As the coal price remains in the doldrums with no uptick in view, the Australian coal industry is being forced to adapt to what seems to be the 'new normal' over the medium term. In this article, we describe some of the ways we are seeing the current environment impact on the way in which companies approach corporate strategy, M&A and coal mining operations.
Background to current market
The Australian coal industry is continuing to struggle under the impact of the global downturn in coal prices that started in August 2011 as a consequence of oversupply from Australia and Indonesia and worsened in 2013 as demand from China began to ease.
Coal mining is a cyclical industry and the challenge of lower commodity prices should eventually lead to a contraction in supply as high cost producers exit, which in turn supports higher commodity prices and investment. Counterintuitively, Australia has seen record coal exports in 2014. This is arguably due to the market-distorting impact of Australia’s infrastructure 'take or pay' system. Fixed 'take or pay' commitments represent such a high proportion of total costs that, as coal prices fall, mining companies are incentivised to boost production in order to reduce unit costs, in turn placing downward pressure on the coal price.
Australian coal industry trends
We are witnessing six distinct market trends developing in response to this combination of continuing low coal prices and fixed high infrastructure costs.
Major coal companies reducing exposure to the Australian coal sector
Major international mining companies are reducing their exposure to coal in Australia, both as a result of changes in global strategy and the need to repair balance sheets. Although a significant number of non-core divestment plans have been announced, the success of such plans has been mixed, with a number of proposed divestments being scaled back or delayed due to disparities in pricing expectations between sellers and potential buyers.
Major United States coal companies have also abandoned plans to expand into Australia as they respond to structural changes in the United States coal market. Long-term competition from cheap unconventional gas has placed extreme pressure on the balance sheets of these companies and triggered major reductions in market capitalisation. These market changes have virtually eliminated the possibility of significant expansion into Australia.
Small-cap coal companies forced into recapitalisations, mine closures and external administration
Small-cap and mid-cap coal companies have found themselves developing projects that are no longer economic at current coal prices. The traditional option of reducing project expenditure is not possible in many cases due to rail and port 'take or pay' obligations.
Companies have struggled to raise equity or debt to undertake the development of such projects. Faced with insufficient cash-flow, for some companies the only solution is formal external administration or a major re-capitalisation. Recent examples are Cockatoo Coal (recapitalisation with Noble Group (HK), PT Harum Energy Tbk (Indonesia) and Liberty Mutual (US)) and Bandanna Energy and Tiara Coal (external administration).
Mines unable to pay cash costs are being closed. The duration of remaining 'take or pay' commitments is a major factor in considering when to stop operations and place the mine into 'care and maintenance'. Recent examples include Peabody Energy’s Wilkie Creek, Vale’s Integra and Isaac Plains, BMA’s Norwich Park and Centennial’s Angus Place coal projects.
M&A driven by strategic goals
M&A deals are being driven by the strategic goal of securing future supply. The current market is a great opportunity for end-users of thermal and metallurgical coal (such as power utilities and steelmakers) to invest and create a natural hedge on raw materials cost. Recent examples are the acquisitions from Idemitsu Kosan of interests in the Boggabri Coal Project by Chugoku Electric Power Company (10%) and Nippon Steel (10%) and the proposed development of the Bylong Project by KEPCO and the Hume Coal Project by POSCO.
Changes in the 'investor' base
Private capital and financial investors are showing an increased interest in investing in the Australian coal sector. One relevant example is Liberty Mutual Insurance’s investment in Cockatoo. The increased interest of these investors may support the view that the sector has reached a 'tipping point' or the 'bottom of the market'. These investors, which include sovereign wealth funds and private equity vehicles, can act counter-cyclically, attracted by the prospect of potentially strong returns driven by low asset valuation.
Where investors have access to 'patient capital', there is a chance to capitalise on reduced competition and lower valuations. However, the investment time horizons of private equity do not match well with the longer-dated cycles of the resources industry and transactions are also complicated by the need to secure credible operators for the projects. As a result, despite the increase in interest, few material deals have completed to date.
With limited potential short-term upside in coal prices, managers of JVs and owners of projects are looking for synergies through operational mergers (single mine plan, joint use of equipment, sharing of mine infrastructure, transfers of rail and port capacity and sharing of workforces). An example is the joint venture between Peabody Energy and Glencore to expand mine life and lower costs at the Wambo open-cut mine. These strategic deals seek to minimise upfront capital costs and share risk.
Changes in operations
Investors are focussing on production or near production projects rather than greenfield projects. These projects offer greater certainty for investors (given political risks around the time and cost of obtaining approvals in New South Wales and Queensland) and better opportunities to reduce costs.
Many mine operators have significantly reduced on-site costs through replacement of contractors, micro-management of cost and use of inventories. Reducing off-site costs has been more difficult with fixed 'take or pay' contracts in place and on-going negotiations with port and rail providers regarding infrastructure access.
From 2008 to 2013, the costs of production in Australia for thermal coal increased by 48% and metallurgical coal by 73%, much of this relating to increased labour costs. Over the last 12 to 18 months discussions have started between mine managers, unions and workers on how to lower total wage costs (through changes in rostering and personnel numbers) and increase productivity through greater flexibility in work practices and redeployment of workforces across mines.
We expect that the Australian coal mining industry will continue to struggle until a recovery in coal prices occurs, notwithstanding that the general downward trend in the AUD has partially offset falling USD coal prices.
We further expect that future rail and port infrastructure development will require more flexible financing structures involving a sharing of risk and return between mine owners and infrastructure owners.