The Hindu Business Line : Why coal is still red-hot

Although various commodities have taken a hard knock of late, the fundamentals of coal indicate that high prices will continue to rule for some more time.

The demand for coal is expected to be robust until the myriad alternative energy sources currently being developed find wider application.

Sunil Kewalramani

As China and India industrialise, the demand for steel has increased exponentially. Coal is one of the important raw materials used in the manufacture of steel. Coal prices have doubled over the past year and are expected to spike even further as a power crisis in China combines with supply problems in leading exporting countries to tighten the market. Although various commodities have taken a hard knock of late, the fundamentals of coal indicate that high prices will cont inue to rule for some more time.

Coal is the cheapest form of energy for power generation, which is reflected in the large amount of new built plans for coal in many countries. Almost 80 per cent of Chinese electricity generation requirements rely on coal.

The Chinese power crisis is likely to be a major driver of the global coal market in the near-to-medium term. In addition, many traditional exporting countries, such as Indonesia, the world’s largest exporter of thermal coal, South Africa or Poland are increasingly relying on domestic coal supplies for power generation, thus adding to supply-demand disequilibrium.

Coal prices are also expected to find support from Chinese government’s efforts to shut more than 4,000 small coal mines and reduce their numbers to below 10,000 by 2010 from 16,000 currently in hopes of reducing the number of deaths by accidents.

The world coal market had been expecting that record prices would trigger an improvement in supply, but supplies from the main coal exporting nations have fallen this year. China produces a large amount of thermal coal, but most of this output is consumed domestically. The country’s energy market is distorted by government price controls that have reduced the incentives for coal producers to lift output. The net result is that China’s next exports of coal have sunk by more than half over the past four years and the country even became a net importer in April 2008, putting a significant strain on supplies in Asia.

European utilities too could begin to feel the impact soon as Poland and Russia have reduced their coal exports to Europe, exacerbating the shortages. There is not much time for restocking before the start of Winter 2008.

Hedge funds make strong entry

Fresh interest from hedge funds and other investors looking to gain exposure to the commodity, thanks to greater liquidity in the till-now opaque over-the-counter coal market, has exacerbated the supply-demand disequilibrium which persists in coal.

The one-year forward contract for the Asian coal benchmark, known as API-4, has risen by over 100 per cent over the past year to trade, moderating recently after reaching a record $179.5 a tonne in early August.

In a bid to secure coal supplies, user industries are establishing backward linkages. British Gas is taking up to 30 per cent of QGC (Queensland Gas Company)’s share of acreage.

In India, Reliance Industries, Reliance Power, Tata Power, IOC, GMR, Lanco and the Jindal group are among the groups that have expressed interest in 6 billion tonnes of coal blocks in Orissa that the government had put on offer for Coal to liquid technology.

Where India stands

India has got the fourth largest coal reserves in the world. The coal reserves of India are estimated to be 248 billion tonnes (up to the depth of 1,200 m) of which 93 billion tonnes are proven reserves (7 per cent of the world’s proven reserves).

Out of the total proven reserves, coking coal reserves are about 16.4 billion tonnes and out of this, the prime coking coal reserves amount to a mere 4.6 billion tonnes. It is ironical that India still needs to import coal which is mainly on account of delays in project commissioning, inadequacy of policy framework and inability to create appropriate infrastructure.

The NTPC, in the recent past, raised an alarm over low coal stock at its Ramagundam plant in Andhra Pradesh. In April 2008, the unit which has capacity to produce 2,600 MW, was running with just two days’ of buffer stockpile as it failed to secure supply the quantity of coal required daily.

Coal India IPO

On July 11, 2008 ‘Navratna status’ was granted to Coal India to free it from the need to approach the government for approval of projects irrespective of their size. Coal India is also considering an IPO. CIL has posted over 12 per cent growth in profit before tax — from Rs 8,522.22 crore in 2006-07 to Rs 9,576.22 crore in 2007-08.

Turnover has crossed the Rs 40,000-crore mark. The next few years will be eventful for Coal India as the public sector coal major has a host of significant projects in the pipeline. CIL expects to go ahead with its proposed acquisition of mines in Australia, Indonesia and South Africa through the SPV (Special Purpose Vehicle) — Coal Ventures International, which includes four other PSUs.

CIL has also lined up investment of Rs 14,000 crore to scale up production of coking as well as non-coking coal in its Jharia and Raniganj coalfields. Arcelor Mittal is mulling a Joint Venture with Coal India for extracting coal from abandoned and unexplored reserves. Reliance Industries has also expressed interest in a joint venture with Coal India for surface coal gasification.

Investment opportunities

Coal companies listed elsewhere may throw clues on valuations they are likely to enjoy. Singapore-based as well as listed Straits Asia, with a market capitalisation of $2.9 billion, is involved in a de-merger with Perth-based miner Straits Resources. With the de-merger, proximity to customers in Asia gives it an advantage over producers in South Africa or Australia. Indonesia is the world’s largest thermal coal exporter and its miners have gained from strong demand from China and India and supply constraints that have pushed thermal coal prices to record highs. Shares of Indonesian coal firm PT Adaro Energy Tbk have leapt as much as 60 per cent in their market debut and raised $1.3 billion in the country’s largest ever initial public offering.

The highly successful IPO in Indonesia, Adaro was priced at about seven times its forward earnings. These instances offer a few global benchmarks for valuation of coal companies.

As India nears general elections 2009, this gives rise to the possibility of increases in various administered and quasi-administered commodity prices post-elections, to achieve market-parity and counteract the large budget deficit. The demand for coal is expected to be robust until the myriad alternative energy sources currently being developed find wider application.

The author is CEO of Sunil Kewalramani Global Capital Advisors.