There are varying opinions on the outlook for thermal coal. Whether one is an optimist or a pessimist – or somewhere in between – the reality is that life is set to get even tougher for coal producers.
One school of thought is that changing environmental attitudes combined with stricter environmental legislation, will lead to further swift and terminal damage to coal’s reputation as an appropriate 21st Century energy source.
Another view argues that thermal coal will remain an essential component in the energy mix of many countries (particularly emerging ones). There’s logic behind both arguments.
Coal is without doubt becoming less acceptable within the construct of modern Western world economies and this will inevitably impact upon demand – but at the same time thermal coal demand will likely continue to increase over the near-to-medium term, as a result of population growth and corresponding energy demand escalation in emerging economies.
The key issue however is that life is set to become increasingly more difficult for the companies that actually mine and produce thermal coal, irrespective of the overall demand outlook. This means that investors, for a range of reasons, are most likely going to be less inclined to invest in thermal coal producers.
Thermal coal plays are under all sorts of pressure from superannuation funds and other key investor groups to reduce, or ditch altogether, their coal-related activities. Companies are experiencing a rush of major ethical investors heading for the exits, which in turn has compounded the relatively poor share price performance of coal plays generally as a result of weak prices and soft demand.
Europe’s largest insurer, Allianz, this past week joined a growing number of institutional investors like California’s pension funds and Norway’s sovereign wealth fund, to sell off coal investments.
Companies are also finding it increasingly difficult to source bank financing for new coal projects, with many financial institutions subjected to growing shareholder pressure in this regard.
Coal producers are also under growing pressure from competing primary interests, most particularly the farming industry, in a battle over environmental credentials and the sharing of natural resources such as water – which in turn has also attracted the support of environmental groups and in many instances governments. In fact governments are typically viewing coal mining as potential vote-losers.
Even the most open-minded and objective of investors are therefore hard-pressed to view investment in a coal company as a prudent investment choice. Irrespective of the underlying level of thermal coal demand, the plummeting levels of acceptance amongst larger investment funds, the growing headwinds in terms of securing project funding and the almost nightly barrage of negative news stories directed against the sector – investors will seek to identify ‘easier’ opportunities where they can invest their funds. For all of these reasons, thermal coal companies that manage to generate robust earnings will find that business achievements alone won’t be properly valued or appropriately reflected in their share prices. This in turn will provide further disincentives for potential investors with respect to the sector.
This represents the biggest issue facing thermal companies – their product may well have a rosy medium-term outlook – however they will be faced with headwinds from almost every direction as they look to maintain and expand their business activities.
An interesting example is that of mining heavyweight, Rio Tinto. As a Bloomberg article this past week highlighted, “Rio Tinto and coal used to have such a bright future together.”
Back in 2008, Rio’s 13 open-pit thermal coal mines produced a total of around 153 million metric tons of thermal coal, with its energy division (which also includes two uranium mines) accounted for $2.6 billion of net income, or around 22% of the group total.
Since then Rio’s energy unit has sold or shuttered eight coal mines, but still recorded a $210 million net loss last year. Private-equity firm X2 Resources is in talks about buying three of the five mines that remain – and if those sales go ahead, one of the world’s biggest thermal coal producers will have been reduced to shipping out a few hundred thousand tons a year as a by-product from two mines that mainly produce coking coal.
As Bloomberg journalist Matthew Brooker points out, “The confusing thing for coal is that Rio Tinto’s management keeps saying such nice things.”
“Coal demand is not going to disappear," the company’s copper and coal boss, Jean-Sébastien Jacques, told a Bloomberg Address in Sydney last week, pointing to the growing energy needs of China, India, and Southeast Asia. “Our assets are absolutely world class." However he also later added, “Today I’ve got better options than to spend money on coal.” At the same time Rio is also trying to offload most of its thermal coal assets.
Rio this year dismantled its energy division, responsible for coal and uranium assets, in a restructuring seen by some as signaling a potential exit from coal.
Making the situation even more topical is the fact that more than 130 world leaders have gathered this week at a United Nations conference in Paris to open negotiations on a new climate change deal intended to limit warming to 2 degrees Celsius.
Thermal coal is currently used to generate around 40% of the world’s electricity. However, the aggregate hides a distinct shift away from coal in a number of advanced economies. Over the past decade this has been more than offset by a sharp rise in coal usage from China.
Coal-fired power generation fell within the United States and the Euro-Zone over the past decade, reflecting a move towards cleaner energy sources and a more competitive gas sector. Australia remains dependent on coal-fired electricity generation, but we too have diversified our energy demand and supply over the past decade.
The major turning point for the coal market though sits with China, which has signaled a clear shift towards cleaner energy sources.
As part of its 12th Five Year Plan, “the Chinese Government announced plans to reduce energy use per unit of GDP by 16% from its 2010 levels by 2015, and reduce coal’s share of energy consumption from 68% to 65%”. More recently, the National Development and Reform Committee announced bans on coal that does not meet certain ash and sulphur content requirements.
Based on the need to address and adapt to climate change (and assuming that Chinese authorities achieve their goal), the coal sector may be on borrowed time as a viable energy source. At the very least, the coal market will be a very different beast ten years from now.
Where it gets ugly for thermal coal producers is that the world has turned against coal at the same time that new production has come online. Coal production skyrocketed in response to elevated commodity prices, with some projects justified on the faulty assumption that Chinese demand would continue to grow at existing rates indefinitely.
It reflects the risks associated with new mining projects. The significant lag between project approval and completion means that miners are often dealing with a very different set of circumstances by the time they are ready to begin operation.
Unfortunately at current prices, “a significant share of seaborne coal supply is unlikely to recoup its costs of production”. Unlike iron ore, Australian coal miners are not among the lowest cost producers — though a weaker Australian dollar is certainly helping — which points to considerable consolidation or even bankruptcy within the sector over the next few years.
So the bottom-line is that irrespective of whether you are a climate change believer or skeptic, life generally is inevitably to get even tougher for thermal coal producers. Given the challenges that are appearing from all quarters, there will inevitably be an ongoing negative impact with respect to investor appetite for coal plays. This is likely to lead to investors looking elsewhere within the resource sector for opportunities.
