Are Coal Prices Topping Out?

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Supply and demand factors have induced a jump in coal prices in recent months but analysts are not convinced the high levels are here to stay.

-Downward trajectory for thermal coal in particular likely in 2019
-Disruption to shipments of Australian coking coal supporting prices currently
-China's policy could still be successful in bringing down coal prices
 

By Eva Brocklehurst

Coal stockpiles in China have dwindled at both ports and utilities, causing prices to rise sharply. Analysts contemplate the latest surge in seaborne prices and the structural factors underpinning their longer-term forecasts.

Morgan Stanley envisages a sharp reversion to the mean for coal prices in 2019. The broker estimates prices could drop -39% versus spot and structurally weaker long-term demand is one of the drivers.

The fact that long-term demand is less appealing could also keep investors away, exacerbating the trend. The broker notes little to no investment taking place in new dedicated rail and port infrastructure, which have long pay-back periods, and capital expenditure on new mines is limited in the big export coal producing basins in Australia, South Africa, Colombia and North America.

On the other side of the world, China's supply-side reforms continue to exert a constraining effect on domestic supply. Yet China's power demand has increased by around 10%, while in India coal is being diverted to the power sector from the industrial sector to avert a shortage over the summer months.

Morgan Stanley suggests the challenges around demand over the longer term will prevent the equity market from re-rating these, currently excellent, cash flows from thermal coal in particular.

The broker notes, globally, Glencore has a most exposure to thermal coal, at around 33% of 2019 spot operating earnings (EBITDA). The broker estimates that Anglo-American and BHP Billiton ((BHP)) generate 23% and 16% respectively from coking (steelmaking) coal and 15% and 6% respectively from thermal (electricity) coal.

Coking Coal

Amid fresh concerns around the potential disruption to shipments of top-grade coking coal from Australia, prices have risen sharply, topping US$200/t recently. However, demand is observed to have softened over the year to date and the strong prices are providing incentives for alternative sources of high-grade coal.

Morgan Stanley suggests prices will be supported through June and July as the industry struggles to recover from cyclone-affected trade last year. Damage caused by cyclones to Aurizon's ((AZJ)) rail has continued to hamper exports.

The company originally focused on the Blackwater line that feeds the Port of Gladstone, where shipments are down 4% in the year to date, and has now shifted to the Goonyella line, which supports the 50mtpa Hay Point and 80mtpa Dalrymple Bay terminals. Significant disruption from maintenance is expected in June-July, which is typically a strong season for Australia's exports.

The shortfall in Australian exports, Morgan Stanley points out, is being offset globally by strong exports from Mongolia and the US, to some extent. US steel mills have been directed to lift purchases of US coking coal in order to reduce the country's trade deficit and this further supports seaborne prices.

Meanwhile, China is growing the use of scrap in steelmaking and its strict environmental controls mean local coke production has fallen. This has driven a decline in demand for coking coal and lower import volumes. Nevertheless, the several factors feeding into China's steel mill productivity suggest that demand for top-quality coking coal will continue to support the seaborne trade.

While Morgan Stanley expects Australia's supply disruption to cause significant upside risk to existing coking coal price forecasts, as reductions in Chinese steelmaking next winter come to bear, prices are expected to resume a downward trend.

Thermal Coal

Spot seaborne thermal coal prices are at the highest level since March 2012, responding to shortages in China. Warmer temperatures have boosted coal power generation, while environmental checks and rail maintenance have weighed on domestic supply.

Commonwealth Bank analysts highlight that official and independent sources are at odds on China's actual coal output. What is evident is that maintenance at China's largest coal-dedicated Daquin railway has weighed on the transport of domestic supply while policy makers have reimposed import restrictions at southern and eastern imports in April, exacerbating shortages.

In May, multiple measures were outlined to address the shortages, including increasing oversight of the sector to limit speculation and hoarding, perceived to artificially change prices, and to reduce the share of China's coal power generation to 58% in 2020, from 64% in 2015.

Policy makers have also reiterated their target band for domestic coal prices. While seaborne prices appear to have shrugged off the negative implications of import restrictions, the analysts believe that prices will eventually fall as policies take effect. They now forecast thermal coal prices to fall to US$77/t by the second quarter of 2019.

Since China started targeting coal prices in early 2017, the analysts note domestic prices have seldom moved into the target band, which is RMB500-570/t and equivalent to US$67-77/t. This band is well below spot prices of around RMB640/t.

However, it may be too early to consider the policy a failure. The analysts reluctance to make that call is reflected in China's goals to eliminate outdated coal capacity and improve the industry's profitability.

This has led to the elimination of 290mtpa of capacity, above the reduction target of 250mtpa. With the environmental backdrop, and the government maintaining efforts to bring down domestic coal prices, the analysts suspect the policy might still be successful in coming months.

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