China’s Real Steel Opportunity: Met Coal
Editor’s note: My colleagues Roger Conrad, Elliott Gue and I have teamed up in the Global Investment Strategist to provide coverage of the metals and mining sector and provide readers with timely investment advice for this vital industry. We’ve been fortunate with our Metals and Mining Portfolio recommendations, but more importantly, we were prudent to take profits off the table earlier in the year and book sizable gains.
Nevertheless, many readers have asked us for our medium-term outlook for the sector, given the uncertainty roiling global markets and the possibility of a new recession. For now, we view the current market pullback as an opportunity to build positions in well-run mining companies.
Big-picture concerns about a global economic downturn have been the main driver of performance for metals and mining stocks since spring. Economic data in the US and most other developed-world economies has softened over the past six months, although most indicators point to a period of low growth and economic stagnation rather than outright contraction.
More recently, the ongoing financial crisis in the EU sovereign bond markets has heightened fears of a global credit contagion similar to what financial markets faced in the wake of Lehman Brothers’ bankruptcy in September 2008. To date the actual contagion from the EU to US and other global credit markets has been modest. We continue to expect the EU to take the steps necessary to stabilize sovereign bond markets and prevent the crisis from spreading to the larger economies of Spain and Italy.
The headlines about Greece and the lackluster US economy will continue to dominate trading in metals and mining stocks in the near-term. But the fundamentals for the industry remain solid and there have been few fundamental signs of slowing demand, particularly in China and other emerging markets. Given the pullback in the stocks, this looks like an excellent time to buy into our favorites.
One of the metal industry’s subsectors we continue to like is that of metallurgical (met) coal. Metallurgical or coking coal is used to produce steel in blast furnaces in contrast to thermal or steam coal that’s burned in power plants to produce electricity.
Australia accounts for roughly two-thirds of global seaborne exports of met coal and is a key supplier to Asia. About 85 percent of the nation’s met coal output comes from the Bowen Basin in Queensland; operational disruptions in this region can send the price of met coal soaring.
In late 2010 and early 2011, severe flooding forced many coal mines in the country to halt production. Not only did producers have to pump water from their mines before resuming operations, but damage to the region’s railroads and ports also crimped exports. At the height of the crisis, seaborne shipments of Australian coal declined by as much as 40 percent from year-ago levels.
With Australia’s largest producers declaring force majeure to relieve themselves of contractual obligations, their customers scrambled to secure sufficient supplies. This touched off a global supply squeeze. US coal exports to Europe boomed, as countries that historically exported met coal to the EU diverted their cargos to Asia.
Producers generally expect met coal production and exports to normalize gradually in coming months. This dynamic has lowered the contract price for the fourth quarter of 2011 to USD285 per metric ton. Meanwhile, the average price of Australian exports of met coal declined to roughly AUD228 in July from AUD260 in May. Although the price of met coal has declined from the stratospheric levels that prevailed in the first and second quarters, both the contract and average prices are significantly higher on a year-over-year basis.
China is the primary driver of global met coal demand. Not only does the US produce far less steel than China in a given month–8 million metric tons versus almost 60 million metric tons–but US steelmakers tend to rely more heavily on electric arc furnaces that use scrap metal to produce steel. As you can see, Chinese steel production continues to hover near its record high.
The resilience of Chinese steel production at the height of the Great Recession demonstrates that the country’s met coal demand is a secular–not a cyclical–growth trend. Although China is the world’s largest steel producer, the nation consumes only 466 kilograms (kg) of steel per capita–compared to more than 800 kg in both Japan and South Korea.
China’s population of more than 1.3 billion people means that a small increase in per capita steel demand produces an outsized effect on global consumption. India’s annual steel demand amounts to only 55 kg per capita. Over the next three decades, China, India and other Asian emerging markets are expected to account for more than 90 percent of the growth in global coal demand.
Our favorite company to own in order to gain exposure to this theme is Teck Resources (NYSE: TCK). Teck is well-placed to take advantage of ongoing strong demand for met coal. First, the company’s main mines are located in North America and haven’t been negatively impacted by the flooding that plagued Australia for much of the first half of 2011.
Second, through a series of mine expansions and upgrades, Teck is on course to significantly increase its met coal production. In the second quarter, the firm produced 5.8 million metric tonnes of met coal and has plans to increase that capacity to more than 30 million tonnes per annum by the end of 2013.
For more information on Teck Resources and our other investment ideas, please visit us at the Global Investment Strategist. The Global Investment Strategist’s Metals and Mining Portfolio is built upon a foundation of diversified, mega-cap companies that generate significant cash and boast strong production growth and solid balance sheets. These companies should fare well in any economic environment.
The Global Investment Strategist’s Metals and Mining Portfolio also highlights some of the industry’s smaller players that complement these mining titans. To learn about our top stock picks in the metals and mining sector, please visit us at the Global Investment Strategist.