Rudi's View | Oct 03 2012
By Rudi Filapek-Vandyck, Editor FNArena
When it comes to commodity markets, medium term developments are seldom the result of changes in demand and supply alone. There's always a multitude of shifting influences, in particular in a world that is changing rapidly post GFC. The global coal markets today are very much a reflection of this.
Think "coal" and what you are essentially thinking about is "global growth". On one hand (coking coal) demand is closely linked to the global production of steel, which in itself is closely linked to how much building activity is taking place around the world.
On the other hand, (thermal) coal demand remains a close reflection of how much energy the world requires to keep growing and developing. We are, as a global community, turning more energy efficient by the day and China in particular is making rapid progress, yet global demand for energy is still on the rise and this is not expected to change anytime soon.
What has changed over the past 18 months or so is weaker growth. Not only in Europe or in the US, but also in China and elsewhere. Looking back, it should now have dawned on everyone that the global synchronised high growth phase the world experienced between 2003 and 2007 was one of those rare exceptions. A once-in-a-lifetime event. Post the GFC, the world experienced a temporary boost on the back of fiscal stimulus from governments and monetary stimulus from central banks, but the effects, it would seem, have been gradually evaporating since early 2011.
Probably no coincidence then that prices for all varieties of coal peaked at around the same time. Here's the bad news: virtually nobody expects to see coal prices back at those peak levels in the foreseeable future. There's some good news too: coal prices are currently trading at or close to levels that keep the higher cost exporters around the world in business, but only just.
Conclusion number one therefore must be that, temporary exceptions excluded, there shouldn't be too much downside after the gradual decline in prices from early 2011. Recent experience in the iron ore market has taught everyone there's always risk for a temporary overshoot to the downside. After all, every commodity market nowadays includes a fair number of financial participants and coal is certainly no exception.
Alas, for coal enthusiasts and investors, most analysts covering these markets do not anticipate much upside for prices either. The main rationale behind this is because coal remains, to put it in financial lingo, a "well supplied market".
That's just another way for saying there's too much coal around the world; inventories are high while demand growth is likely to remain lacklustre. In the meantime, some of the bigger producers have started to announce production cuts and mine closures, while some of the marginal producers have gone out of business, but there's still too much coal available for a market that is essentially under downward pressures from multiple fronts.
Major culprit number one is the all-obvious slowing in economic growth. Take any chart that depicts GDP growth in any of the major economic zones since the start of 2011 and what instantly emerges is a very marked and obvious deceleration in growth.
Culprit number two is the US revolution in shale gas which has had a significant impact on market dynamics for thermal coal much quicker than anyone thought possible. Shale gas has turned the US into a net exporter of thermal coal and that at a time when there's not exactly a shortage on the supply side. The impact on coal producers in the US has been two-fold: on one hand, because US gas prices plummeted to all-time lows, more power plants started converting from coal to gas. On the other hand, the US may have the ambition to start exporting gas to the rest of the world, but to date the country doesn't have the necessary infrastructure and neither have those ambitious gas entrepreneurs the required export permits.
So in an overall environment of declining power usage (weakening growth) and increasing emphasis on cheap domestic gas supply, US coal was simply pushed out of the domestic market into the global arena (where it encountered ever so lower prices).
Culprit number three is China. Whereas the US does not have the infrastructure to start exporting gas on a major scale, China is still lacking the necessary infrastructure to transport domestically sourced coal to various user destinations across the country. As a result, domestic coal prices in China did not immediately follow international prices on the way down and it didn't take long before trading houses and intermediaries picked up on this. This so-called "arbitrage" lasted longer than most market watchers thought it would. No doubt, there's an element of speculation involved whether the government in Beijing will soon announce another stimulus package which would have kept more speculators on the buy side than otherwise might have been.
That arbitrage window has now closed, for the time being, but it has left China with bloated inventories at a time when domestic growth is still decelerating and growth in electricity usage is abysmal, if we can believe the available statistics. Note this is not necessarily a reflection of economic weakness alone as China is also making progress in becoming more energy efficient. At the same time there are quite a number of China watchers around who believe the situation on the ground, in particular for manufacturers and exporters, is much worse than the official statistics suggest. It's good to keep this in mind.
What is also becoming increasingly clear is that domestic production in China is more resilient than most analysts had expected. Chinese authorities have assisted local producers with subsidies to keep production going and to safeguard jobs; plus large enterprises often pay higher prices for local produce as it is closer to access and supply is more flexible. Note that post the Queensland floods, neighbouring Mongolia has overtaken Australia as the number one supplier of coking coal to China and the Chinese have shown no intent to revert back to the previous market leadership for Australia.
Culprit number four is the industry itself as many an analyst would have anticipated a quicker supply response than has become visible over the past 18 months. Those pesky high cost producers are simply refusing to leave the market and this isn't helping anyone (other than saving their own bacon, of course). One of the reasons as to why some of these producers (outside China) have been able to sustain production despite paper thin or even negative profitability (at face value) is a result of a general decline in credit availability throughout the global coal industry.
In short: when things turn sour, as they did, most producers find it difficult to attract loans from banks and they have to operate with less liquidity. In the coal sector, this has had the result that many producers who used to hedge, no longer can. The result of this is a "contango" in the coal futures market. Contango means prices are higher further out into the future. For financial participants, it's not easy to arbitrage this price differential in the physical market as the costs for storage et cetera make it not worthwhile, but for those high cost producers selling six or nine months into the future is the difference between staying in business or having to shut down.
The bad news here is that experts predict the contango will likely remain in place for the next few years or so, effectively keeping marginal producers in business.
The situation could have been far worse, believe it or not. India has turned itself into a major supportive force in the Asian markets both for thermal and coking coal. Apart from growing domestic demand in India, production in the country has been stunted as the government started to clamp down on environmental and other legal violations by the domestic coal industry (see also last week's Weekly Insights on iron ore).
It remains an open question whether any worse market dynamics would have had much impact on the price. The answer to that question might well be negative. After all, exports from high cost producers Russia and the US are barely profitable on current prices. More price weakness for a prolonged time would simply squeeze both countries out of global export markets and reduce overall supply available to importing countries such as Japan, China and India.
Culprit number five is -of course- Europe. Apart from being seen as the major force behind the current deceleration in global growth (Europe is the second largest economic entity, almost equal to the US), the European continent is also a major importer of coal. Whereas the US is currently enjoying very cheap gas prices, this is not so in most European countries where gas comes via pipelines from Russia and there's no sight of any shale gas revolution either (countries like France have banned fracking). As a result, there's no large scale switching by coal-fired power stations throughout Europe. Instead there's the anticipated economic recession which for obvious reasons has reduced the overall appetite for coal imports.
Right now the global coal sector is going through serious adjustments, including in the domestic market place in China. Prices probably won't weaken any further (not on a sustainable basis) but for any sizeable and sustainable recovery to kick in, the market needs more than the absence of more bad news – it needs global demand to accelerate. And that might just be the industry's main problem as most sector analysts do not see this happening anytime soon. Some might have expectations for a better looking situation in the second half of 2013, but that's at least still nine months away. There are others who do not see improvement for at least the next two years.
Yet, if we take guidance from recent experience with the iron ore price, there may be an opportunity for traders to benefit from a short spike in the price of coking coal. ANZ Bank's commodity specialist Mark Pervan believes Chinese traders have been responsible for iron ore's quick spike from US$86.70/tonne to above US$100/t in a matter of days and financial data seem to support Pervan's view. At first, reports Pervan, rampant shorting by Chinese traders forced down the price much further than anyone believed it would fall, and then, as some of these shorts started covering, the price spiked back up to above US$100/t – a level where spot iron ore should have remained in the first place according to many an analyst.
Pervan believes coking coal could be next in line for a 10-15% price spike.
The underlying message, however, remains the same: don't bank on a sustainable, more powerful price recovery anytime soon. For iron ore the new trading range is widely believed to be between US$100-130/t. (For now, however, the price remains near the bottom of that range). For coking and thermal coal, I have included a recent industry update by Commonwealth Bank. The projections in the table below speak for themselves.
And here's ANZ Bank's (Mark Pervan's) take on things:
For short term traders in the share market, today's share prices for the producers of coal will likely prove too low when prices do step up a notch or two. Here too the recent experience with share prices for producers of iron ore provides a supportive framework, at least until the spike from US$86.70 upwards ran out of steam. The chart below (thanks to hedge fund Antipodean Capital) suggests global share prices for coal producers could be set up for a nice rally.
For longer term investors the most important message is to not expect a return to pre-2011 dynamics, unless, of course, the weather surprises significantly or something similar happens that cannot be reliably predicted in advance.
A fast growing number of China experts is coming to the conclusion that 2013 likely won't be much different from this year, so that's also one possible upside scenario off the table.
(This story was originally written on Monday, 1st October 2012. It was published on that day in the form of an email to paying subscribers).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)