Analysis : Coal: From hot to horror

The biggest threat for energy-related stocks like coal is technology. And we believe the advent of technology advances are here today, structurally altering the fundamentals of the coal sector.

Evolution in upstream technology, known as hydraulic fracturing, has led to a surge in the production of unconventional gases, specifically shale gas, in the US of late, resulting in abundant natural gas supplies. This coupled with relatively stable US natural gas demand has made natural gas inventory levels to move higher than the 5-year average, leading to natural gas prices dropping to around the USD2.3/mmbtu at present (exhibit 1).

Natural gas cleaner and relatively lower cost to generate electricity has made it the preferred fuel compared to coal. Testimony to this is coal-based power generation in the US has gradually declined from 48% in 2009 to 34% by June 2012, while gas-fired power generation increased from 19% to 32% over the same period.

Our conversation with a local coal expert on the High-Voltage Direct Current (HVDC) technology revealed interesting findings that are currently changing the roadmap for China’s power plant development. HVDC, developed by Siemens and ABB, is an electricity transmission system created to make long distance transmission not only less expensive but also transferred with minimal possible electrical losses. This technology, for example, allows mine mouth coal-fired power plants to be set up in Mongolia with the created electricity to be relayed via thin cables to Shanghai, which is hundreds of kilometers away, with just less than 3% electricity loss.

Thus, with coal transport from North-West areas to South-East coastal cities no longer a hindrance, the outlook for coal exports from Indonesia to China is now bleak with volumes undoubtedly on the decline going forward. We expect the threat from HVDC will only escalate in the future, although it only contributes less than 5% of China’s current total power generation.

With US manufacturers using more gas as described in paragraph 2, US coal companies, starting in 1Q11, have shifted production from domestic to overseas, helped by low transportation cost as reflected by the low Baltic Dry Index. Exhibit 2 also shows that US exports in 2011 grew significantly to 118.2m tons (+31.3% y-y) with Europe (50.3%) and Asia (25.7%) as major destinations. With the eurozone slowing, more and more US coal, most of which are metallurgical coal (for steel processing), are finding their way to Asia, specifically Japan (11% of Indonesia’s 2011 total coal exports) and China (33%).

We note that coal inventories at key power plants remain high, increasing by 5.4m tons from end April to 88.9m tons on 20 May, sufficient to generate power plants in the next 26 days (normally 15-17 days). In China’s Qinhuangdao, the world’s largest coal port by capacity (9m tones), have exceeded levels last seen in late 2008 during the height of the financial crisis. At that time, thermal coal prices dropped sharply. Last week, Qinhuangdao’s inventory reached 8.2m tones, up 1.1m tones in just 10 days, suggesting lack of demand. It is clear that thermal coal prices have only one way to go: Down.

Despite Newcastle average ytd coal price y-y drop of nearly 15%, reflecting nearly 10% fall from its recent peak of USD118.9/ton to USD107.6, exhibit 16 shows that coal prices, remaining much higher than gas prices, have plenty of downside. With coal now trading below USD90/ton in June 2012, the first time since August 2010, we have reduced our 2012 coal benchmark price assumption by 15% to USD97/ton (2H12 average: USD88/ton; Current: USD89/ton) and by 29% to USD85/ton in 2013, before falling further to USD80/ton in 2014, in line with the expected fixing of China’s railway problem, which should allow less external coal usage from the rest of the world, including
Indonesia.

With structural changes and policy risks besetting the sector, we believe there is no reason for investors to be in the coal space. At this stage, we cut our sector’s fundamentals from neutral to underweight.

The writer Irwan Budiarto is senior vice president/head of research at PT Bahana Securities