Is coal the new gold? (February 08, 2008)

UBS and Citigroup have raised their price forecasts for thermal and coking coal for the coming two years and it’s not just because of the disruptive floods washing across Queensland or the power crises gripping China and South Africa.

A potent cocktail of cost increases, infrastructure constraints, hefty margins, sharply increasing exchange rates in producing countries, and unflagging demand from Asia will all contribute to keeping prices higher for the forseeable future, the banks report.

The tightness in the thermal coal market will only ease after 2010 as port and rail bottlenecks in Australia are removed, Citigroup says. And for coking coal, the sources of supply “are much more difficult to identify” so prices “are expected to remain higher for longer.”

In its research note to clients on Feb. 5, Citigroup Global Markets said it believes annual contract prices for thermal and coking coal will roughly double in the current round of negotiations. Prices for thermal coal are expected to reach US$100 per ton, up from $55 per ton, while coking coal will likely jump to US$200 per ton, up from $95 per ton, Citi says.

UBS Investment Research has also raised its price forecasts, explaining that global supply conditions began deteriorating during 2007. “Over the past year, supply growth globally has been limited by several structural factors including cost inflation, labor/equipment availability constraints, and deteriorating resource quality,” it wrote in a Jan. 31 research report.

“However it is becoming increasingly evident that infrastructure bottlenecks, particularly in China (rail/truck and shipping) and Australia (rail/port) are playing a key role in preventing or delaying coal from getting to the consumer. Additionally, recent severe weather in key regions has further threatened supply,” it explained.

UBS estimates prices for seaborne thermal coal in 2008 and 2009 will rise to US$100 per ton and $125 per ton, respectively, up from US$90 per ton and US$105 per ton. The bank is also upping its forecast for coking coal to US$170 per ton and US$165 per ton, a sharp increase from US$145 per ton and US$135 ton.

One of the biggest drivers behind rising prices for thermal coal is rising demand from China and India, which depend on coal-fired electricity generating capacity to power their growth.

According to Citi, India’s 11th long-term economic development plan includes building 78.5 GW of new electricity generating capacity by 2012, of which 40 MW will be coal based. And six of the ten planned 4GW “ultra-mega” power plants that are on the drawing board to be built by the private sector, will use imported coal.

The current energy crisis in half of China’s provinces has also forced the central government in Beijing to ban coal exports until March turning the economic powerhouse into a net importer of coal rather than a coal exporter at least for the time being. (More than three quarters ot the country’s electricity generating capacity is coal fired.)

The energy crisis in South Africa is also playing havoc on coal availability. The impact on thermal coal is two-fold: disruptions to production and the redirection of coal from export to domestic consumption.

Other factors influencing thermal coal prices include port and rail constraints in Australia and similar problems in South Africa. The port of Richards Bay, for example, is being expanded from 72 to 91 million tons. But the rail network will have a hard time delivering the additional coal to the port. The current energy crisis in South Africa, it adds, “has longer term implications.”

Indonesia also has a major role to play in determining thermal coal prices. With coal exports down from Australia, South Africa and China, Indonesia is now the world’s largest exporter of thermal coal.

The country’s coal resources are vast, but only 14% of it has a calorific value of more than 6100 kcal. And much of Indonesia’s high calorific value (6700 kcal) coal production from its current operations is committed under contracts, Citi writes, “and there are limited options to produce more.”

In addition, while the coal is generally low in sulphur and ash and therefore good for blending purposes, it has a high moisture content which makes it more costly to transport more susceptible to spontaneous combustion. “Nearly all future growth of Indonesian coal production will be of sub-bituminous coals with a calorific value of around 5800 kcal,” Citi writes.

Looking even further ahead, another important source of future growth will be coal-to-liquids technologies.

On the coking coal side, Citi says the outlook will be determined by a combination of port and rail bottlenecks in Australia; new projects in Canada that will add about 5 million tons to the market; and demand from India, which is expected to double during the forecast period. (UBS notes in its report, quoting industry sources, that several Indian companies have paid more than US$200 per ton fob for some limited quantities of Chinese coking coal recently.)

Japan’s imports of coking coal are also expected to grow as its steel consumption increases. Currently Japan is the largest importer of seaborne coking coal.

And of course there’s the fluctuating U.S. currency. Citi points out that a weak US dollar will result in higher prices: “In 2008/2009 contract price negotiations, producers will be determined to ensure that USD prices agreed compensate for these disparities and insulate against further USD weakness.

Given that high-quality coking coal is “a rare geological commodity,” Citi adds, production costs will continue to rise. “The coking coal market is set to remain chronically tight because of supply shortages and strong demand from India and China,” Citi says. “Additional supply might be available from Indonesia, Mozambique and Mongolia, but only at high costs and with protracted delays.”

The impact of higher coking coal prices on steel producers will be enormous. “If the price of coking coal doubles and iron ore prices increase by 60% as we expect,” Citi reports, “steel prices will have to increase by about 16% if margins are to be maintained.”