Coal to be in short supplyFrom the CMK board:
The opening comments by CEO Greg Boyce on Peabody Energy’s (BTU) July 20th conference call were enlightening.
Inaddition to making a compelling case for continued strong demand formet and thermal coal, he also signaled, (at least to me) that Mongolia’scoal exports from Tavan Tolgoi will disappoint over the next severalyears. However, what’s bad for coal supply is good for coal prices.Companies poised to benefit from the coming coal shortage will beexcellent long-term investments.
An easy yet powerful way to get exposure to what Boyce calls the coal super-cycle is to buy KOL.KOL is an ETF that has coal companies as well as mining equipmentmakers. KOL is especially exciting because it has a good mix of foreigncoal-related companies. Boyce said,
Theworld remains in the early stages of a long period of major demandgrowth and so-called one-time events in the industry that constrainsupply now occur each quarter.Global coal demand remains robust. World steel production is up 8% year-to-date. Globally, the world will use an additional 70mm to 80mm tons of metallurgical coal this year. Electricity generation is rising rapidly in developing countries and coal is backfilling for nuclear power in Europe.
The consumption of an additional 70mm-80mm tons of met coal this year is a very significant amount.The entire global seaborne met market is just 250mm tons.Chinaproduces and consumes domestically about 550mm tons and will probablyimport 40mm tons of met coal over this year. As Japan bounces back,India grows to become the biggest importer of met coal and Brazil beginsto ramp up for both an Olympics and a World Cup, 2012’s incremental metcoal consumption could top 100mm tons. Boyce continued,
Chinaremains a cornerstone of growth. First-half GDP grew 9.6%. Electricitygeneration increased 14% and steel output was up 10%. Last quarter, there was concern over an easing of China imports, yet imports have now risen for the past four months and we believe we're on a pace for a stronger second half.
There are several factors supporting Boyce's thesis of steady to stronger growth in the 2nd half.First,headline inflation may have peaked, allowing the government to ease itstightening stance. Second, the frequently cited build out of 10mmsocial housing units is picking up steam in the second half. Third,China is in year 1 of its 12th 5-year plan. The first 2 years of a5-year plan typically sees higher expenditures than the last 3 years.
India is now the world's fastest growing importer. Their thermal coal imports are up 45% year-to-date. Europe’s thermal coal imports are increasing as Germany closes its nuclear plants and coal displaces high-priced gas. And, escalatingdemand growth continues to strain global supplies to the point whereany external events take on magnified importance; labor stoppages,rains, permitting challenges and transportation issues are common.
India is in big trouble.TheIndian government under-estimated thermal coal demand by expectingnon-coal energy sources like gas and nuclear to ramp up quicker thanthey have.On the supply side, the government allocated asignificant number coal exploration blocks, many of which they thoughtwould be in production of coal by now.However, government red tape and environmental challenges have delayed this badly needed new supply.Whencoal prices rise rapidly and there’s little to no domestic supplyresponse, that’s proof of a problem that can’t be fixed quickly.The only answer is more imports.
I’msurprised that more has not been written about Boyce’s importantobservation that coal in Europe is displacing high-priced natural gas.Combinedwith Germany's closing of its nuclear plants and Japan’s thermal coaldemand bouncing back next year, this is extremely bullish for thermalcoal pricing.Boyce has been pitching his coal super-cycle theme for some time now.Fundamentals have only gotten tighter.
Strongnear-term fundamentals have kept international pricing near recordlevels for both met and thermal products, with recent settlements comingin higher than most expected. Longer-term the world couldneed more than 500mm tons of additional met coal per year by 2020 andsome 700 gigawatts of new coal-fired electricity generation is expectedto be online by 2020, requiring well over 2 billion tons of additionalthermal coal. Just consider this: China's 12th 5-year plantargets $100 billion in investments in generation, transmission andsubway construction activities by 2015.
Two billion tons of additional thermal coal supply by 2020?That equates to twice the current coal consumption of the U.S.Asdominant thermal coal exporting nations like Indonesia and South Africarequire increasing amounts of coal to be consumed domestically, wherewill the world find an additional two billion new tons?
Withregard to Peabody's recently announced win of a coveted spot onMongolia's Tavan Tolgoi synchronized mining team, Boyce answered ananalyst question as follows:
It'spremature for us to get into much detail on those projects, but I thinkas we're looking at them now, as they begin to develop, you're talkingabout a development horizon that would probably take us 24 to 36 monthsand then begin to start to build the mine out, and probably on both ofthose fronts in a three to five-year window before you see coal comingout and so that's at the highest level.
Wow!My read - 2-3 years to develop BEFORE they start to build the mine.Andthat’s not 2-3 years from today, but 2-3 years from when parliamentsigns off on the project, which could still be a long way off.The Koreans and Japanese are contesting the whole process as unclear and unfair. Let’s say that the clock starts ticking on 1/1/2012.Next,Peabody will have to complete a project development plan that will beunprecedented in its complexity. Peabody needs to reach consensus amonga Russian railroad (the Russian government), a Chinese coal producer(the Chinese government, Mongolian interests (the Mongolian government)AND the Mongolian people who will directly own shares in the project.
More likely, it will take 3-4 years of development / consensus building.Thatwould take us until 2015-16 before Tavan Tolgoi is in meaningfulproduction, and 2016-17 before the project reaches 15mm tons of coalproduction, of which Peabody will control 3.6mm.
Wehave a number of partners with China with the Russian railroad and aswell as the government of Mongolia. But we're fairly confident that, at a15mm ton a year level, the Cap-ex will come in at a number that'sconsistent with what we would see in a normal surface mine that we wouldbe building.
Even after thelogistical nightmare of rail lines, bridges, roads, power plants, miningcamps, schools, hospitals and air strips is resolved, at considerableexpense for all involved, the costs of delivering the coal to the enduser will ensure that margins will be merely mediocre.My guess is that this project will be an epic waste of time and financial resources. Worseyet, the labor, equipment, contractors and consultants that will betied up in this mess will be largely unavailable to help other emergingMongolian coal producers.I am convinced that Mongolian exports of met coal will disappoint over the next several years.
Ifmy thesis on Mongolia is correct, then these statements from the CEO ofPeabody lead to the inescapable conclusion that coal prices will staystronger for longer. To recap, India's coal demand is higher thanexpected and its domestic supply lower. Germany is phasing out nukesand coal and natural gas will have to fill in the gap. Japan's coaldemand is rebounding and will pick up pace next year. Brazil has tobuild infrastructure, stadiums and housing for an Olympic Games and aWorld Cup. Natural gas prices in Europe are rising, enabling lower costcoal to be used. The world needs Mongolia to be producing 50mm tonnesof coking coal in 5 years, it won't be, and export growth from SouthAfrica and Indonesia will be anemic due to domestic needs for the coal.
Yet,the story doesn't end here. Although Boyce raised crucial issues, otherfactors coming into play also suggest that global coal supply will fallshort. China's coal reserves are not nearly as large as many suspect.I calculate that by 2016 China may only be able to count on 14 years ofremaining coal, see here.
Inaddition, It appears that hopes of alternative energy saving the dayhave been diminished by the recent setback in nuclear energy due toJapan's terrible earthquake. Elsewhere, In other countries, theplanning and building of new facilities will be materially delayed andsome will be canceled. And, new studies pose serious questions aboutwind power's ability to adequately replace base load coal-firedelectricity. Finally, Jim Chanos is famously shorting all things windand solar. He believes that neither are economically viable withoutsubsidies. The stock prices of many of these companies have beencrushed and raising capital in these industries just got a lot harder.
Consideringwhat Boyce said and contemplating these additional factors, thequestion may not be if coal prices will remain at or above currentlevels, but how high might they go and how soon will the world realizehigh prices are here to stay. Investing in coal company stocks beforethis scenario becomes conventional wisdom could make for an excellentlong term investment. The best way to get invested in a wide range ofcompanies that will benefit from the global demand for coal outstrippingincremental supply is to buy KOL.
Disclosure: I am long SGQRF.PK, CLNMF.PK.