Price strength exposes market challenge
Prolonged strength in the metallurgical coal market reflects continued tight supply, defying earlier conventional wisdom that suggested producers would churn out more coal than needed on the back of major price spikes to $300.00/t FOBT and beyond.
Past price spikes have indeed led to overproduction and rapid retreats to a relatively low price environment. It was rational to anticipate a similar circumstance in the latter half of 2017.
But an odd thing has happened even as the price environment has shown strength. Investors have remained wary.
"As physical met coal prices have stayed strong through the summer, momentum in many of the equities has cooled down," Lucas Pipes, coal industry analyst for FBR Capital Markets, wrote. "Based on our estimates, met coal-exposed equities are now pricing in about $119.00/t, at a 5.75x EV/EBITDA multiple, including 2017 cash generation, down from our $126.00/t estimate from mid-August, when the benchmark index was at $193.00/t, versus $207.00/t today." Since then prices have fallen to below $200/t.
Earlier this year, US producers Warrior Metallurgical Coal and Coronado Coal pulled debt offerings off the table. Contura Energy backed away from a planned IPO.
A source noted that those hiccups occurred despite "$5 bn plowed into the coal industry this year," as a result of the high price environment, and the Trump administration's ongoing love affair with coal.
"If not now, when?" the source asked "We believe the lower valuations reflect investor fears about slowing Chinese demand, in addition to the preexisting angst that met coal prices are bound for an inevitable correction," Pipes wrote. "In our opinion, current valuations are a call on management teams to consider alternative hedging strategies.
"We believe that multiples could start to improve if producers were able to de-risk a portion of their sales books at the forward curve. As more tons in the seaborne market are priced on index, such strategies ought to become more feasible."
While global met coal business is dominated by index-based price outcomes, liquidity remains an issue. One major met supplier indicated that it hasn't been able to hedge any significant volume of tons, though it has heavily explored the potential to do so.
Javelin Global Commodities, a London-based firm that has become the major exporter of high-sulfur US thermal coal, is proposing to the market a strategy under which Javelin manages coking coal price risk for producers by selling future positions and locking in current sales prices. Similarly, Javelin says it can manage price risk for end-users by buying future positions and locking in current purchase prices.
The plan is ripe because access to capital continues to be a major impediment to coal producers. Absent term contracts to support borrowing, producers can point to high spot prices but not to guaranteed durability of profitable longer-term supply arrangements.
The ability to hedge tons would serve as a proxy for long-term deals. But hedging can't be accomplished with a magic wand.
Because of their relative position on the cost curve and the continued fragmentation of production, US-based met coal producers face the deepest challenge in attracting capital. The US is a swing met coal supplier, in many cases, and a limited amount of US coal is sold at par with prime Australian hard coking coal.
Warrior's struggle to complete a debt offering is especially notable given a significant percentage of its production is sold at par with Australian prime coking coal, and its position on the cost curve is favorable relative to many other US supply sources.
Javelin's proposition could offer support to US producers, and it appears such support is needed. US met exports were up 30% year on year, or 6.5 mt from January through July.
"It's a big absolute number," a source said of the 6.5 mm figure, but in an environment in which global prices have been at $150.00/t-plus for 12-18 months, many analysts had predicted 20 mt of US supply growth.
While other factors impede rapid supply growth, access to capital is widely seen as a leading culprit. Producers need something to take to the bank.
"We are willing to champion a listed met index and a related forward curve," Javelin has informed market players. "Javelin's steam coal experience globally differentiates us from most met traders. Javelin's steam coal volumes and control of logistics enable carriage of small or large coking coal volumes into many markets.
"Certain producers with minimal export participation benefit from Javelin's capabilities. Javelin's strategy is to develop marketing positions with producers of all coking coal types on both major railroads (CSX and Norfolk Southern)."
"It's not just the fact of our experience in domestic logistics, but also having the balance sheet to be able to hedge and manage the working capital requirements to get coal out of west Virginia to the rest of the world, which can involve specific contractual requirements in multiple locations across the globe," Javelin CEO Peter Bradley said.
There will be challenges given the fact met coal is not nearly as fungible as thermal coal, and given the broad spectrum of met coal produced in the US - the most prominent products being "A" and "B" high-vol coal, mid-vol coal and low-vol coal. Producers are also in diverse geographic regions.
"Quality and freight differentials would be agreed and fixed (or floated) upfront," Javelin says. "These structures would allow producers and end-users to secure term index-linked contracts and allow producers and end-users to manage price risk independently."
Challenges aside, US producers have limited opportunity to sell met coal much beyond the prompt quarter. And without such ability, how do they bring term certainty to lenders and investors.
"You really can't unless you're a first-quartile cost producer," a source said, referencing mainly the large Australian producers and Teck in Canada.
This isn't to suggest US producers have been void of opportunities to receive firm prices for the coal they produce. US suppliers such as Xcoal Energy & Resources, the country's most prolific exporter, Noble Energy and Trafigura, for instance, have provided producers opportunities to hedge their coal positions. Those companies and others continue to do so.
Javelin has an appetite to bring its own ideas and experience to the table. It is being evangelical in doing so.
If risk management is to fully develop, participation must extend beyond producers who alone will not drive a successful hedging mechanism. Bradley noted that "part of developing the derivative and commoditized markets is to bring both sides to the table so that both producers and consumers can benefit, with both able to "lock in long-term margins"
Bradley added - "It's no surprise that German car manufacturers trade iron ore and met coal swaps. They are keen to lock in long-term margins too."
Resistance to the commoditization of met coal has broken down in recent years, for good or for ill. Global indexation is the evidence.
"It is worth noting that markets will most likely commoditize with or without US support," Javelin argues.
Certainly the trader makes a strong case. "Major volumes are now traded on index, ending initial concerns with small traded volumes. More traded volumes have also resulted in more price volatility, with wide swings lately."
Javelin sees the nascent market as being primed for further development and thus driving demand for viable hedging instruments.
"Strong shifts to index-linked pricing are driving demand for price risk management tools," the company says. "This momentum has now increased with Nippon/BHP wanting to exit benchmark systems."
FBR's Pipes supports the theory.
"We believe that the undemanding valuations reflect ongoing skepticism about the sustainability of met coal prices above $130.00/Mt, not to mention $150.00/t or $200.00/t," he wrote. "The market's already cautious outlook is exacerbated by bearish expectations regarding the direction of Chinese demand into year-end, and following the People's Congress in October.
"We think the contrast between implied prices and spot prices/forward prices should make hedging opportunities more appealing to producers. With the move towards quarterly and monthly indexing, hedging products tied to similar underlying indexes ought to become more feasible.
"We believe that investors would applaud hedging programs that offer greater earnings visibility, especially when locking in higher prices than those implied by the stock market."
Time will tell whether met producers have more than a strong spot market to take to the bank.
Jim Thompson is Research & Analysis Director, Coal at IHS Markit.
Posted 29 September 2017
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