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Making a case for the coal sector’s rebound

World Coal,

Steve Doyle

A few coal facts: 8.2 billion tpy of production; 1.3 billion tpy of seaborne-traded coal; 30% of the world's energy mix; a necessary ingredient for making primary steel; the least expensive fossil fuel for generating electricity (fossil fuels provide 67% of global electricity). In a perfect world, coal producers with reasonable cost profiles should receive a risk-adjusted return on capital. However, even companies on the low end of the global cost curve aren’t currently covering their all-in costs.

How did a sector as capital-intensive as coal wind up in this predicament?

China's rapid transition from one of the world's top coal exporters to its biggest importer created a multi-year supply imbalance that resulted in higher prices. Severe weather events in Australia (Big Wet I in 2007/2008 and Big Wet II in 2010/2011) accentuated the upward price momentum. Overly optimistic expectations of future prices prompted the cash-rich coal companies to invest heavily in new operations and to expand through acquisitions.

China's coal industry also reacted to the high prices by over-investing, leaving less room for thermal and metallurgical coal imports. To make matters worse, waves of new hydroelectricity displaced coal demand.

China could have taken advantage of its economic prosperity to shutter surplus steel production, but instead it ignored the problem until it was too late. It now forces its surplus steel and coke production into the seaborne market displacing metallurgical coal exports from the traditional exporting countries. According to Doyle Trading Consultants, when factoring in China's metallurgical coal imports and the impact of China's steel and coke exports, China is now an annual net exporter of nearly 33 million t!

When the music stopped, investment in new production came to an abrupt standstill, but many coal projects that were too far along to stop came online, further depressing prices. Australian producers dramatically lowered costs by conventional ‘belt-tightening', as well as by pumping-up the volume in order to lower unit costs. This had a disastrous effect on prices. The market found itself oversupplied by highly-leveraged coal companies, many of whom have already declared bankruptcy.

During much of the price decline, the non-US exporters were partially sheltered by significant depreciation of their home currencies. In spite of Russia's relatively high mining costs, its exports remained competitive thanks to a 62.4% depreciation of the ruble versus the US$ dollar over the past three years. In comparison, the Australian dollar and the Indonesian rupial 'only' depreciated by 32.6% and 30.1%, respectively. However, this helpful trend has tailed off. In the past six months, the Australian dollar depreciated by 1.4%, the Indonesian rupial 1.4% and the Russian ruble 12.6%.

The coal sector is in the intensive care unit, but what is the prognosis? I defer to the trader's familiar adage: low prices are the cure for low prices. Low prices will force the supply curve to drop below the demand curve. Higher prices will be needed to rebalance the scale. Below are just a few of the drivers that I believe will collectively support the coal sector's rebound.

China: China announced its intent to close up to 150 million t of steel production, 70 million t of coke production and unquantified coal production (‘large scale’). Unlike prior announcements that were mostly disregarded in the provinces, this one comes with funds to mitigate the social impact on as many as one million impacted workers. Bottom line: fewer steel and coke exports, and more room for coal imports, which China requires to keep its domestic coal market in check.

Coal supply and depletion: The global project pipeline has been bone dry for a couple of years. Meanwhile, existing operations are gradually depleting their dedicated reserves. There have been numerous cutbacks, voluntary closures and involuntary closures. The U. has been leading the pack, but the closures in Australia, Canada, China, Germany, Indonesia, New Zealand, South Africa and the UK have been meaningful. During this period, minor exporting countries, such as Vietnam, have turned into net importers and the major future exporters, such as Mongolia, have failed to materialise. When the demand curve crosses the supply curve, the response time will be longer than any time in recent memory.

Weather events: We’re coming off a strong El Niño (dry), which could very well flip into a La Niña (wet). It has been more than five years since the last Big Wet in Australia, whose market share is greater than it was back then, while its volume-driven cost reduction strategy means its supply chain is running close to capacity. Any weather ‘glitch’ could easily snowball into a major shortage.

Global coal demand: Intact with the following caveats:

  • China’s demand for imports rebounds to a level required to keep its domestic coal prices in check.
  • China follows through on steel and coke closures, obviating the need to dump into the seaborne market.
  • India remains unable to rely on its low-quality coal reserves to supply its total demand.
  • Rest of Asia continues on track with its strategy to electrify using coal-fired generation.

US as a swing supplier: The US coal sector has declined dramatically – from 900 million t in 2014 to 650 million t in 2016 (with further cutbacks to come). The surviving industry has never been more competitive and is comprised mostly of super-sized open-pit mines or highly-mechanised longwall operations. US coal exports will be 48 million t in 2016 (vs 112 million t in 2012). Theoretically, the US can still serve as a swing supplier to the seaborne market, but global buyers will have to bid against domestic utilities. As US demand for natural gas from the industrial, export and transportation sectors push natgas prices higher, US coal plants could recapture some of their lost market share. The seaborne market could find itself in an interesting bidding war for limited coal supply.

Crude oil: Welcome to coal’s painful world! Crude oil in the US$30s is unsustainable, but in the interim it serves as a nice boost to the global economy. More than two trillion dollars are shifting annually into the wallets of the consuming countries. The oil exporting countries will still spend, albeit not as much, by drawing down their reserves and/or leaning on creditors to bridge their fiscal gaps.

Foreign exchange: As I mentioned, the depreciation of the non-US-dollar currencies have flattened. Further US-dollar-denominated price declines will encourage more cutbacks in non US production.

Global economy: The trend is your friend. Economic cycles notwithstanding, we have experienced global economic growth since the dawn of the industrial revolution. The world comprises about 1.3 billion ‘haves’ and 6 billion ‘have nots’. The urbanisation and electrification necessary to change this mix for the better will require more coal, more cement and more steel.

Climate change policy: The climate change winds are shifting. Rampant data-manipulation signals desperation about this ‘settled science’. The wealthier economies are suffering from their unsustainably expensive renewable energy mandates that have had minimal impact on global CO2 concentrations. The climate change policymakers in the wealthy countries might continue to ‘talk the talk’, but the rest of the world is not ‘walking the walk’.

In conclusion, the coal sector plays a critical role in the global economy and requires much higher prices to sustainably supply long-term demand. Commodity markets typically soar like a rocket and fall like a feather. A rebound is inevitable. The unanswerable question is: how imminent? I expect a volatile rocket to appear within the next two years.

About the author: Steve Doyle has over 30 yr of experience in the coal trading business, founding Doyle Trading Consultants in 2002. He is now President of BtuBarron LLC.

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