Red-hot coal market will moderate: analysts

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 to US$300 per tonne from about US$97, while thermal coal shot up toUS$125 per tonne from about US$56. The question is whether these increases are sustainable.

It is important to note 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 70-100 million tonnes per year.

In a research note from March, 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 2008-10, and “the rising cost curve of the global seaborne market should provide strong support to higher long-term coal prices.”

The perfect storm Credit Suisse alludes to was created by 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, and constraints on exports from Australia and South Africa due to infrastructure capacity. Demand from new power plants will have to be met by higher-priced coal from the U. S. 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.)

The bottom line is that Credit Suisse projects 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 US$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. Morgan Stanley says that 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 U. S. 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 two to three years. This year, the price is US$125 per tonne. Somewhat surprisingly, it is projected to rise to US$140 per tonne for 2009 and 2010. After that, it’s forecast to fall to US$120 per tonne in 2011, US$100 in 2012, and US$60 long-term.

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

A Merrill Lynch research report released in April is bullish on U. S. coal. Eastern U. S. coal is starting to look attractive to buyers both in Asia and Europe, and as export demand increases, coal prices in the eastern U. S. 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 U. S. coal market remains oversupplied because of a lack of railways and port facilities, and because of lower quality.

In a May research note, Macquarie 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, a coal analyst at Patersons Securities in Sydney, Australia, 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 grew by a compound 5.3% per year between 2001 and 2006, and he forecasts that China’s coal consumption will grow to 4 billion tonnes per year in 2030 from 2.7 billion tonnes per year in 2007.

Harrington says that production is not constrained and can be increased in many countries 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. Current capacity is 285 million tonnes per year, but he anticipates that will grow to 325 million tonnes per year in 2010, rising further to 390 million tonnes 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. (This figure is lower than the current thermal coal price in Australia, which stands at US$125 per tonne.)

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

Jeremy Sussman, a U. S. coal analyst at Natexis Bleichroeder in New York City, says the problem with coal supply is not that it is unavailable; rather, the infrastructure cannot cope with demand. The mostly domestic U. S. coal market lacks the infrastructure to increase export volumes substantially.

“Things are extremely tight right now. Worldwide, there is not enough supply to meet current demand for both metallurgical and thermal coal,” Sussman says.

There are some big expansions in infrastructure capacity in Australia planned for the next few years, he notes, which will lift some of the pressure off the metallurgical coal market, but not as many as for thermal coal.

“There are just not enough (expansions) 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 than 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 it prefers to upgrade railways serving that coal market.

Sussman projects hard coking coal prices in Australia at just under US$200 per tonne in 2010 compared with 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 currently about US$100 per tonne.)

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

It seems that all analysts agree that metallurgical coal prices will eventually fall from the current US$300 per tonne, and some forecasts talk about steep declines, perhaps to pre run-up price levels. If Australia meets its ambitious infrastructure build-out targets, these latter projections may materialize. As for thermal coal, prices will also fall from the current US$125.

It is possible that Credit Suisse’s long-term projection of US$75 per tonne of thermal coal will materialize, because it takes into account cost pressures. 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.