Hot coal is cold comfort

Coal output is at record levels, and prices are plunging. Head for the coal exits.

Summary: Coal mining is booming, with electricity producers only too keen to buy ore at discount prices. For coal miners, such as BHP and Whitehaven Coal, the coal flood is slashing their margins.
Key take-out: For investors, the challenge is to separate the political and environmental debate about coal from the market reality. Coal prices are set to stay low.
Key beneficiaries: General investors. Category: Commodities.

Hans Mende and Andrew Mackenzie know more about coal than most people, so when they say it’s time to sell, or stop investing, it’s the equivalent of ringing a bell on coal and calling time.

Mackenzie is the better known of the two in his position as chief executive of BHP Billiton. Mende has a much lower profile, but is more personally involved with coal investing.

Last week both men voted with their cheque books and sent a clear signal that they do not expect a quick return to higher prices. This is thanks to a global glut of both types of coal: thermal, which is used to fire power stations, and metallurgical, which is used to make steel.

Mende reported the sale of a large parcel of shares in Whitehaven Coal. Mackenzie said BHP Billiton did not plan further investment in coal.

Of the two events, Mende’s is the more important for investors. That’s because he is co-owner of the big private company, American Metals and Coal International (AMCI), which specialises in resource investments.

When New York-based Mende filed his Whitehaven ownership change form at the Australian Securities Exchange, it sent a powerful message. If a coal investment specialist is heading for the exit, so should you.

Over the past 10 years AMCI has been a strong supporter of several Australian coal mining companies, and Mende has worked in association with a number of high-profile mining executives including former BHP Billiton chief executive, Brian Gilbertson.

Low coal prices and an apparent belief that there will not be a quick recovery would have been a factor in Mende reporting the August 22 disposal of 7.86 million Whitehaven shares for a return of $15.6 million.

A former director of Whitehaven, Mende has sold smaller parcels of shares in the company before, including 600,000 for $2.2 million in August last year, though the latest disposal is his biggest yet and reduces his stake in the stock from 7.15% to 5.97%.

When asked to comment on the sale Whitehaven chief executive, Paul Flynn, said Mende’s sale was not a vote of no confidence in the company. This might be correct, but it’s certainly a vote of declining confidence or a belief that the funds could be more profitably allocated elsewhere.

Mackenzie was effectively saying the same thing in an interview with the ABC when asked about his preferred investments, which were listed as petroleum, copper and potash. Iron ore was less certain, but coal was off the agenda.

“We’re probably finished for a time investing in coal,” Mackenzie said.

Higher production

The problem for everyone exposed to coal is not simply that it has become a politically unpopular commodity. It is more about the success of the global mining industry in boosting production to a point where it has flooded the market, reducing coal to the status of a low-priced (and low profit) energy alternative.

The use of coal in the production of electricity and steel is not declining. It’s actually rising. The issue is really about supply overwhelming demand.

The latest shipping data at Australian coal ports is an example of what’s happening, with fresh records being set. Newcastle’s Port Waratah Coal Services reported a record loading of 10.3 million tonnes in July, beating the previous record of 10.2 million tonnes set in December last year.

Tonnes might be up, but the price is down. The benchmark Newcastle thermal coal price dropped this month to a four-year low of $US77 a tonne, down 16% since January and 44% since the recent high point of $US136/t reached in January 2011.

Mackenzie’s view is certainly being influenced more by price than volume, with tonnes mined continuing to rise while profits tumble.

Last financial year BHP Billiton lifted its output of metallurgical coal by 13% to 38 million tonnes. Thermal, or energy coal, output rose by 3% to 73 million tonnes, taking total coal production to 111 million tonnes.

However, profit from coal collapsed from $US2.1 billion in financial 2012 to $US746 million last year, thanks to a 34% fall in the metallurgical coal price and a 31% fall in the thermal coal price. This dragged the overall contribution of coal to BHP Billiton’s pre-tax profit to just 3%.

Committed mine expansion projects mean that the pain will continue for BHP Billiton this year, with overall coal production expected to rise by 3% to 114 million tonnes. This is entirely due to extra shipments of metallurgical coal – but whether the extra tonnes will be profitable is questionable.

Coal attraction

While anti-coal campaigners will cheer at the declining profits of coal miners, low prices are having an unexpected effect on the global energy equation because the further coal falls the more attractive it becomes to electricity producers.

In Europe, a region proud of its environmental credentials, coal consumption is rising because it has become the low-priced go-to fuel. The profit on electricity produced by burning coal is easily outstripping natural gas or renewables such as wind and solar.

China, too, is boosting domestic coal production as miners in that country race to win market share as prices fall.

For investors, the challenge is to separate the political and environmental debate about coal from the market reality.

Coal mining, despite facing intense criticism, is booming thanks to abundant supplies in most countries and because electricity prices are rising as governments encourage the use of renewable sources of energy.

The winners in what’s happening are electricity producers able to burn cheap coal. The losers are coal miners, who are shipping more tonnes at lower prices.

It is a perverse situation which has changed my view of coal as an investment, because there is no sign of the coal flood receding any time soon.