerns of pollution. India may be able to fill some of the gap in demand. Its prime minister, Narendra Modi, plans to grow the economy through new infrastructure and reform of the power sector. Australia could also look to Japan as it reverts to coal in the wake of the 2011 Fukushima nuclear disaster. Yet high production and labour costs will mean that alternative importers will need to drastically increase their demand for coal if Australia’s miners are to keep production at current rates.

Securing opportunities

Changing supply and demand patterns are inevitable, but what is unique about China’s change in demand is the scale and impact of this reduction on the world’s leading coal exporting nations. China’s appetite prompted a boom that has underpinned GDP growth – particularly in Australia. New buyers will emerge, but the billion dollar question is whether the demand gap can be filled in the long term.

Written by Amy Gibbs and Daisy Jackson. Edited by Jonathan Rowland. The full report appears in the October issue of World Coal. Subscribers can view the full article by logging in and downloading the issue here.

Read the article online at: https://www.worldcoal.com/coal/01102014/world-coal-china-regional-report-facing-a-new-reality-coal1378/