In my previous article, we looked at one of the most coveted precious metals: gold. We will now take a closer look at a commodity which is essential for electricity generation and steel-making: coal.
Coal
Coal is Australia's second-largest export and is a huge contributor to our economy. The industry is suffering from a global supply glut that has taken the coal price to a 10-year low. It now makes sense why receiving coal in the Christmas stocking is such a punishment!
Coal is a bulk commodity that is usually classified as either metallurgical coal or thermal coal.
Metallurgical coal is less abundant than thermal coal and is primarily used in the steel-making process, along with iron ore and limestone. 1,330 million tonnes (Mt) of metallurgical coal was consumed globally in 2014 to produce 1,662Mt of steel.
Thermal coal is mainly used for electricity generation. It is still the largest source of fuel used in Australia and globally for electricity generation and it is expected to stay that way for many years to come. Australia's electricity generation breakdown by type is shown below.
Like most commodities, the longer-term demand for coal is hard to predict. Issues that may significantly change global coal consumption include the fact that many countries are transitioning towards cleaner and renewable energy sources such as solar, wind, geothermal, hydro and nuclear. Additionally, future national policies or international agreements aimed at reducing or limiting the growth of greenhouse gas emissions could affect coal usage. Metallurgical coal demand is tied to the global steel industry which could come under pressure as China's infrastructure development slows.
China, which dominates global coal consumption (47%), recently banned imports of low-quality coal as part of its attempt to clean up its pollution issues. Another recent development has been the blacklisting of coal and fossil fuel companies from major investment funds. Ironically, Norway's $890 billion sovereign wealth fund, built on more than four decades of oil extraction from the North Sea, was ordered by lawmakers to limit holdings of companies that produce or burn coal.
As developed economies transition to cleaner energy sources, the growing energy demands of developing economies will still require cheap coal. Until the cost of renewable energy sources are equivalent to that of coal and gas the demand for coal is expected to remain strong.
Similar to iron ore, boom-time prices increased the number of coal mines approved for construction resulting in a global supply glut which has punished the coal price lower over the past five years. As a result, several Australian coal mines have closed, such as Vale's Isaac Plains and Integra mines, and mass redundancies have occurred in the industry. Glencore, the largest coal producer operating in Australia, actually shut down (PDF) its Australian coal operations for 3 weeks in December 2014 in response to the excess supply in the market.
The magnitude of the coal price slump is highlighted by BHP Billiton Limited's (ASX: BHP) latest half-yearly results to 31 December 2014. Total revenue for their coal division was US$4.3 billion, yet earnings before interest and taxes (EBIT) was just US$178 million – a margin of only 4% and interest and taxes still have to be paid!
If BHP, one of the world's lowest-cost miners can't make a profit, it is likely that very few producers can at these prices. Higher cost mines and companies will continue to exit the business until the market balances. How long this takes is impossible to predict but lower prices look likely to stay for the foreseeable future.
What is coal?
Coal is formed from the accumulation of organic matter (forests, swamps etc) that have been subjected to intense heat and pressure over the past 15-250 million years. This formation process creates coal in layers of varying thickness that are known as coal seams or coal beds. These coal beds are usually near-horizontal and cover a large area, which can make the mining process quite simple.
Coal is mined by both open-pit and underground methods depending on the depth of the resource from the ground surface. Open-pit coal mines are not space-confined and generally have much higher production rates than underground mines. These open-pit mines utilise some of the biggest pieces of machinery throughout the entire mining industry such as draglines and bucket-wheel excavators, which can weigh up to 10,000 tonnes – the equivalent of 10,000 Toyota corollas compressed into a single unit.
In open-pit coal mining, the confining layers of waste rock and soil (commonly referred to as overburden) are removed to expose the thin coal seams which are then extracted. Open-pit mining will remove nearly 100% of the coal seam and is more efficient in this respect than underground mining, which must leave coal and rock in place to support the underground cavities. Underground mining is used for coal seams located at depths that are uneconomical to mine by open-pit.
Where is it?
Australia's coal resources are some of the largest in the world and cover a significant part of our country. Take a closer look at the map below – you might be sitting on top of some of these extensive coal resources but didn't even know it!
The major players
The Australian coal industry is shared between a large number of international giants and our local miners, both big and small. During 2014 Glencore, Peabody Energy and Anglo American along with BHP and Rio Tinto Limited (ASX: RIO) accounted for around 65% of the 436Mt 0f Australian coal production. Glencore and BHP produced around 80Mt each whilst Rio Tinto, Peabody and Anglo American mined 56Mt, 40Mt and 32Mt respectively.
There are numerous smaller players in the Australian coal industry that make up the rest of our coal production quota. Even Wesfarmers Ltd (ASX: WES) has its own coal division which has an annual production rate of 8Mt. In 2014 the ASX-listed coal miners Yancoal Australia Ltd (ASX: YAL), Whitehaven Coal Limited (ASX: WHC), and New Hope Corporation Limited (ASX: NHC) produced 17Mt, 12Mt and 6Mt respectively.
As the coal price slides it is likely that some of these smaller companies will be hit the hardest and may be forced to exit the industry. The quality of the assets and production costs of each company must be closely analysed when investing in coal companies.
Summary
They may not be the most loved companies in the world, but the demand for coal should be strong for years to come. The market is currently oversupplied and prices are likely to be depressed in the coming years making it hard for any companies (and investors) to make a decent profit.
Later in the series, after gaining an understanding of mining operations, we will take a closer look at the financial side of some of these companies to try and find those which are most likely to survive and profit in the future.
