Coal, the real black gold

PORTFOLIO POINT: As Australia’s biggest mineral export, coal must be part of an investor’s portfolio. Here’s why.

It may be dark, dirty and old but it’s our biggest exporter earner. It’s more than 250 million years old, has been used for fuel since the Bronze Age, produces over 40% of the world’s electricity and today is our largest mineral export. With significant reserves and plans to double exports by 2030, Australia is in the driving seat to continue supply the world with coal.

The abundance of coal and its major cost advantage compared to alternative forms of energy will ensure growing demand will remain for some time. Emerging countries such as China and India, which require access to the cheapest form of power to remain competitive, will underwrite this demand for the next 10 to 20 years. Through significant investment, Australia is positioning itself to be a key beneficiary of this growth.

Not that coal doesn’t have its threats. Today’s carbon-neutral world is the latest threat for coal as the world demands cleaner forms of energy. But the investment and corporate activity within the sector suggests the opposite is happening as both our domestic and international exporters merge and an increase in foreign takeovers of our mid-tier coal miners confirms that exports should continue to grow as the world demands more and more cheap energy. Let’s consider the facts:

• Global energy consumption is forecast to rise 60% over the next 20 years.
• Coal exports represent about 50% of Australia’s energy exports and is continuing to grow.
• 75% of the coal mined in Australia is exported, mostly to eastern Asia.
• Australia plans to double current export levels by 2030.
• Coal provides about 85% of Australia’s electricity production.

So what follows is a look at the Australian coal sector, an update on foreign activity within the sector, an outline of why this is happening and a view on how to add exposure to your portfolio.

Types of coal

Coal is formed from accumulated vegetable matter that has been altered by decay and by various amounts of heat and pressure over millions of years. Inter-layered with other sedimentary rocks, it forms beds ranging from less than a millimetre to many metres thick. Such a bed, or several beds separated by thin layers of shale or sandstone, constitute a coal seam. Two forms of coal are mined in Australia, depending on the coal region: high-quality black coal and lower-quality brown coal.

Black coal is found in Queensland and New South Wales, and is used for domestic power generation and for export overseas. It is generally mined underground before being transported by rail to power stations, or export shipping terminals. The major use of black coal is for generating electricity in power stations, where it is pulverised (PCI, or pulverised coal injection) and burnt to heat steam-generating boilers. Coal used for this process is called steaming coal or thermal coal.

Some types of black coal are suitable for coke-making. These coals are called coking coal (or metallurgical coal) and when heated in the absence of air produce coke. Coke is a solid composed mainly of carbon and is used in blast furnaces for steel making.

Brown coal is found in Victoria and South Australia, and is of lower quality due to a higher ash and water content. Where found near the surface in thick seams, it can be mined economically on a large scale by open-cut methods. In Victoria, almost all of the brown coal extracted is burnt to heat steam-generating boilers in electrical power stations located near the coal mines. It is also made into briquettes, which are used for industrial and domestic heating in Australia and are exported.

Exports of coal

In 2008-09 coking coal exports surged 129% to $36.7 billion and thermal coal rose 114% to $17.9 billion – staggering numbers indeed. These numbers will continue to grow; in 2008 the federal government announced investment in infrastructure projects aimed squarely at expanding Australia’s coal export capacity. This has been followed up by significant investment by existing and emerging producers, all with the aim of continuing the growth in exports. With the target to double export levels by 2030 through private and public investment in the sector, the speculation that coal is an endangered commodity in the new carbon neutral world is looking shaky.

Foreign investment in the sector

The Australian coal sector has a long history of foreign investment from Japan, Korea, Taiwan and the US. China’s investment in the sector goes back to 1996, when Citic bought into Macarthur Coal. The benefits for Australia are huge, with Australia’s ability to withstand the worst of the global financial crisis clear evidence of the advantages of foreign investment in our resources sector. For China it is access to resources; for Australia it is access to project finance and jobs.

With China completing a new coal-fired power station every week and 70% of its energy needs reliant on coal, there is little sign of change in China’s demand for coal. Following the recent move by China to shore up supply by acquiring ownership in the supply chain, we are starting to see significant investment by the Chinese in the Australian coal sector.

In August this year, China’s Yanzhou Coal made a friendly $3.5 billion takeover bid for Felix Resources, which owns the Ashton coal mine as well as a clean coal pilot plant, both in the Hunter Valley. If it goes ahead, the deal will be the largest investment by a Chinese company in Australia. As well, China’s largest steel maker, Baosteel has agreed to spend $286 million buying a 15% stake in Aquila Resources, who own coal interests in Queensland as well as an iron ore joint venture in the Pilbara.

The sheer size of the Felix offer will ensure it is closely scrutinised by the Foreign Investment Review Board (FIRB). Having learnt from the OZ Minerals debate earlier this year, Felix has excised from the Yanzhou acquisition its coal project in South Australia, which is near the Woomera testing range. This should make the offer easier to approve, but as they are bidding for 100% of the company the FIRB could insist on joint ownership in line with the government’s preference for joint ventures.

The environmental factor and clean coal technology

Governments and the industry are investing significantly in new technology to lower Australia’s greenhouse gas emissions by an as yet unproven technology called carbon capture and storage (CCS). CCS is a technology aimed at reducing greenhouse gas emissions from burning fossil fuels, such as coal, during industrial and energy-related processes. It involves the capture, compression, transport, long-term storage and monitoring of CO2 that would otherwise be released to the atmosphere.

Source: CO2CRC

The advantage of CCS is that widespread use of this technique could achieve significant emissions reductions without the need for rapid change in the energy supply infrastructure. Research suggests that Australia can realistically store a maximum of 25% of our total annual net emissions through geological storage of CO2 (geosequestration). CCS should therefore be considered as a promising but still somewhat unproven option.

More information on what the coal sector is doing to achieve lower greenhouse gas emissions can be found here.

The main players

Australia’s coal sector is dominated by the global diversified miners of BHP, Anglo American, RIO and Xstrata, as well as pure coal miners like Macarthur Coal, Whitehaven Coal, Felix Resources and Centennial Coal. BHP owns large open-cut thermal coal mines in the Hunter Valley (Mt Arthur Coal) and is the largest global supplier of seaborne traded hard coking coal from coal mines located in Queensland (predominantly open-cut mines owned in an alliance with Mitsubishi Corporation) and New South Wales (100%-owned underground operations).

Anglo American, through its subsidiary Anglo Coal Australia, owns and operates extensive coal mine operations in Queensland and New South Wales. The company’s major mines are the Callide mine in Queensland, which mines thermal coal, and the Capcoal mine in the Bowen Basin, producing coking coal for export to steel producers. The Dawson mine in Queensland provides coking, soft coking and thermal coal. Anglo American trades on the London Stock Exchange under the code AAL.

In Queensland, Rio Tinto operates the Blair Athol, Hail Creek and Kestrel mines and is constructing the Clermont mine. In New South Wales, Rio Tinto manages Coal & Allied’s operations at Mount Thorley, Warkworth, Hunter Valley Operations and Bengalla. With the acquisition of Alcan, coal is now not a major commodity for Rio (despite it being the fifth-largest seaborne carrier) as it is overshadowed by iron ore, copper and aluminium. Nevertheless, Rio owns quality large-scale coal mines and is continuing to ramp up production.

Xstrata, through its subsidiary Xstrata Coal is, the world’s largest exporter of thermal coal and the fifth-largest producer of hard coking coal. Headquartered in Sydney, Xstrata Coal has interests in more than 30 operating coal mines throughout Australia (Queensland and NSW), South Africa and Colombia. Xstrata trades on the London and Swiss Stock Exchanges under the code XTA.

The pure players

Felix Resources (FlX) is an Australian company investing in, developing and operating projects with a primary focus on coal. Key assets are the Yarrabee and the Minerva coal mines in Queensland; the Ashton open-cut coal mine plus the Ashton underground and the Moolarben coal development projects in New South Wales.

Centennial Coal (CEY) is an Australian thermal coal producer with numerous operating mines in the western, Central Coast and southern NSW coal fields. About 80% of coal produced is sold to domestic power stations under long-term contracts, while the remainder is exported, principally to Asia. Export sales are expected to grow in coming years as production increases at Centennial’s export-oriented mines.

Macarthur Coal (MCC) is a coal company with interests in coal production and exploration in Australia. Macarthur holds a 73.3% interest in its two key mines, Coppabella and Moorvale, both in the Bowen Basin, in Queensland. Both mines principally produce PCI coal, a partial substitute for coking coal in steel making. Macarthur Coal is also exploring the surrounding areas.

Investment merit

The share prices of the majority of the pure coal producers have run up strongly following the Chinese bid for Felix. We remain of the view the preferred way to add exposure to the resource sector is via the diversified majors of BHP Billiton and Rio Tinto. While the issues surrounding carbon pollution won’t be fixed in the short term, the global demand for coal will continue to grow, fuelled by China and India.

Major investment by governments (infrastructure) and the private sector (mines) in Australia’s coal sector will ensure the diversified miners will continue to earn substantial earnings from coal as exports ramp up over the next decade.

Russell Lees is a senior adviser with Lachlan Partners. This article first appeared in the Investing Times.