Coal to consolidate as volatility likely to continue

Before Brexit came along and threw the world’s markets into a spin, met coal miners and steelmakers had already been dealing with months of unusually high volatility and uncertainty. Like the messy UK-EU divorce, stability won’t return for some time; so we all need to get used to it.

Dynamics in the met coal trade are shifting. China’s demand remains erratic as ever and the rising hegemony of the big Australian producers is pushing higher cost miners out of the picture. Meanwhile, market pricing continues on its evolutionary trend – the same path along which steel, iron ore and thermal coal prices have travelled – towards higher indexation, liquidity and transparency. The outcome will be greater uncertainty, but also opportunity. It all depends how prepared you are.

Wild ride ahead for physical coal prices

In early 2016, hard coking coal prices went on a white-knuckle roller-coaster ride. International benchmarks rose over 30% – from US$75/t to US$100/t – between mid-February an
d end April. They then embarked on a stomach-churning plummet to US$83/t during May, before bringing some light relief with a rise through June and July to hit US$95/t . The architect of this wild ride was China and its attempt at managing chronic overcapacity in its steel and coal mine sectors with forced capacity closures and demand stimulus .

Met coal import demand into China will continue to be ‘lumpy’ as safety-related mine closures, economic stimulus and the government’s arbitrary 276-day production limit play out in that market.

Seaborne supply dynamics are also transforming. Mines supplying the highest quality hard coking coal are now operating at very high utilisations, while the unlucky ones have already closed. For the first time in years, miners are unable to respond to the short-term spikes in Chinese demand. The big players look to be aggressively taking advantage of this short-term tightness, with BHPBilliton (BHPB) in particular pushing strongly for price increases earlier this year.

It is a new dynamic that will continue at least while China attempts to rebalance its steel and coal sectors. The prevailing trend since 2012 –  where prices have consistently declined in line with supply costs – has largely run its course.

Pricing evolution inevitable

Steelmaker resistance aside, the met coal market continues to evolve towards greater commoditisation. Barriers caused by the inability of buyers and sellers to agree on generic coking coal value, and the lack of liquidity in some steel markets, are slowly being overcome.

Since the introduction of quarterly contracts in 2010, the market has seen massive growth in seaborne spot sales, independent daily current and forward price assessments, widespread use of indexation, fledgling over-the-counter derivative products, exchanges trading physical coking coal contracts, and financially settled derivative products through the Chicago Mercantile Exchange. All the ingredients for an explosion in met coal market liquidity.

But the changes are keeping many miners and steelmakers awake at night. Specialty steelmakers, particularly those burdened with long-term fixed price steel contracts, worry about the potential mismatch with erratic raw materials prices. While miners worry that fluctuating prices and margins make planning almost impossible. The irony is that by developing a liquid and transparent coal market, participants could eliminate price risk through the use of derivative products. But steelmakers’ fears are also more existential. Highly transparent and liquid prices for raw materials and steel might allow steel buyers to squeeze steelmaker’s margins, limiting profits to some form of conversion fee, as occurs in some other parts of the metals sector.

Consolidation potential is greater than ever

The explosion in diversity of met coal supply during the China boom has turned on its head. Many new entrants have already come and gone, and with them a number of long-lived, but small-scale, high cost mines. The hegemony of the major incumbents such as BHPB and Teck has increased as a result, and has the potential to accelerate. Consolidation of production is still some way below the iron ore industry where the big four account for over 72% of global trade. But the top three met coal miners already own or control over 65% of the best quality traded premium hard coking coal. And with options to expand.

The market is awash with coal mines for sale; our M&A pipeline has more than 50. A multi-year outlook of flat prices will see that number increase. The assets include those of large miners such as Anglo, who now consider coal investment a distant priority. And the field of possible buyers is small, particularly for the best assets. Existing miners are well-placed to increase their footprint through M&A and those with options to also grow brownfield capacity should see growth in market share.

The met coal market is on a transformative journey. There is little that most participants can do to stop the process but they can be prepared to mitigate risk and seize opportunities. Steelmakers and miners need to decide whether to embrace the changing market, or be a prisoner to it.

 

This article originally appeared in full on Wood Mackenzie.

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