Amy Gibbs and Daisy Jackson, JLT Specialty Ltd.
With the price of coal having steadily dropped from peaks in May 2008 to price points previously seen in 2001, coupled with cooling Chinese demand for lower grades of coal, coal exporters, especially those with insufficient domestic demand to offload excess supply to counter falls in global demand (including Australia and Indonesia), have been impacted. Coal mining in Russia, however, offers a glimmer of hope. The Russian government is making a concerted effort to put coal mining at the forefront of its investment agendas. With oil prices remaining far below both countries' fiscal and production break-even points, coal mining is set for a revival.
Blessed with an abundance of oil, natural gas, coal and gold, Russia was always set to capitalise whenever the global commodities price cycle shifted to an upwards trajectory. As such, Russian economic growth hit new highs when oil prices rose during the supercycle, with energy dominating exports and delivering approximately 50% of government revenue. Coal, traditionally the force behind Russian industry, remained important to the economy both domestically for power generation and as an additional source of export revenue. However, despite vast reserves, Russian production did not outstrip coal export rivals Australia and Indonesia.
Between 2000 and 2009, although Russia retained its share of the coal export market, it is important to note that coal production had been in decline since the fall of the Soviet Union. Despite a concerted effort to ramp up production since the late 1990s – and despite having proven reserves of 173 billion t, second only to the US’s 263 billion t – Russia fell behind in the coal export race. From 2000, Australian and Indonesian coal exports increased dramatically as China's appetite for coal boomed. Investors raced to invest in both countries, enabling Australia to increase exports from 200 million t in 2000, to 300 million t in 2009. Indonesia boosted exports from 60 million t in 2000, to 260 million t in 2009. Russia meanwhile, only reached 140 million t for export in 2009, an increase of only 95 million t in eight years.
By 2015, with the global price of oil having collapsed, the Russian coal mining industry is set for resurgence. Last year, sanctions were imposed on account of Russia’s role in escalating and prolonging the Ukrainian conflict. While large corporations and financial institutions have borne the brunt of the sanctions, the coal mining sector has taken less of a hit. Securing finance remains a challenge, since the domestic banking market has weakened under the weight of sanctions. However, owing to the dominance of domestic Russian mining players and the strength of domestic demand, the coal industry can weather the storm.
If there was not already sufficient reason for a Russian ‘pivot east’ towards Asia, given that the continent accounts for 67% of coal global consumption, sanctions, the freezing of US and European trade with Russia will simply accelerate this trend. A large number of Asian economies require power infrastructure upgrades to secure sustainable GDP growth over the next decade. Increasing volumes of coal will be required as a result. In addition, despite the fact that Chinese GDP growth has slowed in recent years and that the Chinese government has indicated its long-term commitment to reduce the country's reliance on coal (particularly lower grades), Chinese demand for high-grade Russian coal will increase in the next 10 years.
With China unaffected by Western sanctions on Russia, the country has an opportunity to significantly increase trade and investment with its neighbour. This trading relationship is further bolstered by the dramatic fall in value of the Russian rouble, which fell by approximately 50% in value over 2014. While the rouble's collapse has severe repercussions across the economy on account of its connection to inflation and given Russia's reliance on imported goods, for the coal mining sector, with the rouble at a low, exports have become more competitive – particularly compared to US coal exports.
Russian coal producers have already increased output for export and are likely to increase these volumes further to capitalise on the weakened currency. Between January and November 2014, Russian exports of coal jumped by 8.8%, with Macquarie Bank attributing the jump in exports to an estimated 40% reduction in local currency mine operating costs. As such, it is unsurprising that Chinese-Russian relations have highlighted the coal sector as a key area for future collaboration.
While traditionally the Russian government has prioritised the position of its own coal miners – to the extent that foreign investment in Russia's coal mining industry is almost negligible – Russian-Chinese joint ventures (JVs), and perhaps Russian-Indian JVs, may start to emerge. With Russian coal producers such as Kuzbassrazrezugol (KRU/UGMK) and Siberian Coal Energy Co. (SUEK), which together account for approximately 40% of Russian coal production, struggling to raise additional capital since the imposition of sanctions, Chinese investment should be welcomed. In September 2014, China’s Shenhua Group and Russia’s Rostech signed a deal worth approximately US$10 billion that will include the construction of coal-fired power plants across the Siberia region.
Meanwhile, in February 2015, India's Tata Group announced plans to invest alongside SUEK to develop a range of energy opportunities. In a clear indication of Russia's changing attitude toward foreign investment in its strategic industries, in March 2015 Russia announced that it would consider allowing majority Chinese ownership in Russia's strategic oil and gas fields. Even six months ago, such an about-face on policy for Russia's fiercely guarded energy assets would have seemed near impossible. If Russia is willing to court Chinese and Indian investment in its oil and gas projects, further investments in the coal industry will surely follow.
In addition to foreign investment, the Russian government has also announced its own commitment to invest in the coal mining industry. This is in a bid to free up more of the country’s natural gas reserves for export and to instead use coal to satisfy 31 – 38% of domestic electricity demand by 2020, as well as to capitalise on Asian coal demand.
Russia is geographically well placed for exporting coal to Asian markets, yet infrastructural weaknesses have long weighed on export potential. Russia’s coal transportation costs are currently some of the highest in the world (between US$80 – 90/t), which has previously prevented Russian exporters from making lucrative spot sales. Upgrades on ports, including Serverniy (which is receiving US$190 million of funding from the Chinese Bank of Development), Primorye and Vostochny, as well as intermodal infrastructure, such as upgrades to highways and the Trans-Siberian railway, will help reduce transport costs and cement Russia's pivot to the east.
The plan will help attract new investment and trade partners across Asia; however, for those coal mining investors that do wish to partner with Russian coal companies, significant political risks remain. While the government has indicated that it is willing to further open up strategic sectors to foreign investment, Russia has a long history of government interference in high profile projects. As a result vital changes to the regulatory environment will also need to be made. While such risks can be transferred to the private political risk insurance market, issues such as corruption are more challenging to manage, with the awarding of licences being notoriously opaque and therefore subject to later government interference.
Written by Amy Gibbs and Daisy Jackson. Edited by Jonathan Rowland. This is an extract of an article that first appeared in the May 2015 issue of World Coal.
Read the article online at: https://www.worldcoal.com/special-reports/11052015/regional-report-russia-a-game-of-risk-coal/