Over the past couple of days I've listened to four coal companies talk about the prospects of their commodity. Peabody Coal. Arch Coal (NYSE: ACI, Stock Forum). Fording Coal Trust (TSX: T.FDG.UN, Stock Forum). Teck Cominco (NYSE: TCK, Stock Forum). The outlook, pretty much without exception, has been bullish.
The best summary of the dynamic occurring in the coal market today was from Steven Leer, the CEO of Arch Coal:
We are not necessarily forecasting a slowdown in the BRIC countries, more of a slowdown in growth. [But] if you go from 10-11% growth to 8-9% growth [as is potentially the case in China], its [sic] still a large number... What we are seeing [in coal demand] is insatiable demand from the Pacific Rim, China, India, and the other Asian economies. Keep in mind that China is adding roughly a power plant a week. Globally the estimates are that demand will increase 1.1 billion tonnes in the next 4-5 years, and if you think about that, if it’s a billion tonnes, that’s the same as trying to replicate the US coal industry in 5 years. Its not that the reserves don’t exist on a global basis, because they do, but it’s the infrastructure demand. We can grow to a point but at some point the infrastructure starts limiting us. You can see that in Australia this year. [We expect there to be a] 30-40Mt shortfall this year and a increasing shortfall as you go forward, led by [demand from] China, India and the countries in the Pacific Rim and then compounded by infrastructure problems in the supply countries. We are forecasting that its [sic] continues to increase 5-10Mt deficit compounded each year.
The zinc analogy
A close analogy to what will happen to coal stocks is what happened to zinc stocks a couple of years ago. It took some time for the market to embrace higher zinc prices, and to give higher multiples to companies like Hudbay Minerals (TSX: T.HBM, Stock Forum) or Breakwater Resources (TSX: T.BWR, Stock Forum). But eventually those companies received high single-digit or low double-digit multiples.
The same thing will happen to the coal stocks. It will, however, take time. We need a flurry of strong earnings reports and a period of cash build-ups on the balance sheets for it to happen.
Of course, in the case of zinc, the story ended badly when the commodity price collapsed due to oversupply in response to the shortage. Hudbay and Breakwater, along with others like Lundin (NYSE: LMC, Stock Forum) and even Teck, have seen their zinc earnings, and their share prices, fall precipitously.
Eventually, the same could happen with coal and the coal stocks. But we are not anywhere near that point yet. We are still early in the cycle.
The infrastructure is the missing link
I would point out that no one can be sure how long the cycle will last. With zinc, the key factor in the price collapse was the number of brownfield projects that were able to be brought into production in only a couple of years. Blue Note Mining, Strategic Resource Acquisition (TSX: T.SRZ.NT, Stock Forum) and Acadian Mining (TSX: T.ADA, Stock Forum) are all perfect examples of such brownfield mines.
With regard to coal, much of the “easy” production was brought on-line at the peak of the last cycle, in 2004-2006. This is particularly true for the metallurgical coal market, which is the coal market that I am invested in.
The remaining coal reserves require development. That development refers to more then just mills and trucks at the mine site. What the coal market needs to move back into balance is an infrastructure build-out through the whole supply chain. Rails, ports, ships, and of course, the mines themselves.
I've written about the rising costs of infrastructure in the past. The cost of rails, roads, labour, oil, and steel make bringing on the vertical integration of new coal mines a large undertaking.
I suspect that this build-out will take years. On the Arch Coal conference call, it was noted that Australia, for one, seems only able to build out its infrastructure fast enough to keep two steps behind what is required.
Stronger for longer
Given the scope of the infrastructure requirements, the price of the alternatives (oil) and the massive demand from the Pacific Rim, I could see this cycle being "stronger for longer." The coal chart could easily show that a closer analogy is to the copper chart than the zinc chart in a few years.
Yet most coal stocks, particularly the metallurgical coal stocks that I am interested in, are trading at less than five times earnings. Western Canadian Coal and Grande Cache Coal are trading at less than three times earnings.
It is more likely that there is more upside left in the price of coal. And it is even more likely, in my opinion, that there is much more upside left in the price of coal stocks.