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A balancing act

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World Coal,

Lloyd Hain

Recent developments show that it is the Indonesian coal sector that is doing all of the hard work of rebalancing the seaborne-traded thermal coal market – but this is not out of altruism. Using CRU's Thermal Coal Cost Model 2015 Edition to assess the competitiveness of seaborne coal into the key clearing market in South China, we see it is Indonesian producers that dominate the first half of the cost curve, meaning these should be the last tonnes to leave the market.

But this is not the case!

Instead, there are a number of factors other than costs, not present in the other main thermal coal exporting countries, which have pushed Indonesian tonnes from the market.

Indonesian supply dominates the first half of the cost curve so why is production pulling back. Source: CRU.

Lowest energy coal

Indonesia produces a wide range of coal specifications, with energy contents ranging from less than 3000 kcal/kg NAR to greater than 6000 kcal/kg NAR; however, most of the coal produced is a sub-bituminous coal lower than 5500 kcal/kg NAR. As a result, Indonesian production has the lowest average energy content of the major seaborne producing countries. As a consequence, as demand for seaborne sub-bituminous coal from China, which was responsible for most of the growth in demand over the past 5 yr, has diminished, and growth in Indian demand has been for higher energy coal, due to increased domestic supply of sub bituminous coal or power plant procurement preferences, Indonesian miners have suffered the largest drop in demand for their product.

Indonesian coals have, on average, the lowest energy content of the major seaborne producers.

Changes in regulatory environment

In the past 12 months, there have been a number of regulatory changes in Indonesia that have adversely affected the coal mining industry. These have included wider economic policy changes, such as requirements for letters of credit for exports and for conducting business in rupiah, rather than US dollars, as well as more coal sector specific changes regarding mining taxes and forestry access charges.

The requirement for Letters of Credit, issued by a local bank, applies to all commodity exports from Indonesia and has been instigated in order to keep track of the country's commodity exports and crack down on illegal mining. However, it has also had the unintended consequence of negatively impacting small, but legitimate, producers that are exporting legally, but who do not have necessary business processes in place to meet the new requirements. Having said this, the overall view of the industry is that the policy change has been successful at significantly reducing the level of illegal mining, particularly into the export market.

The requirement to conduct business in rupiah has caused uncertainty for the coal industry, where the US dollar has been the de facto currency for contracts. In a country where the local currency has, historically, been volatile, the use of the US dollar provided certainty as to the cost structure of operations; this certainty has now been removed.

There has also been new revenue raising measures put in place to increase government revenue derived from the coal industry, including increased payments for forestry fees. The measure that has caused the most concern amongst producers is the introduction of a 1.5% prepaid income tax on coal produced by Izin Usaha Pertambangan (IUP) holders, required to be paid before the shipment can clear customs. This has had the effect of crimping cash flows for producers at a point in time where they are already working on a hand-to-mouth basis, particularly small operators who have limited access to credit.

In addition to these implemented changes, the increase of the royalty rate paid by IUP holders from 3 – 7% to 13.5%, as paid by Coal Contract of Work (CCOW) holders, is currently postponed. CCOWs are generally held by the major Indonesian producers, such as Adaro, KPC and Kideco, who are generally large, well capitalised companies that are currently cash-flow positive and looking to keep production flat this year, compared with last. IUP holders are generally small producers, with low capital investment requirements and a reliance on continuous cash-flow in order to maintain operations. Many IUP producers are already cutting back or ceasing production in the current market in order to stop bleeding cash and, if this policy is eventually implemented, this segment of supply will bear the brunt and may well respond with further production cuts.

Cash flow, contractors and credit

Major issues regarding the ongoing viability of operations are cash flow and the availability of sufficient credit to fund operational expenses. A key feature of the coal mining industry in Indonesia is the use of contractors to provide mining services for the operations at almost all mines. From the perspective of the owners, this has resulted in low capital intensities, as the mining and transportation equipment is owned and operated by the contracting company, but the finances of companies, by default, are structured such that a continuous and sufficient cash flow is critical to maintenance of a viable business. So far, the responses of mine owners to reduced cash flows has been to either partially park up contractors and focus the remaining fleet on lower strip ratio coal or completely park up contractors and stop production.

In addition to diminishing cash flows, small producers and their contractors are also finding it increasingly difficult to secure or renew the credit facilities that are needed to fund day-to-day business. Indeed, the unwillingness to extend credit to the industry, because of the current poor outlook for coal, can be a self-fulfilling prophecy. Without this vital bridging funding between mining the coal and receiving payment, producers are forced to either pare back or close operations.

What has been the result?

Based on our supply research, we forecast that Indonesian thermal coal exports will fall to approximately 375 million t in 2015, from the 2014 peak of 390 million t. This is in contrast to the rest of the world where exports are expected to be approximately flat y/y. The result of this has been that we will see a reduction in the seaborne thermal coal supply, dropping to its lowest level in 5 yr.

Indonesia is pulling more tonnes from the seaborne market than other exporters.

For more information on CRU’s suite of coal strategic forecasting and cost analysis services, or to speak to CRU’s analysts about our market views, please contact Sameer Virani.

About the author: Lloyd Hain, is a Senior Consultant, Steel Raw Materials, at CRU, and editor of CRU’s thermal coal cost service.

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