COAL IS HOT

The Ukraine war wasn't the only reason for this year's coal profit boom What happens when the war is over?

It has been only nine months since the Glasgow Climate Summit ended with a dispute over whether the signatories should agree to “phase down” rather than “phase out” coal-fired power. The weaker “phase down” language was imposed by the Chinese and Indian delegations over the discreet misgivings of European delegates and the tears of Alok Sharma, the UK minister in charge of the conference.

Well, the demand for the black stuff has neither phased out nor phased down. The economic war that accompanied the fighting in Ukraine has led to cuts in Russian gas deliveries to Europe.  In turn, Europe and the UK are “temporarily” reactivating coal fired power plants to build gas reserves and avoid blackouts this winter. This month the EU is also ending imports of Russian coal and replacing them with local production and seaborne supplies.

So the futures price of “thermal” coal for delivery to Rotterdam in January 2023 has increased by over 290% this year. And that may not be a high enough price to bid coal away from power-hungry Asian importers. Indonesia, which supplies about 45 % of the world’s seaborne coal, has imposed export restrictions to keep domestic prices down.

For the first time since the oil crisis of the early 1970s, higher quality “metallurgical coal”, used in steel making, is trading at a discount to thermal coal. Some is even being mixed in “crossover” shipments with thermal coal to meet market demand.

Coal plant closure plans from Indiana to India are being postponed. The Indian government is considering a plan to increase the country’s total coal fired capacity from 204 GW to 250 GW. The increase alone would about equal the California grid operator’s total peak capacity. And in the first quarter of this year, Chinese authorities approved 8.63 GW of new capacity.

Coal miners are producing extraordinary profits. Thungela Resources, a South African thermal coal producer that was spun off from Anglo American Corp in 2021, declared a special dividend this month that was higher than its share price the day it was listed. According to the company, “Considering the increase in our share price, together with the 2021 final and 2022 interim dividends, Thungela has generated a total shareholder return of 1,138% from listing (14 months ago) through the end of June 2022.”

Australian coal companies traditionally served Asian markets, but the boycott of Russian coal has already led to some Australian coal being shipped 13,000 km to Rotterdam. But Australian miners have little extra capacity, even with Chinese restrictions on coal imports.

Whitehaven Coal, a pure-play Australian producer, went from a loss in 2021 to generating A$3 billion of cash flow this year, paying down all its debt, using up its tax losses, increasing its dividends, buying back 10% of its stock, and retaining $1bn in net cash. The stock is up 233% over the past year.

US companies have also been increasing coal shipments to Europe. This has supported their market value, despite the ESG discount. Consol Energy, a 158 year old American coal producer, has seen its share price rise by 260% over the past year. Shares in Arch Resources, another major US producer, are up 166%.

But the coal mining companies still trade at very low multiples of earnings or cash flow. This is understandable. Three years ago, thermal coal looked like a sunset industry. The climate movement had condemned it for coal’s disproportionate contribution to atmospheric carbon.

The UK and EU had set a policy path based on renewable energy, along with a (hopefully diminishing) share of imported natural gas. And while EU governments are reopening coal generation or extending service lives, the intent to reduce coal use is still there, once the Ukraine war is over and the gas supply emergency is past.

We don’t know when the Ukraine war will be over, but when it does, we will see at least some resumption of low-cost Russian gas supplies flowing to Europe. Then what happens to the demand for coal?

“Peace risk, yes,” says one European coal investor. “It has to happen. And not just the end of the Ukraine war, but also the effect on coal demand of the coming recession. The prices for coal will come down from the $400 a metric ton that’s being paid in Europe. They won’t, though, decline to the lows set a few years ago.”

Futures prices and forward purchases support this view. The Rotterdam futures curve has coal prices declining from the present $400/ton level down to the low $200s over the next two to three years, with a flat curve out beyond 2026.  Demand for coal is supported by continued expansion of coal fired power production in India, China, Africa, and Southeast Asia. These countries do not have the domestic gas reserves available to the US, Russia, and the Middle East.

As the European coal investor says, “The Russian gas disruption has accelerated an energy supply crisis, but it didn’t create it.” In his view, (and the view of the long-term oil and gas bulls), “the crisis was caused by underinvestment due to overestimation of what green energy could do to replace fossil fuels. If you’re in Europe, there’s nothing like listening to a bunch of very worried German industrialists or Belgian farmers worried about diesel and fertilizer costs.”

As for my two-year estimate for the “peace risk” to his coal positions, he says “If I knew that for certain I would hold those positions, trading in and out of them opportunistically. Prices will decline, but they will stay significantly higher than production and reserve replacement costs for a long time.”

Usually, in natural resource industries, the cure for high prices is high prices, which, historically, lead to over investment and high production. But state policy and popular sentiment in advanced countries still lean against coal. Even if ESG policy changes to support oil and gas production, coal miners will have to depend more on their internally generated cash if they want to maintain or even increase production.

American and South African coal producers’ ability to expand exports is also limited by their access to rail capacity. Australian producers can export more over the longer term to Asian markets, but they want long term purchase commitments and even joint venture investments from their customers.

Boycotted Russian coal will go to other buyers on the world market. Even if Europe ends its “temporary” coal fired power generation, Russia can sell to Asian buyers. But the roughly $100 in added shipping costs for replacing European customers will still give a cost advantage to Australian and Indonesian miners.

Coal will continue to be used around the world as long as it provides cheap power. If it’s to be replaced by lower carbon fuels such as natural gas, or renewables firmed up by gas or energy storage, or by nuclear power, the direct costs of those substitutions must be competitive.

Middle income or poor countries will not give up prosperity for the sake of climate policies developed in rich countries. Europeans might have more sympathy for them after this year’s energy crisis.   

Even so, decarbonization policies will continue to restrict new investment by the coal industry. So ESG may save today’s coal investors from the sort of over-leveraged expansion that hit the US shale gas industry.