In addition to making a compelling case for continued strong demand for met and thermal coal, he also signaled, (at least to me) that Mongolia’s coal exports from Tavan Tolgoi will disappoint over the next several years. However, what’s bad for coal supply is good for coal prices. Companies poised to benefit from the coming coal shortage will be excellent long-term investments.
An easy yet powerful way to get exposure to what Boyce calls the coal super-cycle is to buy KOL. KOL is an ETF that has coal companies as well as mining equipment makers. KOL is especially exciting because it has a good mix of foreign coal-related companies. Boyce said,
The world remains in the early stages of a long period of major demand growth and so-called one-time events in the industry that constrain supply now occur each quarter. Global coal demand remains robust. World steel production is up 8% year-to-date. Globally, the world will use an additional 70mm to 80mm tons of metallurgical coal this year. Electricity generation is rising rapidly in developing countries and coal is backfilling for nuclear power in Europe.
The consumption of an additional 70mm-80mm tons of met coal this year is a very significant amount. The entire global seaborne met market is just 250mm tons. China produces and consumes domestically about 550mm tons and will probably import 40mm tons of met coal over this year. As Japan bounces back, India grows to become the biggest importer of met coal and Brazil begins to ramp up for both an Olympics and a World Cup, 2012’s incremental met coal consumption could top 100mm tons. Boyce continued,
China remains a cornerstone of growth. First-half GDP grew 9.6%. Electricity generation increased 14% and steel output was up 10%. Last quarter, there was concern over an easing of China imports, yet imports have now risen for the past four months and we believe we're on a pace for a stronger second half.
There are several factors supporting Boyce's thesis of steady to stronger growth in the 2nd half. First, headline inflation may have peaked, allowing the government to ease its tightening stance. Second, the frequently cited build out of 10mm social housing units is picking up steam in the second half. Third, China is in year 1 of its 12th 5-year plan. The first 2 years of a 5-year plan typically sees higher expenditures than the last 3 years.
India is now the world's fastest growing importer. Their thermal coal imports are up 45% year-to-date. Europe’s thermal coal imports are increasing as Germany closes its nuclear plants and coal displaces high-priced gas. And, escalating demand growth continues to strain global supplies to the point where any external events take on magnified importance; labor stoppages, rains, permitting challenges and transportation issues are common.
India is in big trouble. The Indian government under-estimated thermal coal demand by expecting non-coal energy sources like gas and nuclear to ramp up quicker than they have. On the supply side, the government allocated a significant number coal exploration blocks, many of which they thought would be in production of coal by now. However, government red tape and environmental challenges have delayed this badly needed new supply. When coal prices rise rapidly and there’s little to no domestic supply response, that’s proof of a problem that can’t be fixed quickly. The only answer is more imports.
I’m surprised that more has not been written about Boyce’s important observation that coal in Europe is displacing high-priced natural gas. Combined with Germany's closing of its nuclear plants and Japan’s thermal coal demand bouncing back next year, this is extremely bullish for thermal coal pricing. Boyce has been pitching his coal super-cycle theme for some time now. Fundamentals have only gotten tighter.
Strong near-term fundamentals have kept international pricing near record levels for both met and thermal products, with recent settlements coming in higher than most expected. Longer-term the world could need more than 500mm tons of additional met coal per year by 2020 and some 700 gigawatts of new coal-fired electricity generation is expected to be online by 2020, requiring well over 2 billion tons of additional thermal coal. Just consider this: China's 12th 5-year plan targets $100 billion in investments in generation, transmission and subway construction activities by 2015.
Two billion tons of additional thermal coal supply by 2020? That equates to twice the current coal consumption of the U.S. As dominant thermal coal exporting nations like Indonesia and South Africa require increasing amounts of coal to be consumed domestically, where will the world find an additional two billion new tons?
With regard to Peabody's recently announced win of a coveted spot on Mongolia's Tavan Tolgoi synchronized mining team, Boyce answered an analyst question as follows:
It's premature for us to get into much detail on those projects, but I think as we're looking at them now, as they begin to develop, you're talking about a development horizon that would probably take us 24 to 36 months and then begin to start to build the mine out, and probably on both of those fronts in a three to five-year window before you see coal coming out and so that's at the highest level.
Wow! My read - 2-3 years to develop BEFORE they start to build the mine. And that’s not 2-3 years from today, but 2-3 years from when parliament signs off on the project, which could still be a long way off. The Koreans and Japanese are contesting the whole process as unclear and unfair. Let’s say that the clock starts ticking on 1/1/2012. Next, Peabody will have to complete a project development plan that will be unprecedented in its complexity. Peabody needs to reach consensus among a Russian railroad (the Russian government), a Chinese coal producer (the Chinese government, Mongolian interests (the Mongolian government) AND the Mongolian people who will directly own shares in the project.
More likely, it will take 3-4 years of development / consensus building. That would take us until 2015-16 before Tavan Tolgoi is in meaningful production, and 2016-17 before the project reaches 15mm tons of coal production, of which Peabody will control 3.6mm.
We have a number of partners with China with the Russian railroad and as well as the government of Mongolia. But we're fairly confident that, at a 15mm ton a year level, the Cap-ex will come in at a number that's consistent with what we would see in a normal surface mine that we would be building.
Even after the logistical nightmare of rail lines, bridges, roads, power plants, mining camps, schools, hospitals and air strips is resolved, at considerable expense for all involved, the costs of delivering the coal to the end user will ensure that margins will be merely mediocre. My guess is that this project will be an epic waste of time and financial resources. Worse yet, the labor, equipment, contractors and consultants that will be tied up in this mess will be largely unavailable to help other emerging Mongolian coal producers. I am convinced that Mongolian exports of met coal will disappoint over the next several years.
If my thesis on Mongolia is correct, then these statements from the CEO of Peabody lead to the inescapable conclusion that coal prices will stay stronger for longer. To recap, India's coal demand is higher than expected and its domestic supply lower. Germany is phasing out nukes and coal and natural gas will have to fill in the gap. Japan's coal demand is rebounding and will pick up pace next year. Brazil has to build infrastructure, stadiums and housing for an Olympic Games and a World Cup. Natural gas prices in Europe are rising, enabling lower cost coal to be used. The world needs Mongolia to be producing 50mm tonnes of coking coal in 5 years, it won't be, and export growth from South Africa and Indonesia will be anemic due to domestic needs for the coal.
Yet, the story doesn't end here. Although Boyce raised crucial issues, other factors coming into play also suggest that global coal supply will fall short. China's coal reserves are not nearly as large as many suspect. I calculate that by 2016 China may only be able to count on 14 years of remaining coal, see here.
In addition, It appears that hopes of alternative energy saving the day have been diminished by the recent setback in nuclear energy due to Japan's terrible earthquake. Elsewhere, In other countries, the planning and building of new facilities will be materially delayed and some will be canceled. And, new studies pose serious questions about wind power's ability to adequately replace base load coal-fired electricity. Finally, Jim Chanos is famously shorting all things wind and solar. He believes that neither are economically viable without subsidies. The stock prices of many of these companies have been crushed and raising capital in these industries just got a lot harder.
Considering what Boyce said and contemplating these additional factors, the question may not be if coal prices will remain at or above current levels, but how high might they go and how soon will the world realize high prices are here to stay. Investing in coal company stocks before this scenario becomes conventional wisdom could make for an excellent long term investment. The best way to get invested in a wide range of companies that will benefit from the global demand for coal outstripping incremental supply is to buy KOL.