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Playing the long game Down Under

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World Coal,

Tim Hands, Grant Thornton, Australia.

It is an undeniably tough time for coal miners. Prices for both thermal and metallurgical coal are at multi-year lows and recent production cuts by major miners have not done enough to limit oversupply.

A recent 2014 Grant Thornton survey of Australia’s junior miners confirmed this view. It found:

  • While two out of three juniors surveyed are cautiously eyeing a return of investor interest, coal is garnering much lower levels of investor attention than other commodities, such as nickel and graphite.
  • While 72% of respondents anticipate an increase in the price of their core commodity over the coming 12 months, the outlook for coal prices are likely to remain weak in the foreseeable future.

In this climate, getting a new coal mine project up and running is a daunting task. With prices hovering around AUS$70/t, starting up new thermal coal projects is an especially tall order. Thermal coal prices have plunged more than 20% in the past year, triggering painful losses for many producers. A combination of high costs and falling prices forced Peabody Energy to close its Wilkie Creek mine in December 2013, while an attempted sale to the former billionaire Nathan Tinkler has since fallen through.

Australia’s largest thermal coal project, Adani’s Carmichael mine in the Galilee Basin, is relying heavily on an integrated mine, rail and port model with backing from the State Bank of India and infrastructure investment from the Queensland government. Even with this support, Carmichael’s long-term viability has been the subject of intense debate in India.

For juniors, the prospects for embarking on metallurgical coal mines are a little brighter. At prices around AUS$130/t, smaller mines may be more feasible in the shorter term. As an example, Cockatoo Coal has begun mining at its Baralaba North expansion project in the Bowen Basin, producing top quality PCI coal. Baralaba North will eventually ramp up to producing 3.5 million tpy, exporting from the new Wiggins Island Coal Export Terminal in Gladstone.

Ready for recovery

It requires boldness and careful cost control, but there is a valid argument that now is the time for junior miners to invest in coal projects ahead of the next upswing in prices. At current pricing, large metallurgical coal projects will struggle to be competitive. However, juniors (with a market capitalisation of AUS$500 million or less) can feasibly look at smaller projects. With their ability to work off a low cost base juniors can, as the Australians say, run on the smell of an oily rag.

Despite the debate about renewable energy sources, coal is not going away any time soon. The world needs the cheap, reliable energy that coal provides. According to BP’s annual review, coal’s share of global energy demand has risen to its highest levels since 1970, making it the world’s fastest growing fossil fuel. Currently, 41% of global energy is generated by coal, underpinning demand for thermal coal.

Demand across Asia for both thermal and metallurgical coal will continue to rise, eventually balancing out the current oversupply. While the current slump in China’s steelmaking has depressed metallurgical coal prices, some predictions suggest that the expected long-term growth in steel demand through to 2050 may necessitate a trebling of metallurgical coal exports.

As with thermal coal, India is likely to take over from China as the biggest importer of metallurgical coal: unlike China, it has few metallurgical coal reserves over its own and a rapidly urbanising population means more steel production, as well as increased energy consumption.

Added to this, there are no effective substitutes for metallurgical coal in steelmaking as there are for thermal coal in energy production. At predicted levels, metallurgical coal producers – including Australia – may actually struggle to keep up with future global demand.

With its high calorific value and low ash and sulfur levels, Australian exports will continue to be increasingly sought after on world markets, especially as coal quality becomes a growing environmental issue in Asia and other developing regions.

As India looks poised to ramp up coal imports, its attention has turned squarely to Australia as a long-term source. It is of little surprise to hear that Indian investors are looking closely at opportunities for new mine projects in Queensland.

Those junior miners that have the willingness and ability to invest in the current down cycle will be best placed to capitalise when prices rebound. After all, a new mine cannot be built and brought to full production overnight.

There is precedence for this strategy. Macarthur Coal began as a junior coal miner in the Bowen Basin some 20 years ago before it was acquired by Peabody Energy. Going even further back to the late 1980s, the Jellinbah Group’s mines are another success story, exporting to Japan and other markets through the Port of Gladstone.

Growing regulatory support

Along with the long-term macro trends, it is also worth noting changes in the government policy and regulatory environment in Australia. The federal government has repealed Australia’s controversial Minerals Resource Rent Tax and Carbon Tax, lowering costs and removing some of the uncertainty that has shrouded the mining industry.

The federal government’s about face towards mining, in particular towards junior explorers and miners, goes further with the introduction of the Exploration Development Incentive (EDI) from 1 July 2015.

The EDI allows investors in eligible exploration companies a flow-through tax credit equivalent to the exploration spend incurred in Australia on greenfields projects, including coal. It is a recognition by the Australian government that more investment in junior exploration companies was required to discover quality resources.

The EDI is the first of its kind in Australia and is therefore a starting point, working towards replicating the success of the Canadian flow through shares model. It is likely to be a significant contributor to growing the country’s greenfields exploration sector and provides an additional incentive for junior miners contemplating new coal projects.

Another significant development for coal producers is the recent signing of the Free Trade Agreement (FTA) between China and Australia. The FTA allows for the immediate reduction for Australia exporters of China’s 3% tariff on metallurgical coal and a phased reduction over two years of the 6% tariff on thermal coal.

These tariffs were only announced in October 2014 to much shock, but the FTA now puts Australian coal at a significant advantage to junior coal miners from other countries.

State government backing

At a state level, the Queensland government is making a substantial investment in infrastructure with the commitment towards a multi-user common access rail corridor from the Galilee Basin to Port Abbot.

Queensland has put in place a Galilee Basin Development Strategy, under which the government will make targeted investments to ensure coal mine projects go ahead in this newly developed region. The government’s plan is to exit these infrastructure investments once the new mines are in operation.

In effect, the government has recognized the mistakes it made regarding three separate pipeline approvals for the Gladstone coalbed methane projects. The state government has also taken steps to cut much of the red-tape and green-tape delays that had seen approval processes blow out from 12 – 18 months to five years or more in some cases.

Significantly, it has also established the ResourcesQ initiative to drive growth and employment in the state’s resources sector, providing a far more supportive policy environment for junior miners.

Over on the other side of the continent, the Western Australian government has also come to the aid of the mining industry. Although there is only a limited number of exporting coal mines in the state, the government there has replaced cash backed environmental bonds with a mining rehabilitation fund and levy system. This allows junior miners to fund the levy out of operating cashflows, rather than lodging significant cash backed bonds with the government.

The Association of Mining and Exploration Companies is lobbying hard for this move to be replicated in other states to ease the burden on junior miners. While individual state-based initiatives are to be applauded, the industry is urging Australian governments at all levels to settle on consistent, stable policy settings that will restore investment confidence in the mining sector.

Innovation needed

In the current climate, miners need to take an innovative approach to funding projects. The 2014 Grant Thornton survey found that the lack of available equity was the most significant constraint to business.

Here are three ideas for innovative funding models that junior coal miners and explorers can consider:

  • Miners with good project opportunities can look to form relationships with the end user, replicating the kind of partnership that BHP Billiton has with Mitsubishi and Mitsui, and Hancock Coal’s partnership with India’s GVK. In recent months, both Cockatoo Coal and Stanmore coal have formed funding joint ventures with the Japanese government owned Japan Oil, Gas and Metals National Corp., JOGMEC. While only small, this appears to be a step in the right direction.
  • Royalty stream funders, such as Anglo Pacific and Franco-Nevada Corp. have traditionally funded mainly oil & gas and gold projects but, more recently, they have started funding some base metals projects, such as bauxite and iron ore. Consideration may be given to using a royalty stream investor in order to fund the development or expansion of junior coal.

While not entirely innovative, the use of offtake agreements with strong credit backed counterparties, combined with project finance arrangements has also been successful in recent years to develop junior projects

A question of timing

There is little doubt that difficult times are still ahead, especially with thermal coal prices at their current levels. However, larger producers, such as BHP Billiton and Rio Tinto, are backing a long-term future in coal and have bunkered down until supply and price levels stabilise. For juniors with new coal projects, the eventual return to higher prices is all a question of timing. It is now a case of when, not if. As with so many investment strategies, the smart play is to invest on the down cycle. For those prepared to work innovatively on shoestring budgets, the rewards will come.

Written by Tim Hands. Edited by .

About the author: Tim Hands is a Partner - Taxation Services at Grant Thornton Australia Ltd.

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