Theopening comments by CEO Greg Boyce on Peabody Energy’s (BTU)July 20thconference call were enlightening. In addition to making acompellingcase for continued strong demand for met and thermal coal, healsosignaled, (at least to me) that Mongolia’s coal exports from TavanTolgoiwill disappoint over the next several years. However, what’s badforcoal supply is good for coal prices. Companies poised to benefitfrom thecoming coal shortage will be excellent long-term investments.Aneasyyet powerful way to get exposure to what Boyce calls thecoalsuper-cycle is to buy KOL. KOL is an ETF that has coal companies aswellas mining equipment makers. KOL is especially exciting because ithas agood mix of foreign coal-related companies. Boyce said,
Theworld remains in the early stages of a long period of majordemand growthand so-called one-time events in the industry thatconstrain supply nowoccur each quarter. Global coal demand remainsrobust. World steelproduction is up 8% year-to-date. Globally, theworld will use anadditional 70mm to 80mm tons of metallurgical coalthis year. Electricitygeneration is rising rapidly in developingcountries and coal isbackfilling for nuclear power in Europe.
The consumption of anadditional 70mm-80mm tons of met coal this yearis a very significantamount. The entire global seaborne met market isjust 250mm tons. Chinaproduces and consumes domestically about 550mmtons and will probablyimport 40mm tons of met coal over this year. AsJapan bounces back, Indiagrows to become the biggest importer of metcoal and Brazil begins toramp up for both an Olympics and a World Cup,2012’s incremental met coalconsumption could top 100mm tons. Boycecontinued,
China remains acornerstone of growth. First-half GDP grew 9.6%.Electricity generationincreased 14% and steel output was up 10%. Lastquarter, there wasconcern over an easing of China imports, yet importshave now risen forthe past four months and we believe we’re on a pacefor a stronger secondhalf.
There are several factors supporting Boyce’s thesis ofsteady tostronger growth in the 2nd half. First, headline inflation mayhavepeaked, allowing the government to ease its tightening stance.Second,the frequently cited build out of 10mm social housing units ispickingup steam in the second half. Third, China is in year 1 of its12th5-year plan. The first 2 years of a 5-year plan typically seeshigherexpenditures than the last 3 years.
India is now the world’sfastest growing importer. Their thermal coalimports are up 45%year-to-date. Europe’s thermal coal imports areincreasing as Germanycloses its nuclear plants and coal displaceshigh-priced gas. And,escalating demand growth continues to strainglobal supplies to the pointwhere any external events take on magnifiedimportance; labor stoppages,rains, permitting challenges andtransportation issues are common.
Indiais in big trouble. The Indian government under-estimatedthermal coaldemand by expecting non-coal energy sources like gas andnuclear to rampup quicker than they have. On the supply side, thegovernment allocated asignificant number coal exploration blocks, manyof which they thoughtwould be in production of coal by now. However,government red tape andenvironmental challenges have delayed this badlyneeded new supply. Whencoal prices rise rapidly and there’s little tono domestic supplyresponse, that’s proof of a problem that can’t befixed quickly. The onlyanswer is more imports.
I’m surprised that more has not beenwritten about Boyce’s importantobservation that coal in Europe isdisplacing high-priced natural gas.Combined with Germany’s closing ofits nuclear plants and Japan’sthermal coal demand bouncing back nextyear, this is extremely bullishfor thermal coal pricing. Boyce has beenpitching his coal super-cycletheme for some time now. Fundamentals haveonly gotten tighter.
Strong near-term fundamentals have keptinternational pricing nearrecord levels for both met and thermalproducts, with recent settlementscoming in higher than most expected.Longer-term the world could needmore than 500mm tons of additional metcoal per year by 2020 and some700 gigawatts of new coal-firedelectricity generation is expected to beonline by 2020, requiring wellover 2 billion tons of additionalthermal coal. Just consider this:China’s 12th 5-year plan targets $100billion in investments ingeneration, transmission and subwayconstruction activities by 2015.
Twobillion tons of additional thermal coal supply by 2020? Thatequates totwice the current coal consumption of the U.S. As dominantthermal coalexporting nations like Indonesia and South Africa requireincreasingamounts of coal to be consumed domestically, where will theworld find anadditional two billion new tons?
With regard to Peabody’srecently announced win of a coveted spot onMongolia’s Tavan Tolgoisynchronized mining team, Boyce answered ananalyst question as follows:
It’spremature for us to get into much detail on those projects, but Ithinkas we’re looking at them now, as they begin to develop, you’retalkingabout a development horizon that would probably take us 24 to 36monthsand then begin to start to build the mine out, and probably onboth ofthose fronts in a three to five-year window before you see coalcomingout and so that’s at the highest level.
Wow! My read – 2-3 yearsto develop BEFORE they start to build themine. And that’s not 2-3 yearsfrom today, but 2-3 years from whenparliament signs off on the project,which could still be a long wayoff. The Koreans and Japanese arecontesting the whole process asunclear and unfair. Let’s say that theclock starts ticking on 1/1/2012.Next, Peabody will have to complete aproject development plan thatwill be unprecedented in its complexity.Peabody needs to reachconsensus among a Russian railroad (the Russiangovernment), a Chinesecoal producer (the Chinese government, Mongolianinterests (theMongolian government) AND the Mongolian people who willdirectly ownshares in the project.
More likely, it will take 3-4years of development / consensusbuilding. That would take us until2015-16 before Tavan Tolgoi is inmeaningful production, and 2016-17before the project reaches 15mm tonsof coal production, of which Peabodywill control 3.6mm.
We have a number of partners with China withthe Russian railroad andas well as the government of Mongolia. But we’refairly confident that,at a 15mm ton a year level, the Cap-ex will comein at a number that’sconsistent with what we would see in a normalsurface mine that we wouldbe building.
Even after the logisticalnightmare of rail lines, bridges, roads,power plants, mining camps,schools, hospitals and air strips isresolved, at considerable expensefor all involved, the costs ofdelivering the coal to the end user willensure that margins will bemerely mediocre. My guess is that thisproject will be an epic waste oftime and financial resources. Worse yet,the labor, equipment,contractors and consultants that will be tied upin this mess will belargely unavailable to help other emerging Mongoliancoal producers. Iam convinced that Mongolian exports of met coal willdisappoint over thenext several years.
If my thesis on Mongolia iscorrect, then these statements from theCEO of Peabody lead to theinescapable conclusion that coal prices willstay stronger for longer. Torecap, India’s coal demand is higher thanexpected and its domesticsupply lower. Germany is phasing out nukes andcoal and natural gas willhave to fill in the gap. Japan’s coal demandis rebounding and will pickup pace next year. Brazil has to buildinfrastructure, stadiums andhousing for an Olympic Games and a WorldCup. Natural gas prices inEurope are rising, enabling lower cost coalto be used. The world needsMongolia to be producing 50mm tonnes ofcoking coal in 5 years, it won’tbe, and export growth from South Africaand Indonesia will be anemic dueto domestic needs for the coal.
Yet, the story doesn’t end here.Although Boyce raised crucialissues, other factors coming into play alsosuggest that global coalsupply will fall short. China’s coal reservesare not nearly as large asmany suspect. I calculate that by 2016 Chinamay only be able to counton 14 years of remaining coal, see here.
Inaddition, It appears that hopes of alternative energy saving thedayhave been diminished by the recent setback in nuclear energy duetoJapan’s terrible earthquake. Elsewhere, In other countries, theplanningand building of new facilities will be materially delayed andsome willbe canceled. And, new studies pose serious questions about windpower’sability to adequately replace base load coal-firedelectricity.Finally, Jim Chanos is famously shorting all things wind andsolar. Hebelieves that neither are economically viable withoutsubsidies. Thestock prices of many of these companies have been crushedand raisingcapital in these industries just got a lot harder.
Consideringwhat Boyce said and contemplating these additionalfactors, the questionmay not be if coal prices will remain at or abovecurrent levels, buthow high might they go and how soon will the worldrealize high pricesare here to stay. Investing in coal company stocksbefore this scenariobecomes conventional wisdom could make for anexcellent long terminvestment. The best way to get invested in a widerange of companiesthat will benefit from the global demand for coaloutstrippingincremental supply is to buy KOL.