Credit rating agencies, often thought of as experts, disagree about the risks of investing in coal ports
The coal industry has gone through some tough times in the last 12 months with coal prices remaining heavily subdued, massive job losses, investments put on hold, much lower company share prices and the latest blow to the sector, declining credit ratings on some companies and their bonds.
Pre-Easter, credit rating agency, Moody’s announced credit rating downgrades on two Australian coal port businesses: Adani Abbott Point and Dalrymple Bay Coal Terminal. Newcastle Coal was also in the firing line but Moody’s have deferred its decision pending the outcome of an internal capital structure review.
Moody’s cut the Adani and Dalrymple Bay credit ratings by two notches with the view the current market is in structural decline as opposed to a cyclical low, moving them from investment grade to non-investment grade.
Standard and Poor’s, the other major credit rating agency, seemingly has an opposing view with stable investment grade credit ratings on both ports which were last reviewed mid-2015.
The divergent views present a predicament for investors. Is the industry fundamentally and permanently weaker, supporting the lower ratings? Or, is it a cyclical blip, offering higher returns on assets that are expected to perform over the long term?
Mining coal has become an emotive issue and while we may not like what it does to the environment, there remains significant global demand for Australian coal. Surprisingly, Japan is Australia’s largest coal export market taking 31 per cent of production, with China 24 per cent and India 12 per cent. Despite a stagnating global coal market, Australia could extend its market share in export coal because its product is seen as high quality.
What is rarely discussed is that there are two types of coal: thermal used in the production of electricity, and metallurgical in the production of steel. You could say that Australia has some of the ‘most efficient’ coal in the global market, which will mean there will be an underlying demand for Australian coal so long as coal remains a source of power generation and remains a key ingredient in steel.
Coal ports are expensive long term infrastructure. In order for investors to outlay large initial sums there are inherent protections for them in the way the ports are set up. For example, contracts for use span years and are on a “take or pay” basis meaning miners contract and pay for defined capacity, no matter what they ship through the port, thus protecting against lower volumes.
The combined contracts of all the miners that use the port are socialised, meaning if one counterparty were to default, payments to the port by other counterparties would need to step up in proportion to recoup lost revenues. As long as the cost of the defaulting counterparty is socialised, the terminal cashflows are made whole after a reset adjustment.
Investors in coal ports should take a collective view of all counterparties to the port, making it less likely a single default could deliver a fatal blow to the port.
This is the heart of the argument. How many miners are likely to default and can the remaining miners step up and fill the void? Further, can the port successfully renegotiate contracts when they expire?
US miner, Peabody Energy recently failed to make interest payments on two of its bonds, a worrying sign. Peabody ships coal through all three ports: Adani where shipments constitute 6 per cent of total volumes, Dalrymple Bay which has the largest exposure at 25 per cent of volumes and Newcastle Coal with 14 per cent.
There are many issues to consider when assessing investment in coal ports. The contracts are key. There are protections for bondholders that may mitigate some of the risks. For example Dalyrmple Bay bonds have a type of credit insurance against default making them lower risk that Adani and Newcastle Coal.
For some institutional investors, investments must be rated investment grade by all credit rating agencies – any sub investment grade rating may mean they are forced sellers, pushing prices down. But, for those investors without that restraint and with a long term “survival” view of the sector, higher returns now available may be attractive.
Yield to maturity on the bonds range from 6 per cent per annum for Dalrymple Bay bonds maturing in 2021 to 11.5 per cent per annum for US dollar Newcastle Coal bonds with a first call in 2027. Adani bonds maturing in 2018 and 2020 range from 8.4 to 8.9 per cent per annum.
Prices quoted are accurate as at 31 March 2016