Here's Why a Pop for Big Thermal Coal Producers Is Due

by: David White

Last week Goldman Sachs and Morgan Stanley made a bullish call on commodities. By itself this was bullish for thermal coal. This week China announced that it is raising industrial electrical power prices in 15 provinces. These new prices will go into effect Tuesday June 1, 2011. The intent is to get the Chinese power companies to produce more electricity during the high use summer months. The companies had cut back on electrical production due to the high price of imported coal. This price increase for industrial electricity should make their electrical power production more profitable, although the increase only amounts to about 2.2% this time. This means they will produce more. It means they will buy more imported coal over the summer. It likely means the price of thermal coal will rise even further. Longer term the Chinese government has to realize that its strategy for cutting coal imports is backfiring. Many industrial companies are just using their own backup diesel generators to supply the missing electrical power. The government has responded by curbing diesel exports. This whole scenario is less efficient than using a main coal powered power plant. It is more costly. It means that the Chinese government is actually feeding inflation more than if it fostered the further importation of coal (possibly by raising electricity costs more). The government is bound to realize this in time.

As a general trend coal imports in China are trending up. In 2008 China produced 79% of its electricity from coal. That percentage probably hasn’t changed much since then. In 2009, China imported 102M tonnes of steam or thermal coal. In 2010, that figure was 147M short tons (a short ton is 90.72% of a tonne, so that‘s 133.36 tonnes). That’s a 31% increase in just a year. Some might point to a the worldwide recession to account for this difference, but let’s remember that China did not experience a recession. Its GDP kept growing at a high rate without a glitch. Its businesses kept producing at a quickly growing rate. This 31% increase in imports by China is not a rebound from a recession.

China’s electricity generation is forecast to grow at 9% per annum over the next 5 years. It has been growing in double digits for the first several months of 2011. If thermal coal consumption is any indication, it has been growing significantly above the 9% growth forecast per annum.

Japan is one of the biggest thermal coal importers at 115M tons in 2010. That number is supposed to rise to 118M tons in 2012, as some earthquake damaged coal power plants are brought back on line. Japan may use another 5M-10M tons of thermal coal if it runs its coal power plants at 95% capacity to try to partially make up for the loss of the electricity generating capacity of the damaged nuclear power plants (about 10% of Japan’s electricity generating capacity).

India increased its imports of thermal coal by 17% last year to 47M tons. Coal imports are expected to rise to 60M tons in 2011. That’s nearly a 28% increase over 2010. One forecast for coal imports for India calls for 11% per annum increases for the next 5 years. Given the increases of the last two years, this figure seems conservative.

If all of this wasn’t bullish enough, Indonesia may ban exports of low energy coal in order to retain more of its coal to fuel its own growth. Djunaedi, deputy director of oil, gas, and mine products at Indonesia‘s Ministry of Trade, said at the Ninth Annual Coal Markets Conference, “From 2014 onwards, we will only export value-added coal of more than 5,600 kilocalories.” This ban would hit 60% of Indonesia’s coal exports. Since Indonesian exports account for approximately 30% of all exports worldwide, a 60% curb of those exports would amount to an approximately 18% hit on overall global coal exports. This ban is by no means a sure thing, but the rationale for it makes sense. The implementation of such a ban would be very bullish for thermal coal prices worldwide. As it is, Jakarta-based PT Bumi Resources, Asia’s biggest exporter of power station coal, forecasts prices may rise to $140-$150 a ton by Dec. 2011, due to increased demand from China, India and Japan.

All of the above should mean that major thermal coal suppliers, especially suppliers to China, India and Japan, should benefit over the next 5+ years. Some of these companies include: BHP Billiton Limited (NYSE:BHP), Peabody Energy Corp. (BTU), Rio Tinto Plc (NYSE:RIO), XSTRATA PLC (OTC:XSRAY), Anglo Am Plc ADR (OTCPK:AAUKY), and VALE S.A. (NYSE:VALE). VALE is expanding its coal operations worldwide. In addition it is taking delivery of 30 or more mega bulk carriers of approximately 400,000 tonnes each between 1H 2011 and the end of 2013. This should make it more economical for VALE to ship its coal and iron ore around the globe. The appearance of these mega ships is expected to dampen capesize bulk carrier prices over the next few years. This should make all coal (and other bulk loads) shipping cheaper. This in turn will be a boon to other coal producers (and other ore producers).

All of the above companies have good fundamentals. The fundamentals vary depending on a number of factors, but all are strong companies. VALE S.A. trades at the lowest multiples. With its shipping finally beginning to appear, it may be in a position to blossom. In any case I will skip to the technical analysis (charts). You may check the financial statement data yourselves as you really should, but it is solid. Above, I have presented much of the “real fundamental reasons” that dictate why thermal coal use and prices are likely to go higher over the next several years. This article is meant as long term investment advice. (Click charts to expand.)

The 1 year chart of BHP:

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The 1 year chart of BTU:

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The 1 year chart of RIO:

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The 1 year chart of XSRAY.PK:

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The 1 year chart of AAUKY.PK:

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The 1 year chart of VALE:

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All of the above charts look similar. They are all rebounding from recent lows. The recent news from China should help that rebound. In fact it should help the stocks extend upward. Ditto the expected price increases and the expected shipping price decreases. The Indonesian ban on low kcal coal exports, if it does become law, should provide a further leg up. It is a bit of a wildcard, but if Indonesia wishes to continue to grow, it will have to reserve some of its coal for itself.

The charts of BHP and XSRAY.PK are perhaps the strongest. Neither of these stocks made it down to or below the 200-day SMA before turning upward in the latest rally. This is a sign of strength. If you prefer a market basket of coal stocks, you could choose the ETF, KOL.

To manage risk in this uncertain market, it may be best to average into any position you decide to take. 

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BHP over the next 72 hours.