Sunday, November 16, 2014

Indonesian Thermal Coal

In one of his books, Aswath Damodaran mentioned a strategy for investing in cyclical commodity companies. When the commodity price is low, below the marginal cash cost of production, buy the lowest cost producer, who will survive and benefit once the commodity price recovers after the more expensive players are forced out of the market.

Newcastle (Australia) coal has dropped 50% since 2011:

(Source - indexmundi)

Futures have it between USD 63 now and USD 72 in 2020.

A google for thermal "coal cost curve" beings up this chart (from mid 2013), showing many players above the current price.

More googling shows Indonesia being the 2nd lowest cost producer, after South Africa (See here) (See p8).  A more recent chart (p24):

This is worth looking at further.

Quick Notes on the Thermal Coal Industry

Thermal coal pricing is regional, due to high transportation costs.  Coal often costs several times more to transport than it does to mine.  Cost to transport to port (for export) is the largest component of production costs.  Therefore, mines by the sea have much lower costs.

The simple 2011 map below gives rough costs for shipping coal.  Indonesia has the cheapest costs to China and India:

(Source: Nomura p11)

This one is more recent and detailed (source - Accenture p14):

We can see that Kalimantan has the lowest shipping costs to India, Japan and China.  The price differences between the importers (Qingdao, Japan) and exporters (Australia, Indonesia)  is maybe 10-15% once shipping costs are added.  A small change at the margins can have a large effect.

In the US, coal has been slowly replaced by Natural gas due to the fracking boom (p10) (more graphs here).  I don't think this will happen in South East Asia, as LNG is expensive to ship, and many regions here are so poor that they don't have reliable electricity.

Even though Australian producers are losing money, they are forced to continue production by long-term take-or-pay contracts.
It is expected that Chinese imports will decline over the next few years:
Mongolia is a producer of coking coal, but it is probably uneconomical to produce thermal coal there, with production costs estimated "in the order of $10-$30/tonne" with the same costs being incurred for freight into China.

Indonesia has a policy to replace diesel with coal for electricity generation.  They expect to double thermal coal consumption over the next 8 years.  This may not be good, as the government has tried to interfere with the coal industry:
The thermal coal market is quite fragmented.  Glencore is by far the largest player.  It probably controlled 50% of South African exports before its merger with Xstrata in 2013.  In 2010, it had 28% of the seaborne thermal coal market, plus Xtrata's 9%.  Glencore will be responsible for half the new coal coming onto the market in the next year.  They have been accused of trying to flood the market to remove competitors.

As with any market, no one can predict future coal prices.  Prices may be low until the 2020s, due to Glencore flooding the market and Australian mines being forced to produce.  I can't see a catalyst for coal prices to increase...but if I could, then so would everyone else.  Have to be willing to buy before everyone sees the light at the end of the tunnel.

The uncertainty introduced by the Indonesian government's ever changing rules may make me take a smaller position.

What to look for in a Coal Company

  • Low debt, to survive the cycle.
  • Low production costs:
    • Short distance to port (pit-to-port)
    • Low stripping ratio
  • Reserves: long mine life.
  • Are they selling coal on the open market, or at a hedged price?  Selling coal at a price higher price hedged years ago can make the company seem more profitable than it is.
  • Operating leverage: especially high fixed costs for transportation.

No comments: