Coal Country

By virtue of its proximity to Asia’s emerging economies and abundance of critical resources, Australian equities offer exposure to China and India’s growth as well as developed-world transparency.

Although takeovers involving Australian firms fell by 30 percent to USD102.5 billion in 2011, the average deal premium increased from 39.3 percent to 47.4 percent. The energy sector was once again a hotbed of M&A activity last year, accounting for USD28.6 billion worth of deals (about 28 percent of the total transaction value).

Australia’s coal industry furnished a number of blockbuster deals, including ArcelorMittal (Amsterdam: MT, NYSE: MT) Growth Portfolio holding Peabody Energy Corp’s (NYSE: BTU) joint acquisition of Macarthur Coal (ASX: MCC), the world’s leading producer pulverized coal injections (PCI). This type of coal is crushed into a fine powder and injected into blast furnaces as a partial replacement for met coal in the production of pig iron.

We expect consolidation in Australia’s coal industry to continue in 2012, given the group’s attractive long-term growth prospects.

Although concerns about air quality and carbon emissions standards will limit the construction of coal-fired power plants in the developed world, Asia’s energy-hungry emerging markets have latched onto coal-powered generation as an important part of their energy mix.

In fact, recent estimates suggest that coal-fired power capacity will be the single largest source of incremental generation capacity globally from 2008 to 2020, accounting for an additional 3,516 terrawatt-hours, compared to 1,604 terrawatt-hours for natural gas and a mere 107 terrawatt-hours for solar power. Much of this growth will occur in China, India and other Asian markets.

As the quintessential emerging market, China’s appetite for coal receives a lot of attention from investors and commentators.

The Mainland’s utilities built up their winter coal inventories ahead of schedule in 2011, amassing a record 81.5 million metric tons (21 days worth of consumption) in November. Some of this record inventory stems from an uptick in domestic output–government-mandated consolidation in the industry has improved productivity–but looser credit requirements on the part of domestic suppliers also factor into the equation. Meanwhile, relatively mild weather has suppressed demand relative to previous years.

Nevertheless, the Mainland’s thermal-coal imports are expected to increase consistently over the next several years because of rising electricity demand and insufficient rail capacity to transport output from coal-producing provinces in western China to end-markets in eastern and southern China. These logistical bottlenecks increase the appeal, coupled with rising wages and production costs, increase the price competitiveness of imported coal and should encourage Chinese companies to acquire international coal assets aggressively.

In November 2011, the National Development and Reform Commission also instituted a ceiling on coal prices in an effort to limit losses related to rising coal prices and regulated electricity prices. Previous efforts of this nature, which address the domestic market and fail to account for global supply and demand factor, have failed; we expect this latest attempt to suffer the same fate.

In short, we remain bullish on China’s long-term demand for seaborne thermal coal. The country’s electricity consumption increased by more than 10 percent annually in 2011, and China is expected to build 250 gigawatts worth of new coal-fired generation capacity between 2011 and 2015. Imported coal from Australia will be a big part of this story.

Meanwhile, Indian demand for thermal coal will likely outstrip Chinese demand over the next decade. Domestic coal production has lagged the growth targets laid out by India’s Planning Commission in the current five-year economic plan. Much of this shortfall reflects the operational difficulties facing Coal India, which produces 78 percent of the nation’s domestic coal supply, and has struggled to ramp up production. Some of these challenges relate to difficulties obtaining mining permits and acquiring land in the densely populated nation.

All of this adds up to a massive supply shortfall that must be offset by expensive imports, primarily from Australia and Indonesia. In the fiscal year ending March 31, 2012, the gap between domestic supply and demand should reach 142 million metric tons and will only continue to expand.

Investors have expressed concerns about China’s demand for seaborne metallurgical (met) coal, the varietal used in steel production. The markets continue to worry that weaker economic growth an industrial production in China and other emerging markets will weigh on met coal prices. Although China’s steel production has tailed off slightly in recent months, we expect industrial production–and demand for imported met coal–to remain relatively strong.

The long-term supply and demand picture for met coal is even more bullish. Peabody Energy estimates that urbanization in China, India and other Asian emerging markets will lead drive global demand for met coal roughly 5 percent higher each year.

Global coal demand is in the midst of a super cycle that should last for some time, which explains why international operators have been quick to snap up Australian companies with the potential to grow their output of met coal. In 2011 Peabody Energy forked over USD4.9 billion to acquire MacArthur Coal and Yanzhou Coal Mining (Hong Kong: 1171, NYSE: YZC) spent USD2.1 billion to take over Gloucester Coal. That foreign investors are willing to snap up these assets despite the high value of the Australian dollar underscores the magnitude of the long-term growth opportunity.

Deal flow over the past several years has thinned the ranks of Australia’s midsize coal producers. Rumors of an impending takeover swirled around Whitehaven Coal (ASX: WHC) in late 2010, but the interested parties failed to produce a bid that met management’s price target. In December 2011, the company sweetened the pot for a potential acquirer, announcing a merger with Aston Resources (ASX: AZT).

If the deal goes through, the company would become Australia’s largest pure-play coal company and would have the potential to transform its current combined production mix of 78 percent thermal coal and 22 percent met coal to 40 percent thermal coal and 60 percent met coal. The proposed deal would give Aston Resources the necessary cash flow to develop its world-class Maules Creek asset. However, whether the company meets its production targets will hinge on the construction of a fourth terminal at Port Waratah, a project that could face delays. Whitehaven Coal rates a buy under AUD6.