The short term outlook for the coal market is for some softening but it is important to distinguish between the various coal categories. In the lead up to annual price settlements last year, analysts continually upgraded coal price forecasts. Coal company share prices moved similarly upwards. The market this year looks different with forecasts for next year if anything moving down. Production issues and development delays for some of the coal miners have added to earnings forecast pressure and negative sentiment. We believe the long term China demand story is intact and the recent share price pullback enhances long term value. That said, there may be further short term share price turbulence.
In the past month or so, market expectations have pulled back from stable thermal and coking coal prices to an approximate 8% decline in the premium coking coal - as exported by BHP and RIO - price to US$115/t and a 10% drop in the thermal price to US$47/t. Persistent lower spot thermal coal prices around US$40/t have a few investors and commentators spooked, as have reports of Xstrata settling contracts for next year at US$40/t. The majority of Australian export thermal coal is traded under term contracts with prices negotiated annually. Spot thermal coal is more thinly traded. Sales of inferior quality coal, which would ordinarily attract a discount, have potentially distorted the real spot price. Recent premium coking coal contracts have settled around US$120/t compared to the current benchmark of US$125/t indicating supply and demand are close to balance.
The story for intermediate grade coking coals looks worst. Last year tight premium hard coking coal supply saw buyers scramble into lesser grade coking coals. The supply/demand balance remains tight but quality hard coking coal is more readily available. Market watchers are concerned growing Chinese coke and steel inventories will give buyers the upper hand in negotiations for prices from April 2006. Coal producers question if the Chinese are simply playing games. High blast furnace utilisation among steel makers also dictates a preference for higher grade coking coals to maximise productivity. As a result, we expect a 25% drop in the price of semi soft coking coal from April 2006 to US$60/t and a 21% fall in the price of Pulverised Coal Injection (PCI) coal to US$75/t. PCI coal is used as a cost saving substitute for coking coal. Our previous forecasts were for falls of 11% and 12% respectively.
The Players
YMW covers the main ASX200 listed Australian coal producers: entennial Coal (CEY), Macarthur Coal (MCC) and Excel Coal (EXL). A major point of difference between the three is the source of production, open cut versus underground. Opencuts are generally more reliable but potentially exposed to cost pressures as diesel is a major input. Almost all of CEY's production comes from underground mines. The balance will shift towards opencut late in the decade with the new Anvil Hill mine to provide roughly 30% of production. EXL has a production balance of roughly 35% underground and 65% opencut. The underground proportion is set to decrease with new underground output at Wambo to be offset by the Wambo opencut expansion and new surface mines at Cosila, Wilpinjong and Millennium. MCC's production is exclusively opencut but the future mix is expected to include some underground mines. Over the next five years, MCC aims to develop five new mines with up to three being underground.
The main products are export coking and export thermal coal and domestic thermal coal. Domestic thermal coal can almost be considered an annuity revenue stream with contracts often over 10 years duration at a fixed price plus inflation. Australian export coking coal is generally sought after due to its high quality and producers enjoy a competitive advantage. Prices are subject to the vagaries of steel market production, which has been strong in the recent past due to China. Thermal coal is plentiful globally and export producers compete on unit costs.
CEY's marketing strategy revolves around balancing domestic thermal coal with export thermal and coking coal. Approximately 50% of CEY's revenue comes from the domestic thermal business with the remainder fairly evenly split between export thermal and coking coal. The proportion of revenue from the domestic business should stay relatively stable. The export balance should swing from coking to thermal coal as coking coal prices revert to the long term average and Anvil Hill boosts the thermal output line later in the decade.
EXL has the greatest product diversity of the group but is almost entirely focused on the export market. Approximately 40% of sales revenue comes from export thermal coal, 40% from export coking coal. The remaining 20% includes pulverised coal injection (PCI), semi soft coking, domestic thermal coal and coke. Domestic thermal coal contribution will rise to 20 - 25% of revenue with the development of Wilpinjong. Export coking coal is expected to decline to 20 - 25% of revenue as prices revert to the long term average while export thermal coal should stay fairly stable around 35%.
MCC has the least product diversity with nearly all revenue coming from PCI coal. Thermal coal contributes roughly 10% of revenue. The company has some flexibility to switch production from PCI to thermal coal and coking coal as market conditions dictate. MCC is expected to continue to focus on the high margin coking coal and PCI segment of the market. The company is also investigating the feasibility of a 3.2Mtpa coke making plant with first production in late 2007.
CEY is probably best placed to capitalise on any short term additional exports from an infrastructure point of view, although recent production events suggest otherwise. Approximately 80% of its export coal is shipped through Port Kembla, which has excess capacity. The remainder is exported though Port Waratah in Newcastle which has improved its performance throughout the year. EXL has the greatest port diversification, exporting through Port Kembla and Newcastle with new production to go through Dalrymple Bay and Venezuela.
In the short term, MCC's expansion plans are constrained by infrastructure. It exports almost exclusively through Dalrymple Bay in Queensland. Higher cost exports through Abbot Point have mitigated the short term restriction but unit costs are under pressure as mines deepen and volumes cannot be grown to offset costs. Constraints are expected to ease by mid 2007 when Dalrymple Bay is expanded from 60Mtpa to 65 - 68Mtpa. A further expansion to 80 - 85Mtpa should be complete in 2H08. Future infrastructure risk is expected to be diversified by exports through Gladstone.
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