Coal market is red hot, but prices will moderate eventually

Coal has been a stellar performer lately, with prices advancing in recent contract negotiations for both metallurgical coal (coking coal), used in steel manufacturing, and thermal coal, used to produce electricity. In Australia, premium hard coking coal jumped from about US$97 to US$300 per tonne, while thermal coal shot up from about US$56 to US$125 per tonne. The question is whether these increases are sustainable. If they are, high coal prices are here to stay. Conversely, if the recent run-up is the result of temporary factors which will disappear, prices will eventually drop.

It is important to realize that a large part of coal production is consumed domestically, with only a portion, known as seaborne coal, being exported. China, for example, produces 2.5 billion tonnes coal per year, while it exports only about 70 to 100 million tonnes per year.

In a research note dated March 4, Credit Suisse says that, although the higher contract prices for seaborne coal are the result of a “perfect storm” in the short term, the supply deficit for seaborne thermal coal is likely to persist in 2008-2010, and “the rising cost curve of the global seaborne market should provide strong support to higher long-term coal prices.”

The short-term “perfect storm” that the Credit Suisse report alludes to is mine flooding in Australia, supply disruptions in South Africa, and transportation problems in China owing to blizzards. While Credit Suisse does acknowledge the influence of these short-term factors on coal prices, it also says that rising costs are a long-term phenomenon, so thermal coal prices are unlikely to drop to levels seen before the recent run-up.

Credit Suisse says that the supply deficit will persist, driven by China’s rising imports on the one hand, while on the other hand exports from Australia and South Africa are constrained by infrastructure capacity. Demand from new power plants will have to be met by higher-priced coal from the USA and Russia. Credit Suisse’s long-term price projection for thermal coal is US$75 per tonne. Short term thermal coal prices are projected at US$120 for 2008, and US$100 for 2009 and 2010. The price for hard coking coal, the highest grade for this commodity, is projected at US$200 per tonne for 2008, US$160 for 2009, US$140 for 2010, and US$95 long-term. (The price rose to US$300 per tonne of hard coking coal after the Credit Suisse report was issued.)

Bottom line: Credit Suisse projects that long-term prices for hard coking coal will eventually settle down to pre run-up levels. Long-term thermal coal prices will also drop, but will stay about $20 higher than prices that prevailed before the recent run-up.

In a research note dated April 9, Morgan Stanley starts with coking coal, identifying flooding in Queensland mines as a major supply constraint. Work to drain flooded coal mines has started, and coal prices may come under pressure once mines start producing again. Despite this, Morgan Stanley issues bullish projections for coking coal, because it will take time to bring the mines back to production. Metallurgical coal is projected to cost US$300 per tonne in 2008, US$240 in 2009, US$200 in 2010, US$160 in 2011, US$140 in 2012, and US$90 per tonne long-term. Chinese net imports of coking coal are forecast to grow slowly, coking coal exports from US to Europe are forecast to rise, and new coal projects are seen as slow to materialize.

Turning from coking coal to thermal coal, Morgan Stanley identifies major supply and infrastructure issues in South Africa, Australia and China. The seaborne thermal coal market is forecast to remain tight for 2-3 years. The price is US$125 per tonne in 2008, and is projected to rise to $140 for 2009 and 2010. Thereafter it is forecast to fall to US$120 in 2011, US$100 in 2012, and US$60 long-term.

Comparing Morgan Stanley’s forecasts to those by Credit Suisse, the Morgan Stanley long-term projection for coking coal is slightly ($5) lower than that by Credit Suisse. The difference in thermal coal is more pronounced, with the Morgan Stanley long-term projection a full $15 lower than that by Credit Suisse. The difference is explained by the fact that the Credit Suisse forecast takes into account not only supply vs. demand, but also the influence of rising mining costs.

A Merrill Lynch research report dated April 25 is bullish on US coal. Eastern US coal is starting to look attractive to buyers both in Asia and Europe, and as export demand increases, coal prices in eastern US are likely to increase. Tightness in the metallurgical coal market will place upward pressure on thermal coal prices too. Although Merrill Lynch has a positive outlook on coal, it identifies risks from a possible global slowdown and from increased coal production in China. In addition, the western US coal market remains oversupplied because of a lack of railways and port facilities, and because of lower quality.

A Macquarie research note dated May 1 says that coal inventories at Chinese power stations have dropped. The government is expected to let electricity prices go up, which may help address the problem. However, the power-generating sector keeps expanding, which increases coal demand.

Andrew Harrington is coal analyst at Patersons Securities in Sydney. In an interview, he says that after the recent price spikes, coal prices face major drops over the next few years as capacity is aggressively increased. He says that price spikes occurred as a result of mine floods in Australia, storms in China and blackouts in South Africa, making it difficult to meet surging demand, particularly from China. Worldwide coal consumption has grown by a compound 5.3% per year between 2001 and 2006, and he forecasts that China’s coal consumption will grow from 2.7 billion tonnes per year in 2007 to 4 billion tonnes per year in 2030.

He says that production is not constrained and can be increased in many places around the world. The main problem is logistics: how to get the coal from the pit to the ship. Coal miners are more motivated to invest in metallurgical coal projects, rather than in thermal coal, because prices and margins are higher.

Harrington says that port capacity in Australia is being increased in order to eliminate the bottleneck. At present, capacity is 285 million tonnes per year. He anticipates that it will grow to 325 million tonnes per year in 2010, rising further to 390 million tonnes per year in 2013. Harrington forecasts that, as a result, premium hard coking coal prices will drop to US$140 per tonne in 2010, to US$105 in 2013, and to US$92 in 2015. His long-term projection is even lower at US$80 per tonne.

Harrington forecasts that thermal coal prices will also plummet, to US$85 per tonne in 2010, to US$55 in 2013 and to US$48 over the long term. So Harrington’s long-term price forecasts for both coking coal and thermal coal are lower than other projections. He justifies his conservative stance by the fact that, beside logistics and infrastructure capacity, there is no real constraint on production.

Jeremy Sussman is U.S. coal analyst at Natexis Bleichroeder in New York City. Similar to Andrew Harrington’s views, Sussman says that the problem with coal is not that it is unavailable, but that currently, the infrastructure cannot cope with demand. He adds that the U.S. coal market is mostly domestic, and lacks the infrastructure to increase export volumes by a large percentage.

In an interview, Sussman says: “Things are extremely tight right now. Worldwide there is not enough supply to meet current demand for both metallurgical and thermal coal. Metallurgical will probably get fixed before thermal, because there are some big expansions in infrastructure capacity in Australia planned by 2010-2011. For thermal coal there are a couple of expansions, but not as many as for metallurgical coal. There are just not enough of those planned over the next few years to meet current and future demand. So we see both markets remaining tight in the near term, but we think metallurgical coal prices will correct quicker t
han thermal coal prices, just given that we see more expansions happening in metallurgical coal. This is natural given the higher prices and margins in metallurgical coal.” He adds that railroads in Queensland are owned by the government, which receives higher royalties from metallurgical coal, so government prefers to upgrade railways serving the metallurgical coal market.

Sussman projects hard coking coal price in Australia at just under US$200 per tonne in 2010 compared to US$300 at present. He does not provide longer-term forecasts for coking coal prices. For thermal coal, Sussman only forecasts U.S. domestic prices, as opposed to seaborne coal. For long-term deals in the highest quality thermal coal, he projects a domestic price of US$92 per tonne for 2010 and for 2013, which is similar to current contract prices. (The spot price for U.S. domestic coal is about US$100 per tonne at present.)

He says: “We feel comfortable that these forecasts are conservative, because the market is tight and is going to remain tight. Like I said, we don’t see where new supply comes on-line.”

It seems that all analysts agree that metallurgical coal prices will fall from the current US$300, and some forecasts talk about steep declines, perhaps to pre run-up price levels. If Australia meets its ambitious infrastructure build-out targets, these projections may materialize. As for thermal coal, prices will also fall from the current US$125. Long-term projections run all the way from Andrew Harrington calling for US$48 per tonne, Morgan Stanley’s projection of US$60 per tonne, Credit Suisse calling for US$75, and Jeremy Sussman’s projection of US$92 (although his forecast refers strictly to U.S. domestic thermal coal.)

It is possible that the Credit Suisse long term projection of US$75 per tonne of thermal coal will materialize, because it takes into account cost pressures. Jeremy Sussman’s projection of a firm US$92 per tonne for domestic U.S. coal may also materialize, based on a lack of new supply. These prices may, in turn, limit the extent to which metallurgical coal prices drop.