Coal Is Still King

The bull market in coal mining stocks came to an abrupt end in early 2011 and the group has been out of favor ever since. Coal mining stocks underperformed global equity markets during last summer’s vicious stock market rout as well as the ensuing October through April rally.

However, the sell-off in coal stocks has been overdone and fundamentals for the group are poised to improve this year.

Two basic types of coal are traded globally: steam coal and metallurgical coal, often called met or “coking coal.” Steam coal has lower energy content per ton and is primarily burned in power plants to produce electricity. Metallurgical coal is used in steel blast furnaces.

In a blast furnace, raw iron ore that’s primarily iron mixed with oxygen is heated to extreme temperatures in the presence of carbon in the form of coke, typically produced from metallurgical coal (see “Steel Stocks Steal the Show,” March 28 issue of Global Investment Strategist). The carbon combines with oxygen in the iron ore to produce carbon dioxide gas, effectively removing the oxygen from the ore. The resultant product is pig iron, a brittle and useless substance on its own.

To create steel from pig iron, much of the carbon and impurities must be removed. In an oxygen furnace, purified oxygen is pumped through molten pig iron. Oxygen bonds with carbon, to produce carbon monoxide, and with other impurities to produce slag that can be removed from the molten metal.

The result is steel, a low carbon and low impurity form of iron. The resultant steel can be alloyed with metals such as tungsten, chromium, molybdenum, and nickel to produce a product with increased strength, lower weight and resistance to rusting.

Roughly 70 percent of global steel production comes from blast furnaces including 90 percent of production from China and 81 percent from all of Asia. The reason for the popularity of blast furnaces is that the alternative steel production technology, known as the electric arc furnace, requires access to scrap steel metal, a commodity that’s in short supply in fast-growing economies such as China and India.

Metallurgical coal has a higher value per ton than steam coal and, in recent years, profit margins and returns on investment in the metallurgical coal industry have been higher than for steam coal. That means that many of the world’s largest miners are focusing their mine development budgets on boosting met coal production. That said, most mining firms produce a mixture of steam and metallurgical coal, making it impossible to analyze the industry without considering both markets.

Rising Steam

Steam coal demand and pricing are driven largely by demand for electricity and substitution between coal and other sources of power generation such as natural gas. Coal market conditions are not the same in different parts of the world. In particular, the North American steam coal market currently faces far different fundamentals than the seaborne coal market in Asia.

The US is the world’s second-largest coal producer and consumer, trailing only China. The nation also boasts the largest proven reserves of coal, accounting for more than one-quarter of the world’s total reserves. US coal reserves include significant metallurgical coal resources primarily located in Appalachia as well as steam coal. However, while the US coal industry is one of the world’s largest by any measure, the nation is less important as an exporter. In 2010, the US ranked fourth in terms of total exports behind Australia, Indonesia and Russia.

More than two-thirds of the nation’s 74 million metric tons of coal exports are met coal, not steam coal. The US only exported 23 million metric tons of steam coal last year, a fraction of the amount exported by countries such as Australia, Indonesia and Russia (see chart below).

Source: World Coal Association

Because exports aren’t yet an important feature of the North American steam coal market, US and Canadian steam coal prices tend to be most affected by domestic supply and demand conditions.

US steam coal prices are currently depressed for two major reasons: ultra-low natural gas prices have prompted coal-to-gas substitution and warm winter weather depressed demand for electricity.

The chart below tracks anomalous weather conditions from January 2012 to the end of March 2012, by comparing recent temperatures to the average between 1971 and 2000.

Source: National Oceanic and Atmospheric Administration

The US and Canada enjoyed one of the warmest winters on record, with temperatures averaging 5 degrees to 6 degrees Celsius (9 degrees to 11 degrees Fahrenheit) above normal. This unusually warm weather and lower-than-normal precipitation likely boosted the economy in the US and Canada above seasonal norms.

A heating degree day (HDD) is a way to measure how much heat is required to bring a building to a comfortable temperature. To calculate HDDs, subtract the average temperature each day from a base value of 65 degrees Fahrenheit. If the average temperature on a certain day is 40 degrees, that day would be worth 25 heating degree days (65 minus 40). The more HDDs, the colder the weather and the higher heating demand.

The graph below depicts population-weighted HDDs at a national level. Between December and February 2012, the US experienced 13 percent to 18 percent fewer heating degree days than usual. HDDs were about 36 percent below average in March 2012, the warmest March on record.

Source: US Energy Information Administration

Warmer than normal temperatures depressed demand for electric heat as well as the consumption of natural gas in both residential and commercial heating applications. Although the extraordinarily warm winter exacerbated the weakness in natural gas prices, excess production remains the biggest challenge.

The rapid development of unconventional US natural gas and oil shale fields such as the Haynesville Shale in Louisiana, the Eagle Ford in Texas and the Marcellus Shale in Appalachia has led to a surge in US natural gas production, pushing US natural gas in storage to seasonal record levels.

Source: US Energy Information Administration

With natural gas prices near decade lows over the past six months, US utilities with the flexibility to do so have burned more natural gas and less coal. As a result of unusually warm winter weather, total US electricity generation in the first three months of 2012 was down about 3.6 percent compared to the same three months in 2011, but generation from coal was off more than 21 percent while generation from natural gas rose by roughly one-third.

While coal still accounted for the largest share of the US electric power grid in the first three months of this year, coal’s share of the power stack fell from 45 percent in 2011 to about 36 percent this year. That’s the most dramatic year-over-year shift in fuel sources in more than three decades.

US utilities are sitting on unusually large inventories of coal to the point that many are renegotiating supply contracts with major US coal producers, to defer or reduce scheduled deliveries this year. Most producers have also idled steam coal production capacity in an effort to reduce output to match demand.

US steam coal supply and demand conditions will eventually normalize, but that will take time, even if 2012 brings a hot summer and the winter of 2012-2013 is cooler than normal.

However, while US steam coal market conditions look rather weak, do not make the mistake of assuming that similar conditions prevail outside the US. For example, US natural gas prices are currently trading around $2.50 per million British thermal units (MMBTU), off their wintertime lows under $2/MMBTU but well off the $4.80 natural gas fetched in the US one year ago.

In contrast, Europe and Asia do not yet have strong domestic production growth from unconventional shale fields to boost supply. Long-term gas supply contracts outside the US are typically indexed to Brent crude oil prices; at well over $100 per barrel (bbl), Brent crude oil prices are currently still trading at elevated levels. Meanwhile, gas futures traded on the Intercontinental Exchange in London fetch close to $9.50/MMBTU, nearly four times the US price.

Clearly, at those prices, natural gas is not as formidable a competitor to coal in Europe and Asia as it is in the US. For example, in Asia, coal imported from Newcastle port in Australia trades for around $4.79/MMBTU, a sizeable discount to natural gas and oil prices. Coal to gas substitution just isn’t much of an issue in these markets.

The outlook for demand is also much better outside the US and Europe. While weak economic conditions and warm winter weather have pressured US and European electricity demand over the past year, Chinese generation continues to grow despite the slowdown in China’s overall economic growth rate over the past year (see chart below).

Source: Bloomberg

In addition, both China and India continue to rely heavily on coal for power. In China, total electricity generation was up about 6.5 percent in the first three months of 2012 while coal-fired power generation jumped about 7 percent over the same time period. In India, total coal-fired generation jumped by an even stronger 9 percent in the first quarter of this year. India now ranks third behind China and the US in total coal consumption.

Longer-term trends continue to favor coal demand growth in Asia. While the US and Europe-centric investment community continue to focus on the low number of new coal plants planned on either continent, the fact is that more than 385 gigawatts (GW) worth of new coal-fired capacity is slated for construction between 2011 and 2016. Of that total, more than 300 GW will be constructed in China and India and the latter country, in particular, is reliant on coal imports to meet domestic consumption needs. In 2011 alone, Indian thermal coal imports surged 35 percent year-over-year.

One of the key grades of international seaborne steam coal to watch is called the All Published Index (API) grade 2, which currently trades at $92.65 per metric ton down from its April 2011 highs of $132. Some of the decline in API 2 coal prices over the past year was undoubtedly due to concerns that the Chinese government’s efforts to quell inflation and cool economic growth would hurt demand.

Continued weak economic growth in developed markets has also negatively affected seaborne volumes. However, as the chart below indicates, the bigger effect on coal prices over the past year stems from supply.

Source: Bloomberg

The chart depicts Australian thermal coal exports over the past few years. Australia and Indonesia are the two largest steam coal exporters in the world; the former country is expected to be the largest exporter in the future, thanks to significant investment in export and port capacity.

Australian steam coal exports have been growing steadily in recent years, but in late 2010 and early 2011 mine production, rail transport and port infrastructure were all damaged or interrupted by the worst flooding since the 1970s. API 2 coal prices jumped from under $90 per tonne in late 2010 to over $130/tonne in early 2011 due, in large part, to Australian supply disruptions. As Australian production volumes came back online in late 2011, some of this immediate supply crunch was alleviated, helping push steam coal prices down.

Longer term, however, seaborne coal prices are likely to remain relatively elevated as Australia and other exporters struggle to keep pace with growing demand for imports from countries like China and India.

Metallurgical Coal

The main driver of met coal demand is global steel demand. China is both the world’s largest consumer and the world’s largest producer of steel, accounting for nearly half of total global production of the alloy. China’s dominance of both sides of the steel industry has been steadily increasing for years and that trend is likely to persist for the foreseeable future.

As recently as 2001, China accounted for just 15 percent of global steel production and a similar share of consumption. The nation’s rapid economic growth and development in the past decade has resulted in a dramatic increase in demand for steel and a tripling in the country’s share of the global market.

We highlighted the main drivers of steel demand in “Steel Stocks Steal the Show.” Construction alone accounts for 60 percent of Chinese demand, so the outlook for the nation’s residential and commercial construction markets is a key driver of demand for metallurgical coal as well.

As we pointed out in the article, one of the biggest factors pressuring steel and met coal demand over the past year has been the Chinese government’s efforts to reduce economic growth and fight inflation. The government has been worried about the potential for a real estate property bubble in China, making it particularly eager to slow activity in that sector of the economy.

The government was successful. Since our steel article in late March, the data on Chinese residential and commercial construction has remained weak (see chart below). That said, lending activity is positive on a year-over-year basis and the Chinese government is now focusing more on supporting economic growth rather than fighting inflation and the property bubble.

In mid-May, the government cut its reserve requirement ratio for Chinese banks by a further 50 basis points to 20 percent, the third such cut since last November. That move will free up additional capital to support lending and help keep the property market from weakening further.

Source: Bloomberg

All signs suggest there’s more easing to come. On May 20, Chinese Premier Wen Jiabao stated: “The country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations. We should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth.”

This statement stands in stark contrast to the anti-inflation rhetoric of the Premier a year ago and suggests that China take more aggressive efforts to stimulate growth. We continue to expect the Chinese economy to post growth of about 8 percent in 2012; fears about a collapse in Chinese steel and metallurgical coal demand are overdone.

Meanwhile, while China meets a significant portion of its met coal demand through domestic production, the country’s average met coal quality has been declining in recent years. That means that the nation may have to import additional volumes of high quality met coal from nations such as Australia to mix with lower grade domestic coals.

Meanwhile, India is emerging as another major source of met coal demand. As the chart below shows, the nation’s steel production has risen from less than 50 million metric tons annualized in 2005 to about 75 million metric tons in 2012. By 2016, the nation expects total production of 130 million metric tons. While that’s still well shy of China’s near 700 million metric ton capacity, it would make India the world’s second-largest producer of crude steel. Because India has even more limited domestic coal production capacity than China, it’s more dependent on seaborne imports.

The key country to watch on the supply side of the metallurgical coal market is Australia, accounting for about two-thirds of global seaborne met coal exports. Just as with steam coal, prices ran up in late 2010 and early 2011, partly because of flood-related disruptions to Australian supplies of seaborne met coal. Australia’s average coking coal export prices soared from less than $200 per metric ton to a high of nearly $260 per metric ton in mid-2011. Average Australian export prices include coal volumes sold under long-term contracts; spot met coal prices topped $330 per metric ton at the height of the early 2011 met coal bull market run-up.

Just as in the steam coal markets, the return of Australian met coal export volumes as flood-related outages faded has helped push met coal prices back down to their late 2010 levels.

Longer-term, the market for met coal looks even tighter than for steam coal. Strong steel production growth in China, India and other emerging markets will continue to power demand for met coal, as emerging markets rely heavily on steel blast furnaces. Meanwhile, while some of the extreme met coal export outages that reduced supply in early 2011 have eased, the potential for future disruptions remains high. In March, flooding in Australia’s Bowen Basin, home to the vast majority of the nation’s met coal mines, disrupted output once again and helped stabilize prices.

Over the next few years, producers in Australia and elsewhere will need to open up significant new met coal production capacity to keep pace with projected steel demand growth.  There is no glut of met coal capacity relative to demand growth.

Against this backdrop, we continue to favor coal mining firms with significant met coal and seaborne thermal coal production over those exposed to the North American thermal coal markets. We have three recommendations in the Metals and Mining Portfolio with significant exposure to met coal production and prices: Glencore International (London: Glen; OTC: GLNCY), Mongolian Mining (Hong Kong: 975; OTC: MOGLF) and Teck Resources (NYSE: TCK).

We highlighted our investment case for Glencore in “Changing Horses” (the April 25 issue of Global Investment Strategist), while Mongolian Mining was profiled in “Coking Coal: The Mongolian Affair” (the March 1 issue). Canada’s Teck Resources is this week’s Stock Spotlight.

 

 

 

 

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