Adam Parums, CRU, UK.
The metallurgical coal industry has had a tumultuous few years. The volatility of prices since 2006 – and the shifts in valuations of assets that such movements cause – means that metallurgical coal is a commodity that, depending on timing, has either created or destroyed value for mining companies at an unprecedented level. In the last 18 months, assets have been sold for mere fractions of sums paid for them just a few years ago and some of these eye-watering deals have been a significant factor behind a handful of senior mining executives losing their jobs.
As prices have fallen and remained very low on the industry cost curve, the buzzword has become productivity: produce more material to spread an asset’s fixed cost across more volume, as a means to push down unit costs and, hopefully, maintain a positive cash margin. This strategy has been implemented in combination with efforts to reduce total costs through a variety of means, such as reducing headcounts at mines, less use of contractors, negotiating down the cost of mining equipment, parts and spares, and reductions in sustaining capital spend. As a result of these efforts, as well as outright mine closures, tens of thousands of direct jobs have been lost globally.
These actions by mining companies have coincided with a handful of deflationary, macroeconomic shifts that have also helped to push down unit costs of production. For example, CRU estimates that the collapse in the oil price to US$50/bbl, from US$100/bbl, has lowered industry average costs (before accounting for the resulting reduction in ocean freight) by approximately US$3/t, while the depreciation of the Australian dollar from 93 cents in 2Q14 to today’s level of 78 cents, lowers average Australian costs of production by 11%. The above translates into operating costs across the industry that are considerably lower now than in years gone by.
In many respects, the industry is far more efficient today than during the boom years. However, despite these efforts, operating margins remain thin at best and, should prices not increase significantly in the next couple of years, cash flows for certain companies will not be enough to pay off heavy debt burdens (often resulting from expensive acquisitions made when the market was performing more strongly). Other companies are at various stages of completing projects that will increase supply to the market; these projects, typically with a high capital intensity (especially those in Queensland), were committed to when hard coking coal prices were >US$220/t and there was generally a view across the industry that the market would remain tight.
With this in mind, 2015 is a critical year for metallurgical coal producers. If profitability does not improve, more mines will be forced offline and jobs will be lost. Industry profitability could, of course, be improved by better prices, lower costs or a combination of both. But what are the chances of this happening?
Prospects for profitability
It goes without saying that the likelihood of higher prices would be much improved if metallurgical coal producers were supplying a healthier steel industry. It is important to bear in mind that, while the metallurgical coal industry has been under strain since the end of 2012, the downstream steel industry has been contending with even thinner operating margins since 2008. The slow and bumpy economic recoveries from the financial crisis in 2009, coupled with an industry that has regularly committed to building too much capacity, means that CRU estimates that steelmakers in Europe, for example, have averaged earnings before interest, tax, depreciation and amortisation (EBITDA) margins of an unsustainable 1% from 2010 – 2014. Financial results for 2H14 are yet to be published, but CRU estimates suggest major coal producers will report an EBITDA margin of 10 – 15%, in comparison. Elsewhere – and critically for the metallurgical coal industry – Chinese steel demand growth has all but ground to a halt and Japan, a market that represented 18% of the global import market in 2014, has been battling with economic recession. There are brighter pockets of demand, most notably India, but, to put it simply, metallurgical coal producers should not rest their hopes on stronger global demand to make conditions more favourable for them in 2015.
As is well understood, the efforts to reduce costs at mines were, in some cases, in vain as mine closures added up in 2014. Since prices declined strongly in 2012, CRU estimates that approximately 35 million t of metallurgical coal capacity (outside China) has been idled, equivalent to 11% of seaborne mining capacity in 2014. While such decisions are extremely difficult for those affected, the cumulative effect of a series of mine closures could be positive for the market as a whole. Indeed, even last year the impacts of mine shutdowns began to be seen. For example, CRU estimates that Canadian and US exports of metallurgical coal fell by 9% and 5% y/y respectively in 2014, while certain producers in Australia (e.g. Vale and Rio Tinto) also mined less material than in the year before. Unfortunately, for reasons discussed later in this article, this did little to help prices.
In 2015, CRU mine-by-mine forecasts suggest that global export supply will fall by approximately 5% y/y. Some regions are expected to add tonnes to the market. Most notably, Russian producers, whose competitive position has improved dramatically thanks to the collapse of the Russian rouble, are already pushing to increase market share in the prized northeast Asian steel markets of Japan, South Korea and Taiwan. Vale is also expecting to ship greater volumes of material from Mozambique in 2015, as the sizeable infrastructure challenge in the country is gradually overcome by the completion of its equally costly rail and port investment. Nonetheless, CRU forecasts these supply increases will be outweighed by the reduction in volumes from the US and Canada, where the majority of metallurgical coal mine closures have taken place.
A 5% reduction in export supply, in a world where steel production is still expanding (CRU forecasts global steel production to increase by 3% y/y in 2015) would, simplistically, suggest better pricing for miners. However, the other key part of the puzzle – and one that has not been discussed thus far – is Chinese metallurgical coal supply.
Chinese metallurgical coal supply
A few years ago, China was seen as a bull story for metallurgical coal, largely because it was thought that cost inflation in the domestic industry would continue at a strong rate, effectively creating an ever-rising floor for metallurgical coal prices; one that seaborne producers, who were not experiencing such dramatic cost inflation, would benefit enormously from. Unlike iron ore, China has always been highly self-sufficient in metallurgical coal, so domestic cost inflation, coupled with a nascent import market, provided coal producers elsewhere a great deal of optimism about the future of their businesses. In fact, what has happened is:
- Chinese cost inflation has subsided, due to heavy investment in mechanisation, consolidation and the closure of smaller, inefficient mines.
- Chinese costs have not acted as a support to prices at all, because costs, in some cases, have fallen, while uneconomic production at other mines has continued regardless.
Chinese metallurgical coal prices have undergone a continuous deterioration in recent years, exhibiting a 29% y/y decline in 2014 and CRU estimates that approximately 44% of metallurgical coal output was loss-making for the year. Given the high level of employment the coal industry in China offers and the significant proportion of production in the hands of state-owned enterprises (i.e. 62% of coal supply), the Chinese coal sector receives considerable attention from the central government. Since August 2014, the State Council has held regular meetings, attended by the relevant ministries and commissions, with the specific intention of assisting coal miners in the short term, but also to encourage a better structured industry in the long term. Such government-led changes include, but are not limited to, production volume restrictions, royalty tax reforms, adjustments of provincial-level coal mining fees and quality restrictions on imported coal. There have been hopes in the wider coal industry in the last few months that such production controls would be adhered to, resulting in better fundamentals that will drive opportunities for higher-priced sales to Chinese steel mills. Instead, efforts to enforce such restrictions have been fruitless and, unfortunately for coal miners elsewhere, the quality checks that are now required at Chinese import ports have made Chinese mills more likely to opt for domestic material to feed their coke ovens.
In addition to government-led benefits for Chinese miners, producers themselves are acting to, naturally, protect their best interests, maintain market share and keep imports at bay. For instance, over the past decade, substantial labour cost inflation in China’s coal mining industry has been observed. China’s coal mining productivity of labour has improved by approximately 20% since 2008 but wages over the same period have doubled. However, this trend appears to be reversing as mining companies have been reducing salaries in the last year in order to improve their competitiveness. For instance, the China National Coal Association reported that during 2014 approximately 70% of coal producers had cut salaries by over 10% and that 30% had deferred salary payments during the year. As labour intensity in China remains high compared to other countries such as Australia, such reductions have a large impact on total costs of production. If one assumes a constant 20% reduction in wage rates across the Chinese industry, operating costs for Chinese mines fall by a range of US$3 – 12/t (2 – 8%). In an industry where miners are bargaining for every cent of tonnes sold to buyers and fighting for every 0.5% of productivity improvement, such a reduction is very significant.
The upshot of the above is that, in the author’s view, international metallurgical coal producers are going to be fighting for sales to a shrinking Chinese import market in 2015. As mentioned previously, export supply will concomitantly be lower, and this means, on balance, CRU expects metallurgical coal prices to remain broadly flat in 2015 compared to 2014.
Of course, flat pricing, in an industry that is driving operational efficiencies and in a world where macroeconomic factors have brought lower input costs, means that profitability is likely to improve. In fact, the latest company financial reports have demonstrated this already. For example, Arch Coal’s EBITDA margin in its Appalachian segment (where its metallurgical coal is produced) expanded to 15% in 4Q14 from 3% in 3Q14, despite received coal prices staying flat. In fact, profitability in this segment was the strongest it has been since 2012, when metallurgical coal prices were approximately 80% higher than those today.
CRU believes that coal producers are undoubtedly facing another tough year in 2015. However, the work being done to improve operational performance, which may include painful high-cost mine closures and job losses, are commendable and necessary. The results show that such measures are bearing fruit and a continuation of these efforts are expected to improve margins in 2015, even if prices do not provide any relief whatsoever.
Written by Adam Parums. Edited by Jonathan Rowland.
About the author: Adam Parums is Steel Raw Materials Analyst at CRU.
Read the article online at: https://www.worldcoal.com/special-reports/01042015/no-recovery-here-metallurgical-coal-market-2015-andy-parums-cru-coal2139/