All Coking Coals Are Equal, But Some Are More Equal Than Others

by: Peter Epstein

Coking or metallurgical/MET coal -- i.e., coal used in the steel making process -- commands a premium price to steam or thermal coal used as fuel in power plants to generate electricity. There are multiple flavors of thermal and coking coal. On the thermal side, the key metrics that determine the price are the coal's heat content, moisture, and sulfur levels. While the same metrics are important for coking coal, there are an additional set of physical and chemical properties that play an important role, such as: FSI, Volatile Matter, Ash, Fixed Carbon, CSR and Fluidity. I will describe each of these in detail.

The simplest test to evaluate whether a coal is suitable for production of coke is the Free Swelling Index, 'FSI' test. This involves heating a small sample of coal in a standardized crucible to around 800 degrees Celsius (1500 °F). After heating for a specified time, or until all volatiles are driven off, a small coke button remains in the crucible. The cross sectional profile of this coke button compared to a set of standardized profiles determines the Free Swelling Index. (Source: Wikipedia.)

Okay, maybe I won't describe each property in detail. For the purposes of this article, descriptions of each coking coal metric are not necessary. What is important to know is that the best quality coals in the world are truly scarce. While coal is found in more than 60 countries around the world, premium hard coking coal is only known to be accessible in abundance in Canada, Australia, China, Mongolia, the U.S., Russia, and Mozambique. Two additional countries trying to ramp up to meaningful quantities of premium hard coking coal are Indonesia and Colombia.

Of the 10 named countries, only five are mature established producers of the best stuff. Among emerging producers, two stand out for being slower than expected to join the party. The only thing larger than Mongolia's Tavan Tolgoi coking coal project is the hype surrounding it. This massive resource was supposed to be producing 15 million metric tonnes of premium hard coking coal by 2015. Given ongoing delays and political bickering, I don't expect to see 15 million tonnes from that project before 2018 at the earliest.

Infrastructure challenges are impeding progress in Mozambique. Both Rio Tinto and Vale have begun shipping coal, but total shipments of premium hard coking coal will not exceed 10 million tonnes until more rail upgrades are in place. The mature producing countries are not without problems as well. Canada's Teck Resources, (TCK) is very well positioned as the second largest producer of premium hard coking coal in the world, but Teck is two years behind schedule in reaching its goal of 30 million tonnes.

Australia, by far the largest producer, has experienced two 100-year floods in the past four years and significant strike activity against BHP (NYSE:BHP), the world's largest coking coal producer. Near- to intermediate-term supply constraints appear to be a fact of life. Another factor is that the overall quality of coking coal is falling each year in places like China. The yield loss and quality degradation may equate to a decline of a few percentage points per year.

A key question, though, is why can't end users substitute to a mix of lesser quality coals? The answer is that they can, but only to a certain extent. Eventually coke quality begins to suffer, the blast furnace becomes less efficient, and maintenance costs start to rise. In the end, the optimal coking coal blend fed into a blast furnace must contain a low volatile matter component to balance out the other higher volatility coals in the mix. Only the premium hard coking coals are inherently low volatility.

Therefore, demand for the top coking coals has been solid compared to that of thermal coal. Australia's Bowen basin quarterly benchmark coking coal index recently ticked up to $225 per metric tonne from $210. $225 is still a far cry from last year's high of $330 per tonne, but it appears that a floor of $200 per tonne may be in place. If true, this is bullish for the main producers of premium hard coking coal.

As mentioned, BHP and Teck Resources are the largest producers and exporters of premium hard coking coal. Another important producer is Walter Energy, (NYSE:WLT), producing at about a 10 million ton per year run-rate. Walter has attractive organic, low-cost growth in its future. While the company has been plagued by high costs and geologically difficult mining conditions, the quality of its coal in Alabama ranks it among the best coking coals in the world.

Of the significant producers of premium hard coking coal, Walter stands out as a pure-play. Teck has a great coking coal franchise, but it also gets about half of its earnings from copper and zinc. BHP is the largest miner in the world, so hard coking coal alone is not enough to move BHP's stock price meaningfully.

Teck and Walter are very well positioned to benefit from the continued tightness in global premium hard coking coal markets. Other coal producers who have significant coking coal exposure, like Alpha Natural Resources (ANR), have little of the top-notch coking coal. Alpha Natural is the third largest coking coal producer in the world, but its coking coal is largely "hi-volatility B" quality. These lesser-quality coking coals are currently out of favor. In a bull market for commodities, Teck and Walter will benefit first, but the upside to a company like Alpha Natural is substantial.

In the long run, the easiest bet to make is that producers of premium hard coking are protected on the downside because demand for this scarce resource will remain firm. In a bull case, not only will these producers see earnings spike, but a pure-play like Walter could be viewed (as it is from time to time) as a prime takeout candidate.

Disclosure: I am long ANR, WLT, NRP, CNX, ARLP.

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