Cyclone Debbie has added another wrinkle to the already obtuse coal markets. Spot prices for coal are on a run and Chinese firms have taken the unusual decision to tap American mines to satiate short-term demand. Does this translate into permanent tailwinds for Arch Coal (NYSE:ARCH) and US coal mines (NYSEARCA:XME)? No here's why.
The catalyst for the price surge is fleeting. If steel and therefore met markets are to sustain a recovery, they need to ride the coattails of fundamental economic drivers. Unfortunately, there are none on the horizon.
China carried both industries for decades, unfortunately it is transitioning from an industrial to a service economy. But the biggest threat to met coal is the proliferation of EAF mills, which do not require met to produce steel. 47 of the 83 steel producing countries rely solely on EAF mills.
Chinese demand has dominated the industry for decades. In 2016E the Chinese consumed half of the global total. However, the Chinese market is likely contract over the next decade.
The Chinese economy has reached the tipping point at which all other major economies began their transition into service economies.
...but should Chinese steel be on the chopping block?
In 2016E the country consumed 790.1mt of steel, roughly 50% of the global total. Furthermore of the 10 largest steel producers, China is the sole producer whose domestic demand has yet to peak. Finally, 94% of its steel production is based on OBCs. Consequently, China could not only pick up slack steel demand but also met coal demand. Yet, the financials indicates that Chinese steel has peaked.
A fact that is difficult to reconcile with the Chinese growth narrative, which permeates the investment landscape. It also clashes the belief that industry's share of GDP declines at the $20k per capita mark. A milestone that China hasn't reached. The mixed signals and the recent spike in steel prices have reignited the debate on "early [steel] peaking" in China and given credence to investors who believe in a second coming.
Despite the discord on the timing of the peak, POSCO managed to group market analysts into three buckets. OECD governments and Beijing fall into the "already passed" category. As do I. Goldman, Morgan Stanley, the street believe that the good times are still ahead. It is time for a litmus test.
Early "Peking" in China?
Narrative: The age of China's working population hasn't peaked; it can act as both a source of consumer demand and labor supply.
Counterpoint: Every OECD's demand peaked well before its working age population.
Narrative: Chinese autos account for 7% of national demand, 21% less than their Japanese counterparts. Steel consumption by autos can rise by 3X as China grows.
Counterpoint: Another lemon. China's construction industry consumes more steel than the Japanese by the same margin. China spends (EY estimates) 8.5% of its GDP on infrastructure 2X the World Bank's recommend allocation. Consequently, while autos will rise construction will stumble, netting to 0.
Narrative: Infrastructure spending will translate to steel demand in China and across the globe. For example, President Trump has promised $1tr in infrastructure investments.
Counterpoint: Trumps' effort amounts to 1.75% of the $57t in infrastructure that (Mckinsey) that was allocated to infrastructure globally. If his entire program is completed in a year, it'll constitute 1.9% of global capacity.
Narrative: China's infrastructure lags the G7's, despite boasting aggregate GDP that is 3X of the G7 average. Consequently, China will be paying an intense game of catch up for decades.
Counterpoint: The comparison must be like for like; infrastructure and GDP must be compared on a per capita basis. China ends up dead last on both GDP and infrastructure when compared to the seven richest nations on a per capita basis. China will actually be playing a relaxed game of catch up for centuries. A G7 nation has yet to occupy a top 10 slot on per capita infrastructure availability.
Narrative: EAFs will not gain critical mass in China, because its current scrap reserves cannot satiate demand. Furthermore, the initial uses of steel are for products with long lives such as buildings, thus neither will its future reserves. The rapid entrance of EAFs into the US market in the 1970s (evidenced by the sky rocketing prices of scrap), and their subsequent success. Is a scenario that will not play out in China. As a result China's appetite for met will not wane.
Counterpoint: As a country develops demand for steel stems from products with much shorter lives such as vehicles and appliances. Consequently, by 2025 China will generate 192mt of scrap from obsolete sources. Total generation will constitute ~40% of current demand.
A historical perspective on the fall of Chinese steel
Which leaves us with the tipping point. At ~$20k GDP per capita all advanced economies tilted away from an industrial economy move towards a service economy (chart on left). The shift occurs at the expense of industrials. The chart on the right plots US steel consumption on an absolute level the from 1929-2013 vs. the log of GDP per capita. American steel consumption contracted, it didn't plateau. Chinese GDP per capita is well below the tipping point; a watermark that the IMF expects China to breach in by 2020. Consequently, one can conclude that last few years was a bump on the road to continued growth, but you would be wrong.
The $20k watermark is one based on the observed fact that there is an economic limit on industry's share of an economy (50%). A threshold no major economy had crossed. It tends to correlate with the GDP mark but as depicted in the first chart, the downward spiral of the industrial sector began over a range of GDP values and not any one point. The output share of Chinese industrials peaked in 2010 one year before the super-cycle peaked.
2016 was a dead bounce and so is the aftermath of Debbie.
Disclosure: I am/we are short ARCH, CRSXF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.