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Reproduced below is a recent article that Thomas Jacquot, our Head of Research, published as recent events affecting the Australian coal market were unfolding. To learn more about all the benefits of becoming a FIIG client, please call us on 1 800 01 01 81 or send us an enquiry.
Negative headlines are stockpiling for Australian coal
Summary
- In the space of a few days, global headlines have rocked the confidence in the Australian coal sector. This started late last week with reports that Chinese authorities had been lengthening the time taken to clear coal cargoes from Australia through customs, from an average of about 10 days to approximately 45 days.
- Then, on Wednesday, Glencore, one of the largest coal producers globally with significant operations in Australia, announced that it would cap future coal production at the FY19 level as a commitment to support the transition to a low-carbon economy.
- This string of negative news was capped off on Thursday by reports that ports in Liaoning province of China had implemented bans on import of Australian coal.
- Are we looking at the start of a potentially rapid decline in demand for Australian coal? We don’t believe this is the case.
Glencore Decision
- As part of its FY18 results release, Glencore, one of the largest global commodity producers, announced that it would cap its coal production at the level it will achieve in the current financial year. Glencore provided guidance of 145mt for FY19, or about 12% higher than FY18, which would generate EBITDA of about USD5.4bn.
- While the headline reason for the decision was Glencore’s desire to support a transition to a lower carbon economy, it is important to put the decision into context, and remember that Glencore has demonstrated over the years its ability to maximise value for its shareholders. In our mind, two aspects of the announcement are critical:
- The announcement of coal volume curtailment should not be construed as Glencore no longer making any investment in the sector. By picking FY19 volume as the base level, Glencore is capturing all the volume growth that is expected from its recent acquisitions and organic growth projects. Given the level of capital Glencore deployed in the coal sector in recent years, it would have been surprising to see Glencore spending a significant amount of additional capital in the near term. Hence, capping coal production volume at levels expected to be achieved in FY19 does not appear to be a significant sacrifice. It should also be noted that Glencore announced it would cap coal production but not investment. As existing coal mine reserves are depleting, the commitment on capped production will not stop investment in new mines in order to replenish those reserves and maintain production levels.
- Given its size in the coal sector, Glencore has a lot of influence on the ultimate coal price that end customers pay. The contracts that Glencore strikes with Japanese utilities for thermal coal from the Hunter Valley are widely viewed as a proxy for coal prices in Australia. By capping its production, Glencore is effectively announcing to the market and end users that, as demand grows (which we still believe will be the case for the foreseeable future), production may not necessarily grow in lock-step. It is important to remember that Rio Tinto, one of the other large global commodity conglomerates, has pulled out of the coal sector now, only leaving BHP as the remaining global scale competitor (and coal is not viewed as an area of growth and capital deployment for BHP). As such, supply increase will likely need to come from 2nd tier producers which will at best maintain the current supply / demand balance. What will this mean? Coal prices will remain at their current elevated levels. In other words, Glencore is protecting itself against the downside risk of falling coal prices.
- While the announcement was made in the context of Glencore’s desire to be a responsible global citizen, it is in no way being made to the detriment of the interest of its shareholders and one could argue this will create upside for the company in the near to medium term.
China Coal Import Restrictions
- In recent days, several news reports indicated that importing Australian coal into China had suddenly become a lot more challenging, with longer clearances and even outright ban in certain ports. Does this mean the end of the Australian coal industry? We believe this is still a very long way away.
- Let’s consider the ban of Australian coal import into the Liaoning province. While the headline is clearly worrying, the actual coal volume imported from Australia into the province is at about 6 to 8 mt. These are, in the context of the Australian coal industry, not material.
- A second important factor is somewhat the misconception that the vast majority of Australian coal is exported to China. That concentration risk exists in the iron ore sector but not in coal. Australia’s largest coal importer is actually Japan and China represents only about 20% of total volume. However, Australia is the largest importer into the Chinese market, representing about 3 times more than its closest competitor (Indonesia). The ability of others to replace Australian volumes appear challenging at best. And even if this was to happen, it would likely be through the redirection of existing volume from other countries, which then Australian coal could service. There would likely be an impact on the realised price for Australian coal producers but unlikely to be material and noting that both thermal and metallurgical prices are still currently at healthy levels and about double the low point experienced in 2016.
- We believe the current tension is driven more by political considerations than any other reasons, with Beijing sending a signal to Australia that it has the ability to disrupt one of Australia’s largest industries. Practically though, China has been pushing for greater focus and restrictions on environmental standards which make Australian coal a lot more attractive than other countries given its higher quality.
- Will the Australian coal sector suffer in the near term? It is likely that we will see some disruption and increased nervousness but, since we view this as a political issue, we believe the status quo will eventually be restored.
What does this mean for Australian coal export terminals?
- In the near term, absolutely nothing. It is important to remember that one of the key contractual strengths for Australian coal export terminals (such as Adani Abbot Point, NCIG or DBCT) is the take-or-pay contractual structure. Irrespective of coal volume actually exported, the coal export terminal companies will generate a fixed revenue. Hence, the current potential coal export disruption into China will not have any direct immediate impact.
- Could there be some longer term impacts? Once again, we don’t believe there are tangible material threats on the horizon. While it could be argued that declining Chinese demand for Australian coal (which we believe anyway will only be temporary) could result in certain customers not renewing their contracts with the relevant coal export terminals, we don’t believe this would occur in practice given our view that a long-term Chinese restriction would result in a reallocation of global seaborne export volumes across the countries that import coal. In any event, other than Glencore, Adani Abbot Point does not have any contract expiring until 2026. In NCIG’s case, the contracts are 10-year evergreen, hence very low risk of non-renewal.
Conclusion
- Overall, we believe that recent events, despite their headlines, are not posing a threat to the Australian coal industry. While there will be no doubt some near-term disruptions, we believe global demand fundamentals will continue to provide support to the sector.
- We also do not see any near term disruption to the coal export terminals, with cash flows remaining unaffected by the current events.