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Thermal Coal Glut: Who Will Blink First?

Commodities | Jun 17 2019

Thermal coal is piling up as demand drops away in Europe. Atlantic suppliers are turning their attention to the Pacific but, brokers assess, this region is also oversupplied.

-Switch to gas significant in thermal coal demand destruction in Europe
-Supply reductions needed in high-energy coal to steady the price
-Where will supply reductions emanate from: Columbia or Australia?


By Eva Brocklehurst

Demand for thermal coal is falling, particularly in the Atlantic, as coal-to-gas switching has become a driver of demand destruction in Europe. Brokers note this has ramifications for the Pacific, as suppliers look to Northeast Asia to absorb the glut.

Atlantic coal prices have not staged a recovery at the start of the northern summer, as Credit Suisse had hoped. Power plants are normally expected to re-stock, lifting coal prices, but this has not happened. Moreover, as the northern summer weather improves, renewable generation lifts and takes market share. Credit Suisse flags the fact the UK recently passed 10 days without any coal generation because of warm and windy conditions.

Meanwhile, German coal generators are losing money on falling power prices and rising carbon prices. Credit Suisse assesses thermal coal is under pressure in Germany regardless of the price, as around one quarter of the country's capacity is due to close by 2022 and the deluge of cheap gas is likely to speed this transfer up. Large quantities of gas are coming from Russia and Norway and US LNG is also flooding terminals, as Asian markets are seasonally soft.

Spanish generation in April also showed a clear switch to gas from coal following the removal of a tax for gas-fired generation. Macquarie also finds it hard to envisage how a revival over the northern summer will give a lasting boost to thermal coal prices.

For those shipping from the Atlantic, Asia has become attractive as the Atlantic-Pacific spreads cover the freight costs. However, demand conditions in the Pacific are not robust either and additional supply is bringing down prices.

Japan has been the leading importer in the region of high-energy thermal coal, but its utilities are under pressure to move away from coal and, as Morgan Stanley points out, coal-fired projects totalling around 4GW have been cancelled recently. The broker notes Japan's coal-to-gas switching has not really been forthcoming either, as most LNG to Japan is sold on oil-indexed contracts rather than at spot prices, making gas still uncompetitive versus coal.

Macquarie calculates that at least a fifth of seaborne trade is out of the money and thermal coal is suffering from a "demand problem", being displaced by other sources, namely hydro in China and gas in Europe. Moreover, warmer weather can only do so much to lift electricity production in China, the broker asserts, if manufacturing continues to slow as implied by China's weak June PMI data.

One item worth monitoring, in the broker's view, is that Shell and Tokyo Gas have agreed on the first coal-index LNG contract in April and this may trigger more switching if such indexing is more widely adopted. Meanwhile nuclear re-starts and cost-competitive renewables are also threatening thermal coal's market share in Japan.

Price Outlook

Credit Suisse suspects its forecast for a second-half thermal coal price FOB Newcastle of US$85/t is problematic. As Colombian prices are falling towards their 2016 lows, the broker is looking for what might be the floor. A floor price for China's thermal coal, which is largely self supplied, at a level authorities would accept, is calculated at around RMB530/t.

On parity, Credit Suisse assesses this means the absolute lowest Newcastle 6000 calorie thermal coal, as a monthly average, should be is around US$57/t. However, there needs to be a premium for high-energy coal, as it has to be washed to reduce the ash content to below 15%. Calculating a premium for Australia's Hunter Valley coal, the broker suggests, should be in the region of 22%, in order to break even.

Brokers believe supply reductions are needed in high-energy coal to steady the price. Although Morgan Stanley expects a recovery in demand from Japan and South Korea over the summer, supply will still need to exit to bring the market back in balance, as imports to these two countries are expected to gradually decline over the medium-term.

Higher cost exporters with more supply, such as Indonesia, which have mainly low-energy coal, are defying fundamentals at present, yet Morgan Stanley expects that country's rising exports will ease. As this supply exits the market and the current surplus narrows, the broker forecasts the thermal coal price to recover modestly to around US$81/t FOB Newcastle in 2020.

Meanwhile, Australian thermal coal exports were up 2% from January to April, with just 7% of supply negative at current spot prices. In Australia, small marginal mines account for around 40mt of supply which is currently out of the money and, Macquarie points out, most Australian thermal coal exports break even between US$50-$70/t and remain profitable.

Supply Cuts?

China, which drives the seaborne market in the Pacific, is experiencing weak demand and, although being largely self supplied, the 5500 calorie price has dropped below RMB600/t. The one bullish offset, Macquarie suggests, is that growth in Chinese output has fallen back to nil. Authorities have put pressure on domestic mines after a number of deadly accidents and new capacity additions have slowed.

Yet, Credit Suisse notes soft coal demand in China will affect Indonesian and Australian high-ash coal. Taiwan's power company recently tendered for Australian coal but only because it was a lot cheaper than its contracted supply. The tender was also heavily overbid which signals to the broker that producers have around 1.6mt of coal to move.

All up, Credit Suisse asserts there is too much coal being produced to absorb right now and the question is whether Hunter Valley or Colombian producers cut supply. Major Colombian producers include Glencore, BHP Group ((BHP)) and Anglo American.

The broker suspects Glencore may be prepared to halt some of its mines for long periods, as it has done in other commodities, in order to tighten the market, but would have to decide between its Colombian or Australian mines. In contrast, BHP, the other global miner heavily involved in both these markets, has in the past continued to run its mines hard regardless of the price.

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