Too Late for Coal?
Coal - and coal stocks - have had an impressive run-up since 2000. Will the trend continue?
If you'd bought into coal four years ago, you'd probably have made a nice profit by now; since bottoming out in 2000, prices have been up sharply. Coal comes in two major kinds: thermal coals-the lower-quality stuff used in power plants-and metallurgical coals (or "met" coals), used in steel-making. Coal markets are also highly regional, with prices depending greatly on where the coal is being dug out of the ground and where it is going to be used, so tracking "the price of coal" over time is not as simple as tracking that of a metal, like gold. Index prices for thermal coals imported by Asian nations have risen 115% since 2000, from $34.59/ton to $74.71/ton as of December 2004. In the same period, anecdotal reports suggest that average prices for met coals shipped to Japan have risen 217% to $125/ton from $39.46/ton in 2000, spiking as high as $255.54/ton – a 550% gain. A quick review of numerous indices around the world shows that yes, coal is booming, and booming big.
And of course, as coal goes up, so do coal stocks. Major producer Peabody (NYSE:BTU, US$84.75) has seen its shares run up from US$18.70 in July of 2002 to a recent high of US$86.80. Pine Valley Mining (V.PVM, C$5.21), a Canadian junior, has gone from C$0.46 in January of 2002 to a recent high of $7.21, more than a 1,450% gain.
But very few people have been in on this run from the ground floor. At the turn of the millennium, no one wanted anything to do with coal. Back then, the market was still laboring under 20-year low prices, with export coal indices yo-yoing in a $10-$15 range for much of the last two decades. Peaks and troughs in price came roughly 3-4 years apart, with lows in 1987 and 1994, and peaks in 1990 and 1997. When the 1997 Asian crisis hit, just as coal was set to begin one of its downswings, it lead to 20-year-low export prices in 2000.
Why such a rollercoaster ride? A large part of the reason is the ease with which coal suppliers enter and leave the market. There is a lot of coal in the world: over a trillion tons of recoverable reserves, according to the presumably conservative estimates of the U.S. Energy Information Administration (EIA). World coal consumption, by comparison, is about 5 billion annual tons, meaning that the coal we already know exists could supply us for 200 years at current rates-or even 135 years, using the EIA's highest projection for economic growth by 2025. During periods of high prices, miners crank up production on the more than ample reserves, creating an oversupply in the markets followed shortly by lower prices. Marginal coal mines then shut down, allowing demand to catch up. Prices head back up again, prompting suppliers to produce more, and the cycle repeats.
In fact, between 1982 and 2000, whenever the Queensland index price for met coal went up more than $5-a signal of an undersupplied market-it declined for at least the next 3 years.
Will History Repeat Itself?
So, given that prices have been up dramatically over the past two years and that history tells us that such rises generally last 2-3 years before being wiped out by increased production, is there any reason to believe last year's gains won't vanish as quickly as they came?
Coal bulls have a one-word answer to this question: China. It's the same story we've heard for every other commodity-the Chinese middle class is projected to grow from about one hundred million to over 1 billion people. These people need buildings, which means steel and thus metallurgical coal. They want cars and air conditioners, too. Chinese steel demand grew 23% between 2000 and 2003, raising overall met coal demand by 30 million tons.
This boom has caused a reorganization in Pacific coal export patterns. From 2001 to 2003, China was shaping up as a serious met coal exporter, with shipments growing from 11.5 Mt to 15.3 Mt-a 33% gain, the largest export growth of any nation save Indonesia. At the same time, export growth from the top three met coal suppliers-Australia, Canada, and the U.S.-stayed nearly flat or decreased. The Pacific market-particularly Japan and South Korea, which receive 50% of world met coal exports-became increasingly reliant on China to fill the gap. In 2002, these two nations bought nearly 20% of their met coal from the Chinese.
In Q1 of 2004, however, Chinese exports dropped to 1.1 million tons, after averaging 3.8 million tons quarterly through 2003, according to the International Energy Agency. A recent presentation by Elk Valley Coal suggested that this trend has since continued, with the Chinese cutting exports by 5 million tons from 2003 levels while raising imports by 6 million tons, which would put them at 9.2 Mt imports and 10.3 Mt exports. In other words, the Chinese are close to becoming a net importer of met coal for the first time ever. In fact, Platt's International Coal Report quoted one Chinese official as saying that China's exports were probably more like 6 million tons in 2004, which would put them squarely in the red. This shift in supply and demand, coupled with the tightening availability of transport, triggered the price run-ups we saw this past year.
The China Card
With China being a major factor in higher coal prices, the question is-can that country's extreme growth be sustained? According to Platt's, Australian forecasts show that without Chinese economic expansion, demand growth for met coal would reach only about 40% of current estimates.
Anyone who can definitively make the call on China's economy and time it has the potential to be the next Warren Buffet. Opinions range from raging bullishness (the consensus) to a more lonely sentiment, expressed recently by Frank Veneroso at the Vancouver Resource Investment Conference, that China is overheated and we're in for the biggest Asian market correction ever. What will really happen is anyone's guess.
We tend to side closer to the bulls: China's growth may not stay at the current hyperbolic rate for long, but we expect it to remain a major factor in global commodity (and just about all) markets for decades to come. For the moment, assume that the bulls are right and we're in for several years of sustained Chinese industrial growth. The rosiest forecasts, from BHP's coal pundits, are that seaborne metallurgical coal demand will grow from a current 205 million annual tons to 270 million tons by 2010 (by contrast, the Energy Information Administration pegs met coal export demand for 2010-both sea borne and land borne-at 220 million tons). What kind of opportunities would this create for coal producers, particularly juniors, where speculators could gain the most leverage?
To answer this, look back to the nineties. The boom-and-bust decade in the coal industry had the effect of running smaller producers out of business or into buyouts. Today, 48% of world export metallurgical coal is controlled by six big players: BHP, Xstrata, Anglo Coal, Rio Tinto, Fording, and Teck Cominco.
Not only do these companies have some 100 million tons of annual production capacity, they also hold considerable reserves, which can be brought online during times of high prices, such as now. BHP, which controls between 24 and 30% of seaborne export capacity, has made it clear that it intends to capitalize on the China-induced supply shortage by bringing 36 million annual tons of new Australian met coal into production over the next 5 years, single-handedly meeting over a third of the new demand. It's a safe bet that the other majors are looking at similar expansions.
Too Late for Coal?
Does this mean there won't be any room in the market for coal juniors? Although the situation doesn't look easy for small producers, a few things could happen that might give them more of an opening.
First, the Australian dollar could rise against the U.S. dollar-a near certainty. Australia currently supplies over 50% of seaborne met coal, largely because its coals travel less distance to ports and therefore tend to be $1-$2.50 cheaper per ton than coals from other suppliers. But if the A$ rises (as has been the trend over the past six months), Aussie coal will become more expensive and suppliers could look elsewhere.
Small producers could also benefit if the majors can't ramp up production quickly (or if companies are overestimating their production capacity in order to impress investors, which is always possible). We have seen technical problems at Australian mines this past year, but how long this will last is hard to say.
A final bullish scenario for all coal producers would be a major energy crisis following, say, the fall of the Saudi government or another major terrorist attack. In 1973, the Arab oil embargo caused an energy panic that sent the average U.S. coal price up 53% in 2 years. Given current geopolitics in the Middle East, a catastrophe is a distinct possibility, although there's no way to know when it might happen.
On the other hand, business tends to go where the money is, and any price rise is bound to cause increased coal supply. China itself has resources to add at least 700 million tons per year total coal production. These are undeveloped now, but likely won't remain so if we see coal prices at $150/ton.
Are there hot opportunities in coal stocks right now? Probably, especially as the mania about China causes a stampede of speculation, and supply gets tight before new production comes online. But given the way prices have already run up, it seems to us that it won't be long before increased supply dampens the market; probably not to the $40/ton levels of the nineties, but lower than current prices. If you like coal, that correction might be a better opportunity to buy in than right now. And at that time, we'll have a better idea about the future of China's economy, a major wildcard in the future of coal.