Seaborne Steam Coal

The US boasts the world’s largest reserves of steam coal and is a leading producer of this commodity, though the majority of this output is destined for domestic consumption.

Source: BP Statistical Review of World Energy 2011

In 2011 US shipments of steam coal to international customers ranked sixth in the world, trailing Indonesia, Australia, Russia, South Africa and Colombia.

Source: World Coal Council

As US coal exports account for 10 percent or less of global demand, supply and demand conditions in the international market for steam coal have little influence on North American prices. In the near term, US producers have limited scope to ramp up international shipments of steam coal and alleviate the domestic supply glut. The nation’s operating export terminals have a total capacity of 173 million short tons per annum–equivalent to roughly 16 percent of the industry’s annual output.

Source: Reuters

Moreover, shipments of metallurgiucal (met) coal–the kind used in steelmaking–usually command a higher price than the varietal burned in power plants; steam coal accounts for only two-third of US coal exports. Although the industry’s long-range plans include several export terminals on the West Coast to take advantage of Asian demand, these projects remain in their nascent stages and won’t ameliorate the current supply overhang.

A similar situation prevails in Canada, where met coal accounts for 90 percent of annual exports.

In short, investors shouldn’t assume that supply and demand conditions in the North America prevail in international markets. The US steam coal market hinges on domestic demand for electricity, while the seaborne market for this kind of coal depends on growing power consumption in emerging markets such as China and India.

The coal-to-gas switching that’s plaguing US coal producers hasn’t come in to play in most international markets because the price of natural gas is often four to five times higher than in North America.

The world’s top 10 countries in terms of coal-fired generation capacity account for 80 percent of the world’s installed base. China, home to the largest fleet of coal-fired plants, makes up more than 40 percent of the world’s total capacity.

Source: International Energy Agency

Of the major coal-consuming nations, China and India will drive the seaborne market in the near term and long term. The insular US market depends primarily on domestic production and has little capacity to ramp up exports, while the weak EU economy will weigh on Germany’ electricity demand in the near term. Over the long term, environmental concerns will likely stymie the construction of additional coal-fired power plants in Germany and other EU member states

In contrast, demand for electricity will continue to surge as China and India industrialize. Coal’s cost advantages should ensure that the fuel remains the dominant feedstock in these emerging markets. Liquefied natural gas prices in Asia hovered around USD15 per million British thermal units at the end of May, while the cost of steam coal delivered Australia’s port of Newcastle amounted to less than $5 per million British thermal unit.

Rapid economic growth and development in China and India has fueled growing demand for electricity, as increased urbanization tends to increase power consumption.

Source: Energy Information Administration, World Bank

China’s electricity consumption grew more than twelvefold between 1980 and 2009, while per-capita electricity demand increased ninefold. Over the same period, India’s electricity demand increased by more than 6.5 times and per-capita power consumption quadrupled. These growth rates dwarf the 78 percent increase in total US electricity demand over these 20 years.

Moreover, China and India have a long way to go before per-capita power demand reaches levels that prevail in the US and Western Europe. China’s per-capita power demand would need to increase by an additional 150 percent to equal per-capita electricity use in Germany and by almost 500 percent to match the US.

When you consider that China’s population is about four times that of the US, even a modest increase in the Mainland’s power consumption implies a substantial upsurge in demand for steam coal and other energy commodities.

Not surprisingly, China and India dominate the league tables for new coal-fired generation capacity. Although Western investors often fret that the retirement of older, coal-burning power plants in the US and Europe will weigh on global coal prices, Asia’s emerging markets will continue to drive growth in the seaborne coal trade.

Investors should also disabuse themselves of the misconception that China’s coal-fired power plants are older, less-efficient and more harmful to the environment than their counterparts in the US and other developed countries. Whereas 8 percent of coal-burning plants in the US are less than 20 years old, 90 percent of China’s coal-fired facilities were built within the last two decades.

Roughly 75 percent of China’s electric power plants have a nameplate capacity of more than 300 megawatts, on par with the US and Germany. These larger plants usually operate at higher efficiency rates and have superior environmental controls than smaller facilities. China’s base of newer, highly efficient coal-fired power plants is testament to the country’s commitment to this oft-maligned feedstock.

Source: International Energy Agency

In each of the five-year periods depicted on this graph, the International Energy Agency (IEA) expects China to add the most coal-fired capacity, with India following closely on its heels. Although the US will build some coal-burning power plants, most of these additions will occur in the near term and will be offset by the closure of older facilities.

Factoring in plant retirements, the IEA’s forecast calls for China to add 488 gigawatts of generative capacity by 2035–a roughly 75 percent increase to its current base. Over the same time frame, India is expected to grow its generative capacity to 225 gigawatts from 101 gigawatts. At this rate, India will overtake the US as the second-largest consumer of steam coal within the next 15 years.

How will China, India and other emerging markets obtain the coal to fuel these power plants? Imports will be a big part of the equation. Although China is the world’s leading producer of steam coal and India ranks third, domestic production won’t keep pace with demand growth.

Over the past five years, China’s output of steam coal has increased by 38 percent, while demand has surged by 41 percent. India’s production of steam coal has grown an impressive 33 percent, falling short of the 50 percent increase in consumption. These supply gaps appear relatively minor, but the size of these markets translates into substantial demand for imported steam coal.

Although investors tend to focus on China’s insatiable appetite for oil, iron ore and other commodities, India’s demand for imported steam and met coal will likely increase at a much faster rate. Not only are the country’s domestic coal reserves of relatively low quality, but the country has also struggled to grow production because of government restrictions on land use. India’s transportation infrastructure also makes it difficult to deliver this output to the marketplace. The government has effectively acknowledged that these challenges will persist by siting most of its newly built power plants near the coast, a location that facilitates seaborne imports.

In recent years, Australia and Indonesia have battled for the title of the world’s leading exporter of steam coal. Together, the two nations supply about 45 percent of the global market for seaborne steam coal. In coming years, we expect Australia’s efforts to expand terminal capacity to enable it to hold the top position. According to the Australia’s Dept of Resources, Energy and Tourism, the country’s total export capacity will increase to about 448 million metric tons per annum (mmtpa) from 333 mmtpa at the end of 2008.

Indonesia has grown its exports of steam coal considerably in recent years, benefiting from the predominance of relatively inexpensive-to-produce surface mines that are located near waterways. Meanwhile, the nation’s rapidly expanding economy has fueled an almost threefold increase in domestic coal demand between 2000 and 2010, prompting the government to debate new laws that would restrict exports.

Colombia, Russia and South Africa also have the capacity to export significant amounts of steam coal. Although reserves of steam coal are more widely distributed throughout the world than the metallurgical variety, rising import demand in emerging markets should support the price of seaborne steam coal over the long term.

Based on these long-term trends, we expect coal remain the world’s leading source of electricity for at least 15 more years.

Metallurgical Coal

Although steam coal accounts for about 72 percent of the seaborne market, this varietal commands a lower price per ton than metallurgical coal. As a result of this differential, met output is far more important to export-oriented producers.

Australia controls about 60 percent of the market for seaborne met coal, while the US and Canada together account for another 29 percent. With supply concentrated among a few nations, investors should expect the international market for met coal to remain tight in coming years.

The vast majority of global steel production occurs in one of two industrial settings: a basic oxygen furnace (BOF), which uses pig iron as the primary input, or an electric-arc furnace (EAF), which enables the producer to use scrap steel.

To create pig iron, raw iron ore is heated to extreme temperatures in the presence of carbon, which combines with oxygen in the iron ore to produce carbon dioxide. This process removes the oxygen from the ore, leaving a brittle substance that’s relatively useless without further processing. In the BOF, oxygen pumped into the system bonds with carbon and other impurities in the pig iron, producing slag that’s removed from the steel. This steel can be alloyed with tungsten, chromium, molybdenum, nickel and other metals to endow the product with desirable characteristics such as increased strength, reduced weight or rust resistance.

EAFs use electricity to heat scrap steel and remove the impurities. Producing steel in this manner is cheaper but requires significant quantities of scrap steel, which accounts for the technology’s predominance in developed nations.

About 70 percent of global steel production occurs in basic oxygen furnaces, with the electric arc variety accounting for the remaining 30 percent. In Asia, the world’s most important steel-producing region, about 81 percent of steel production comes from BOFs. In China, more than 90 percent of steel is produced in this manner.

The world’s leading consumer and producer of steel, China accounts for almost half of global output; tracking developments in the Mainland’s steel industry is critical to understanding trends in the global market for the alloy and met coal, a key input in the manufacturing process.

Source: Bloomberg

Over the past decade, Chinese steel production has surged to almost 50 percent of the world market from 15 percent. Despite this rapid growth, the Mainland’s per-capita steel demand remains low relative to consumption in developed countries, suggesting that there’s plenty of scope for growth as the nation industrializes. Even Brazil and India consume more steel per capita than China.

Source: Peabody Energy Corp

The same economic forces that drive demand for electricity and steam coal fuel China’s steel consumption. As rural populations relocate to cities, demand for structural steel used in the housing and commercial construction industries rises. Automobiles, home appliances and other consumer items also contain significant quantities of steel.

As China and India’s economies develop and urbanize, per-capita steel consumption in these nations should approach levels that prevail in the developed world. This growth won’t occur overnight: Japan and South Korea’s per-capita steel demand gradually inched toward current levels over the course of several decades.

In the near term, trends in the construction industry will drive steel demand on the Mainland, with shipbuilding and the manufacturing of machinery also making significant contributions. 

Source: Bloomberg

Through much of 2010 and 2011, China’s government focused on fighting inflation and preventing real estate price from reaching unsustainable levels. By hiking interest rates, upping banks’ reserve requirements and placing certain restrictions on lending, policymakers slowed economic growth from 11.9 percent in the first quarter of 2011 to a more sustainable 8.1 percent in the first three months of 2012.

Efforts to curb inflation likewise proved successful, with China’s consumer price index (CPI) falling to less than 3.5 percent from a high of 6.5 percent in July 2011. Food and energy costs are a major component of the country’s CPI, inflation should continue to moderate in the near term.

The government’s efforts to cool China’s red-hot economy have slowed activity in the Mainland’s real estate markets.

Source: Bloomberg

This graph tracks the year-over year change in four indicators of Chinese real estate and construction market activity. The spike in construction of residential (blue line) and commercial real estate floor space (red line) in 2009 and 2010 reflects the implementation of a stimulus package to blunt the effect of the global financial crisis and recession.

The tailwinds began to fade in late 2010, when the government tightened monetary policy and reined in bank lending. In early 2012, land sales and commercial and residential construction contracted from year-ago levels for the first time since 2009. Slowing construction is bad news for Chinese steel demand and has filtered through to inventory levels and rebar prices.

China’s steel inventories usually build in the first quarter of the year in anticipation of the seasonal increase in construction activity as temperatures warm up. This year’s inventory build fell short of last year’s restocking phase, while the decline in supply suggests that construction activity has picked up. However, inventories haven’t declined as quickly as in 2011 and remained about 10 percent higher than a year ago–a potential indication that steel sales could disappoint in 2012.

Source: Bloomberg

Weakness in China’s real estate market has also weighed on the price of rebar, or steel bars widely used in construction. Chinese rebar prices rose steadily from late 2009 to early 2011 because of an upsurge in residential and commercial construction, before tumbling 20 percent for their mid-2011 high.

Source: Bloomberg

The outlook for Chinese steel demand in the second half of 2012 depends on the prospects for China’s economy and construction activity. Investor sentiment toward names with exposure to the seaborne met coal market also hinges on this outlook.

In recent months, a spate of weaker-than-expected economic data has pressured shares of Growth Portfolio holding Peabody Energy Corp (NYSE: BTU). For example, China’s Purchasing Managers Index (PMI), which tracks activity in the manufacturing sector, slipped to 50.4 in May from 53.3 in April.

Source: Bloomberg

PMI readings of greater than 50 indicate an uptick in manufacturing activity; an index value of less than 50 suggests a contraction. In China, a PMI reading near 50 indicates a slowdown, while values in the low to mid-40s suggest a collapse in economic growth.

China’s PMI had trended higher in recent months, suggesting that the domestic economy had bottomed and that growth would reaccelerate in the back half of the year. Although Beijing has targeted economic growth of about 7 percent in 2012, analysts widely expected the country to exceed this goal.

May’s disappointing PMI data point, coupled with weak industrial production, has stoked fears that China’s economy is slowing at a faster-than-intended pace. Some economists have expressed doubts about whether economic growth will accelerate in the final six months of the year.

However, Western observers underestimate the Chinese authorities’ ability to manage the nation’s economy. Although many developed countries have turned to quantitative easing and other unconventional measures to stimulate growth, China has significant scope to ease monetary policy. And unlike the US and many Western European nations, China’s government could easily afford another infrastructure spending bill.

At the beginning of 2011, many pundits underestimated Beijing’s ability and willingness to curb economic growth and control inflation; today, too many armchair observers underestimate the government’s ability to prevent growth from slowing down too much.

The government has already lowered banks’ reserve requirements by 1.5 percent since last November, freeing up more capital for lending. Nevertheless, these levels are high by historical standards, leaving the scope for at least two to three additional cuts of 0.5 percent before year-end.

Source: Bloomberg

Policymakers also cut the benchmark one-year borrowing and deposit rates for the first time since 2008. As part of this move, banks will also enjoy additional freedom in setting the amount they pay on deposits and the interest they receive on loans.

The government has also announced that it has accelerated a number of infrastructure projects that were slated to begin in 2012 and 2013. Chinese Premier Wen Jiabao also stated that the government plans to focus more on promoting economic expansion, a sign that policymakers are seeking to maintain growth targets.

Any uptick in China’s economy should bolster global steel demand and drive up met coal prices.

Checking in at the Peabody

Shares of coal producers have sold off for three reasons over the past few months.

Growing concern about the health of the global economy has prompted investors to reduce their risk and take profits from the rally earlier this year. Regardless of company-specific growth prospects, traders have dumped energy and basic materials stocks because of their perceived economic sensitivity.

Investors eventually will begin to differentiate between individual companies, but babies tend to get thrown out with the bathwater in the early stages of a selloff.

We’ve warned of a potential correction for some time, citing a likely deterioration in US economic data, uncertainty surrounding US fiscal and tax policies in 2013 and the never-ending EU sovereign debt crisis. Investors should prepare for further downside in July and August, a period of seasonal weakness.

Despite our cautious near-term outlook, many bearish commentators overestimate the risk of a US recession. Recent weakness in economic data likely reflects the dissipation of tailwinds related to the seasonally warm 2011-12 winter. Likewise, Chinese authorities have the scope to stimulate growth now that inflation is under control, limiting the risk of a hard landing. European economies will continue to suffer, but the region should prevent its sovereign-debt crisis from ballooning into a global credit crunch.

A year ago, severe flooding in eastern Australia–the center of the nation’s thermal and met coal production–severely curtailed exports of these fuels, sending prices for these commodities sharply higher. As these supply disruptions eased in the back half of 2011, coal prices have receded. Recent weather-related disruptions have been less severe; the fading of these supply constraints is reflected in seaborne coal prices.

Finally, the glut of coal in the US market has soured investor sentiment toward the industry to the extent that the market has even sold off names with limited exposure to tumbling thermal coal prices.

Growth Portfolio holding Peabody Energy Corp remains our top play. The stock has pulled back significantly over the past year, stung by declining coal prices and short-term concerns about Chinese demand.

However, Peabody Energy is well-positioned to navigate the current environment. The company in October 2007 spun off its coal mining assets in Central Appalachia (CAPP), a region where rising costs remain a permanent headwind, with the initial public offering of Patriot Coal (NYSE: PCX). Not only did Peabody Energy monetize these mature assets in a bull market for coal, but the move also enabled the firm to focus on building its exposure to growing its production in Australia.

Today, this move appears prescient: Shares of Patriot Coal recently plummeted to less than $2, and the company appears to be on the brink of bankruptcy.

In 2007 Peabody Energy generated about 83 percent of its operating earnings before interest, taxation, depreciation and amortization (EBITDA) its domestic market, while its Australian operations accounted for the remaining 17 percent. In 2011 Peabody Energy’s operating EBITDA was roughly evenly split between the US and Australia.

The coal producer’s US operations focus primarily on the Powder River Basin (PRB) in the western US and on the Illinois Basin in the Midwest.

Almost three-quarters of the company’s US coal shipments originate from the PRB, where the firm operates surface mines and produces thermal coal. Although PRB coal contains less energy than coal from CAPP, surface mining involves fewer production costs and safety regulations are less onerous. Coal mined in this region contains less sulfur than production from other regions in the US, an important consideration for utilities looking to cut their sulfur dioxide emissions to meet environmental regulations.

The remainder of Peabody Energy’s US coal volumes comes predominantly from the Illinois Basin, an area that yields coal that contains higher levels of sulfur. For this reason, coal deposits in the Illinois Basin haven’t been mined as aggressively as formations in Central Appalachia. In addition to lower production costs, the Illinois Basin has also benefited from growing demand for high-sulfur coal as utilities install advanced scrubbers that eliminate much of the sulfur dioxide emitted from power plants.

As mine seams thin and output from CAPP declines, expect utilities to increasingly turn to the PRB and Illinois Basin for coal supplies.

Peabody Energy also sells the majority of its US coal production under fixed-rate contracts. All the firm’s expected 2012 output–between 185 and 195 million short tons–is covered by contracts. In a conference call to discuss first-quarter results, management noted that some utility customers have asked to renegotiate contracts after an unseasonably warm winter led to a supply overhang. Oftentimes, this process involves rescheduling shipments originally slated for 2012 into 2013 or 2014. Management also indicated that it’s making every effort to maintain the original value of the contract when rescheduling deliveries.

Peabody Energy’s management team has also been slightly more sanguine about the US thermal coal markets than its competitors, likely because of its limited exposure to CAPP and substantial position in the PRB. As coal-to-gas switching has been most prominent in regions that burn CAPP coal, inventories are slightly less glutted among utilities that burn PRB coal.

Management has also pointed out that the industry is responding to excess coal stockpiles by slashing mine output. In April 2012, annualized US coal shipments came in at 932 million tons–more than 150 million tons less than a year ago and the lowest volume in 15 years. This data doesn’t include additional curtailments slated for May and June.

Peabody Energy has pushed back contract negotiations with utilities on 2013 shipments until the third and fourth quarter, suggesting that management expects at least some modest upside to US coal prices in the second half of the year.

That being said, Peabody Energy isn’t immune to the industry’s woes. Given the current price environment and inventory levels, the company may need to curtail production in coming years to match demand.

Peabody Energy’s extensive operations in Australia distinguish the company from its US peers.

Management expects the company to produce between 33 and 36 million tons from its Australian mines: 7 million to 8 million tons of thermal coal destined for the domestic market, 12 million to 13 million tons earmarked for the seaborne market, and 14 million to 15 million tons of met coal. In other words, metallurgical coal will account for about 45 percent of Peabody Energy’s Australian output, a favorable production mix in the near term and over the long haul.

Management emphasized said that Peabody Energy hasn’t received any requests to defer met coal deliveries; this market remains appears healthy, even though prices have retreated as production normalizes.

Peabody Energy has allocated about two-thirds of its 2012 capital expenditures to projects in Australia and plans to grow its production to between 45 and 50 million tons per annum by the end of 2015. Met coal will account for much of this 35 percent upsurge in output.

In late 2011, Peabody Energy completed the USD3.8 billion acquisition of MacArthur Coal, a massive deal that pushed the company’s total debt to almost $6.7 billion for about $2.5 billion in the third quarter of 2011. Some analysts complain that the firm overpaid for MacArthur Coal. But the deal will immediately increase Peabody Energy’s production and expands the slate of potential growth projects.

Peabody Energy continues to pay down the debt used to finance this transaction, with the goal of restoring its leverage ratio to pre-deal levels. Management has also instituted a cost-cutting campaign to improve efficiency and profit margins at the acquired mines.

Although the US market for thermal coal faces undeniable headwinds, investors haven’t given Peabody Energy enough credit for its domestic asset base and substantial operations in Australia. Trading at only 0.8 times revenue, the stock has more than priced in any additional bad news. In fact, the shares command a lower valuation than they did at the height of the 2008-09 financial crisis.

2009. The key upside catalyst for the stock will be a turn in sentiment regarding Chinese steel demand, which we expect to occur in the back half of the year. Peabody Energy Corp rates a buy under 45.