Coal is dead; long live coal. Not too long ago, it seemed the fossil fuel was a spent commodity. Clobbered by oversupply, weak steel prices, high operating costs relative to other energy sources, a vocal divestment campaign and the prospect of decades of punitive environmental legislation, many energy watchers were ringing the death knell for both thermal and coking coal.
Then 2016 happened. First, and most importantly, China shuttered a big chunk of its coal production in a bid to boost the industry's profitability and help its domestic miners repay their debts. Within a matter of weeks, the price of coking coal (the form used in steelmaking and also known as metallurgical or 'met' coal) had more than doubled. The decision by the People's Republic also caused a drop in exports of thermal coal used in power generation, thereby sparking a rise in spot prices.
Shortly after, the United States elected a president who had campaigned on a promise to revive domestic production in the world's largest economy. Within hours of his inauguration, Donald Trump laid out his commitment "to clean coal technology, and to reviving America's coal industry, which has been hurting for too long". At the risk of ignoring the market forces that had led to its multi-generational decline - and in specific defiance of Barack Obama's attempts to reduce emissions from coal-burning power plants under the Clean Power Plan - the effect has been to put coal back on to the energy agenda.
That might have happened regardless, judging by recent results for the largest London-listed miners, which have a slight bias towards coking coal. As the chart below shows, price climbs meant coal accounted for 19 per cent of underlying cash profits at London's five biggest miners in the second half of 2016. That figure stood at 12 and 11 per cent respectively for the previous two six-month periods. There's a good chance 2017 could help the bottom line again.
Take Glencore (GLEN) as an example. Between the first and second halves of 2016, the company's average thermal coal and coking coal prices jumped by 55 and 135 per cent respectively, aiding a 73 per cent increase in adjusted earnings for the industrial division. The 16 per cent cash profit jump in the energy segment of Glencore's marketing business, which trades commodities and tends to benefit from wider spreads or price volatility, was largely due to coal. What's more, the contribution from coal would have been even stronger had the commodities giant not hedged much of its production - a decision that resulted in a $980m (£788m) opportunity cost. As those hedges tail off, the company should profit from its low costs of just $39 a tonne of thermal coal, against the current spot price of $90.
At the same time, there are understandable concerns that prices will unravel further, having peaked above $100 at the end of 2016. When those prices were topping out, South32 (S32) chief executive Graham Kerr said his company's growing cash pile would not be used to acquire or develop any more thermal coal projects, although the group did press ahead with the $200m purchase of Peabody Energy's Metropolitan mine in November.
Rio Tinto (RIO) has taken a similar stance. In January, it used the bump in prices to forge an agreement to sell its Coal & Allied subsidiary, which comprises the company’s thermal and coking operations in the Hunter Valley and Mount Thorley Warkworth mines. The $2.45bn deal, which chief executive Jean-Sébastien Jacques said represented “outstanding value” to shareholders, might have been completed last week had the acquirer taken an option to buy the mine at a $100m discount. However, fears that the deal will now be scuppered seem overdone, given that the buyer, Chinese state-owned Yancoal, has given itself a longer grace period in which to raise the $1.1bn of finance needed to fund the purchase. Once completed, it will be Rio’s third major coal mine sale since 2013, and follows last year’s disposal of the Bengalla coal mine, leaving the mining giant with just the Hail Creek and Kestrel mines in Queensland.
That state is also home to two of Anglo American’s (AAL) remaining met coal mines, Moranbah and Grosvenor, which will now be run for cash a year after the group pledged to exit all commodities bar copper, diamonds and platinum group metals. It’s hard to know what to make of this about-turn, which depending on your perspective could either be a display of short-termism or strategic flexibility. Aside from October’s $0.6bn sale of the Callide thermal coal mine, chief executive Mark Cutifani was clear that outside interest in the company’s remaining coal assets failed to meet Anglo’s “strict value thresholds”. But longer-term, it is likely that Anglo will come under pressure to divest more, given that much of its coal output from South Africa and Colombia – and the majority of production on a volume basis – is destined for power stations rather than steel manufacturers.
IC VIEW:
Coal provides a fascinating glimpse into current attitudes to national energy security. It might be an abundant resource in both China and the US, but the two countries' views towards future exploitation appear to be bifurcating. Beijing's heightened focus on alternative power sources such as hydro, solar, wind and nuclear implies a shift away from the fuel that turbocharged its economic ascent, but it also reduces the risk of importing inflation and demonstrates a plan for a lower carbon future. And while India's appetite for coal-fired power is set to grow, Japan is turning back towards nuclear energy. In the long term, the latter position seems to make more sense, given that thermal coal is twice as expensive as solar and wind power generation in some parts of the world, making it a sitting duck from both an economic and environmental perspective. On this note, it would be encouraging to see the big miners use the recent price bounce to pull out of steam coal altogether.
Favourites
Although its ability to cover its dividends in recent years has occasionally faltered, mining royalty outfit Anglo Pacific Group's (APF) income rocketed in 2016 on the back of a strong improvement in coking coal prices. That was very well timed for an uptick in production from its royalty from Rio's Kestrel operation, which is set to contribute an even greater proportion of earnings this year. What we particularly like about Anglo is its strong recent record of striking deals at depressed points in the cycle, together with a cost base unaffected by sustaining capital requirements. Aside from Kestrel, the group should see greater production at its share of the Whitehaven Coal-owned Narrabri mine in New South Wales in 2017, while stakes in uranium and precious metals elsewhere in the portfolio act as useful hedges.
Outsiders
BHP Billiton (BLT) benefited hugely from the coal boost in the final months of 2016, booking a half-year underlying operating profit of $1.6bn against a loss of $342m in the same period in 2015. But while the majority of its coal production is metallurgical, that means its exposure is now heavily weighted towards Chinese steel production. Although BHP is bullish about the country's infrastructure plans, cooling economic growth could still hit two of its four sources of earnings. And with the group's copper production temporarily rocked by industrial action, supportive coal prices are needed.
