Rio's canary for Australian coal

The conclusion of the protracted annual negotiations with Japanese utilities over benchmark thermal coal prices provides a context for Rio Tinto’s testing of the market’s appetite for a number of its Australian coal interests.

While the potential sell-down of Rio’s interest in Coal and Allied and of its interests in the Clermont and Blair Athol mines in Queensland could quite correctly be seen as part of a wider spring cleaning of the under-performing and non-core elements of the Rio portfolio by new chief executive Sam Walsh, there does appear to be another dimension to Rio’s testing of the market for those mines.

Rio isn’t committed to selling those interests but is keenly interested in establishing their market value. At a conventional level Walsh wants to exit sub-economic assets and strengthen his balance sheet but understanding the value of the mines today is important to informing a deeper analysis of the changes occurring within the energy coal sector.

The settlement of the annual contract negotiations for thermal coal, which were led by Xstrata, helps illustrate the question mark over the sector. According to the Financial Times, benchmark contract prices have been reduced 17 per cent to about $US95 a tonne. Five years ago the price was closer to $US130 a tonne.

Some of the pressure on thermal coal prices is due to a slowdown in China’s demand but there are structural shifts occurring on the supply side that have longer-term implications, and it is those that Rio is trying to work through.

The biggest shift in the market in recent times has been the dramatic emergence of the US shale gas sector and its accelerating displacement of coal within the domestic US energy market. That has pushed US coal into the Asian market, albeit largely on an opportunistic basis thus far.

In any event a new source of supply and potential supply has entered the market – as well as, given that there are vast shale resources in China and elsewhere, a new and potentially very substantial source of energy.

At the same time as US coal has been pushed into the Asian markets, exports of coal from Indonesia and Colombia are surging and, while not without its well-publicised issues, Mozambique is emerging as a potentially significant producer.

For the Australian industry, price alone wouldn’t have been a threatening factor in the past. Before the commodity price boom really took off nearly two-thirds of Australian thermal coal producers were in the lower half of the industry cost curve, which meant a lot of higher-cost supply would be withdrawn from the market before they lost volume.

Today, however, nearly three-quarters of the Australian mines are in the top half of the cost curve and for many of them their profit margins are so skinny that the latest settlement is likely to push them into losses, if they aren’t there already. There are analyst estimates that at least a quarter of the Australian industry would lose money at the new contract price.

Soaring capital and operating costs during the investment boom and the continuing strength of the Australian dollar have already seen mine closures, large-scale job-shedding in the sector and the deferral of plans for new mines or expansion projects as the big miners attempt to restore their competitiveness.

It may be that they are fighting a losing battle.

The miners could, if their attack on costs were successful, ride through a cyclical downturn in prices. If, however, there is a new and lowering ceiling on energy coal prices created as a result of fundamental structural changes on the supply side that could be a losing battle, with significant and unpleasant implications for the Australian industry and for exports.