There is a lot of excitement currently in Australia that the coal industry (VanEck Vectors Coal ETF (NYSEARCA:KOL)) is on the path to recovery. The price for both thermal and coking coal has increased dramatically over the past few months. In Australia, suddenly coking coal has gone from being a loss-making headache to it being hugely profitable again.
The reason that most analysts have given for the dramatic changes is all about crude actions taken to reduce coal production within China. Changing days that miners can operate from 330 to 276 has to have a dramatic impact on production. In effect, the coal industry has been so brutally and abruptly shut down that there has been a need for increased coal imports, even though coal is clearly in decline in China. While Chinese total coal production is down 10% year on year for the first three quarters of this year, this dramatic reduction has mostly been in thermal coal, with domestic coking coal down just 1.6%. Chinese coking coal imports are a small fraction of China's coking coal consumption.
Coking coal supply
At the end of the day, coking coal use is about steel making. Australian premium coking coal dominates the international price and the spot price was $242.90 a ton on October 20. The spot price does not reflect the price most importers pay, but the quarterly contract price is above $200 per tonne currently.
So how is the increased coking coal price affecting steelmakers? It has been argued that Chinese steel producers are better positioned to cope with increased coking coal prices than Japanese, Korean or European steelmakers. The reason for this is that Chinese steel producers are less reliant on seaborne coal imports. So is this just going to make the oversupply of Chinese steel an even bigger problem on the international stage?
The complexities of the steel industry are in full view, with Chinese steel sales in trouble because of alleged dumping in international markets. Local manufacturers in Japan are seeking to increase steel prices because of increased coking coal prices. There is pressure on all sides.
It is also interesting to consider where China is sourcing its imported coking coal.
While Australia is the largest supplier at almost 50%, supply from the second biggest source (Mongolia) has increased dramatically (by 51.7% for the first eight months of 2016), while Australian exports of coking coal to China increased by 8.5% over the same period. The price paid for Mongolian ($34.20/tonne) versus Australian coking coal ($93.92/tonne) over the first eight months of 2016 is dramatically different, as the Mongolian suppliers have less bargaining power. The upshot is that Chinese steel producers are at a significant advantage to their competitors in the price they pay for coking coal.
Scrap steel price booms
The dramatic increase in price of coking coal has made steel producers re-look their cost structures, with coking coal becoming a big issue in cost of steel making. One consequence is that blast furnace operators are maximizing the amount of scrap steel in their mix to reduce the amount of coking coal needed.
This in turn has a knock-on effect on steel makers using electric arc furnaces as they are facing increased costs because the price of scrap steel is going up. Both Nucor (NYSE:NUE) and Commercial Metals Company (NYSE:CMC), leading electric arc furnace steel makers in the US, have suffered some reversal in their share prices since July, although no doubt lower steel prices are another major factor in this decline.
With so many levers being pulled, it becomes difficult for investors to make sense of how to value companies in the steel industry. Do you buy or do you sell? With blast furnace operators increasing the percentage of scrap steel in their mix, what change in the price of coking coal is needed to change this mix?
Peabody Energy (OTCPK:BTUUQ) share and bond prices go crazy
The above issues started the recovery of the Peabody share and bond prices, with the fact that Peabody has achieved a price of $200/ton for coking coal in its Q4 contract with Nippon Steel & Sumitomo Metal Corp. (OTCPK:NSSMY)
However, it is clear that the big producers BHP Billiton (NYSE:BHP) and Glencore (OTCPK:GLNCY) are cautious about restarting mines that have been mothballed. In the short term, BHP's share price is strong, up from a low of $A14.20 in January to close at $A23.04 in the latest trading on the (ASX), partly because much of its coking coal is sold at the spot price. Coal contributes ~15% to BHP's bottom line, but this is likely to be higher in 2016.
However, none of the above gives reason to believe that coal is emerging from a disastrous cyclic reversal that is returning to normal. Indeed China has already partially reversed its change in mining days allowed for 66 efficient coal mines (back to up to 330 days) to address the coal price increases, while keeping pressure on inefficient production.
In the case of Peabody Energy, Ross Rummel made a useful comment about the context for the current changes at Peabody Energy share price. In essence, he shows that equity investment in Peabody is a sideshow, because even with dramatic increase in the price of Peabody shares, the market capitalization is still less than 1% of issued debt. So if you are an equity investor, think about what you are buying. It is doubtful that you are buying any stake in the future of Peabody as this is in the hands of the bond holders.
The Peabody share price may have a very short time to run before it begins a decline to zero as bankruptcy is resolved. Here is what Peabody said about the value of its equities and other securities on 20 October.
"It is uncertain at this stage of the Chapter 11 Cases if any proposed plan of reorganization would allow for distributions with respect to Peabody Energy equity or other securities. It is likely that Peabody Energy equity securities will be canceled and extinguished upon confirmation of a proposed plan of reorganization by the Bankruptcy Court, and that the holders thereof would not be entitled to receive, and would not receive or retain, any property or interest in property on account of such equity interests. In the event of cancellation of Peabody Energy equity or other securities, amounts invested by the holders of such securities would not be recoverable and such securities would have no value. Trading prices for Peabody Energy's equity or other securities may bear little or no relationship during the pendency of the Chapter 11 Cases to the actual recovery, if any, by the holders thereof at the conclusion of the Chapter 11 Cases. Accordingly, Peabody Energy urges caution with respect to existing and future investments in its equity or other securities."
So it is pretty clear that the recent dramatic price increases have nothing to do with the actual product, or indeed equity in the company, and everything to do with financial engineering. With 18.5 million shares issued and call options out for almost 29 million shares, something has to give.
It is a huge gain for shareholders and a disaster for call option writers. This will get resolved, but there is a lot of money being made and lost on the way back to reality.
I suggest that anyone considering investment in the coal industry, especially based on increasing coal demand in Asia, might reflect on what is going on. I am reviewing the latest on coal consumption in the markets where coal recovery is supposed to happen (India, China and SE Asia) and the evidence is that markets that were expected to be growing strongly are now questioning the balance between coal, other fossil fuels (especially gas) and renewable energy. The coal outlook is getting bleaker rapidly.
While there is money to be made from nimble investment in coal (or at least the financial engineering behind coal companies), the coal industry is likely to suffer further reversal in the near future. So it is worth being cautious.
A lot of money is being invested on the basis that coal has started to recover from a cyclic reversal. There seems little evidence of recovery for coal and the price increases seem almost certainly due to clumsy implementation of reductions in coal production in China. Coal continues to be in structural decline. Draw your own conclusions about long investment prospects.
Regarding Peabody Energy, the share price may have closed at $10.59, up 69% on the most recent trading, but the company indicates that its shares may be worthless. If you own shares the situation is happy for now, but think about whether you should stay invested. If you are contemplating buying Peabody Energy shares, why?
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