Editor’s note: This article first appeared as a Stockhouse blog entry: Coal: A Bet on a Slow Supply Side Response.
I've written about my Western Canadian Coal Corp. (TSX: T.WTN, Bullboard) purchases, and I've posted a lot of information about coal and in particular met coal (metallurgical coal), but I haven't ever dedicated a post describing the reason behind my bullishness on coal.
First, the distinction needs to be made between metallurgical coal (which WTN produces) and lower value coals. While there is plenty of coal in the world, there is a good deal less met coal. Global coal production is 5.8Bt, while metallurgical coal production is 745Mt, of which only around 225Mt is for export.
Fording Canadian Coal (TSX: T.FRD.UN, Bullboard) calls hard coking coal a scarce resource. In one of their investor presentations they point out that only eight regions in the world have substantial coal deposits of suitable quality for coking coal. Massey Energy (NYSE: MEE, Bullboard) described the “scarcity of met quality reserves” on their recent Q1 conference call. Arch Coal (NYSE: ACI, Bullboard) pointed out in their conference call that “everyone is challenged with met coal reserves.”
Yet there has been tremendous new demand for coking coal from China, Brazil and India. I have made my arguments enough times on this blog that it goes without saying that I do not see this demand letting up anytime soon.
Has the easy supply been used up?
Up until now, a good deal of the demand for coking coal has been met by supply increases in Indonesia.
Yet Indonesia production appears to be increasing at a slower rate. NPC recently pointed out that Indonesia's coal reserves are "being depleted at an alarming rate." Mineweb notes that "after years of solid production, Indonesia's output growth is set to halve largely on a dearth of investments in the last decade...Top five Indonesian producers -- Bumi, Banpu, PT Adaro, PT Kideco and PT Berau -- which account for nearly 75 percent of the country's total coal output, have forecast total production from the five miners to rise just 7.5 million tonnes to 155 million tonnes in 2008, half the range of 2007's increase."
The dearth of investment
My basic argument is that a “dearth in investment,” not only in Indonesia but across the world, is going to create a situation where coal prices will be “stronger for longer” than anyone is expecting.
I've pointed out on InvestorVillage that the market is not giving adequate value to built and operating mines. My argument is that the capital costs of building new infrastructure has gone through the roof, the time required to build new infrastructure has increased dramatically, and that this needs to be reflected in the value of existing operating mines. While my arguments on IV have been intended for zinc, I believe the same applies to coal.
Preston Chiaro, the CEO of Rio (NYSE: RIO, Bullboard), recently commented that "coal supply/demand tightness won't ease for many years due to limited infrastructure and strong demand." Chiaro went on to say that Rio has capacity in Australia in New South Wales and Queensland which the company cannot bring on because of a lack of rail and port space.
Similarly, Massey described "the availability of rail cars as being extremely tight." Don Blankenship, CEO of Massey went on to say that "we also believe that tight capital markets and other significant barriers to entry have limited new mine start-ups."
This is not a new argument. The same basic idea has driven copper, oil and potash to higher highs. It takes a long time to bring on new greenfield production, and the costs of greenfield production are not what they were a few years ago.
That this same dynamic would now play itself out with coal should not come as a surprise. The price of steel keeps going up, the availability of tires has not improved, and labor in Australia and the United States for miners remains extremely tight. When new mines do come on-line, they will require higher coal prices to offset these increases in capital and operating expenditures.
I believe that the following Macquarie analysis is prescient:
There are now signs that Chinese steel mills will be facing desperate shortages of met (metallurgical) coal in the coming years, and look set to meet previous expectations of strong import growth… However, the delays in new capacity, combined with disastrous floods in Queensland earlier this year (which look set to cost at least 15 million tonnes of lost supply in 2008), appear to have created a structural shortage of met coal that could now last for several years.
This outcome seems quite possible to me. Yet the coal companies, in particular Grande Cache Coal (TSX: T.GCE, Bullboard) and WTN, are trading at three to four times earnings, even after their recent run-up. I think that represents a reasonable risk and the potential for a lot of upside.