Thermal Coal and Frontier Markets
Thermal coal represents inexpensive energy to the Frontier Markets we cover, but to the more developed world, it represents a dirty fossil fuel whose days have long passed. China finds itself juxtaposed between these two views. It needs the cheap energy provided by thermal coal, but at the same time it faces increasing pressure from a wealthier citizenry to clamp down on the pollution that thermal coal brings.
2015 has been a disastrous year for the global thermal coal industry. In particular, for the US coal industry which has seen a hollowing out of its most notable members. Walter Energy filed for bankruptcy on July 15, Alpha Natural Resources was delisted, and Arch Coal is in the midst of fighting for its life. It has a 1 for 10 reverse stock split which will be effective Monday (July 27), but this is unlikely to prolong its death by much. Peabody energy, which had a market cap of over $3bn 5 years ago, now has declined to ~$300mm. The US’ electricity generation has been moving away from thermal coal to natural gas for quite some time, and increased regulations concerning greenhouse gas emissions and water regulations have been the knell for the US thermal coal industry.
For some time, the US thermal coal industry was able to eke along due to profligate credit markets and some demand for exported coal. However, US coal companies have suffered from USD appreciation and a tightening of credit access for the thermal coal industry. As a result, we believe the age for thermal coal in the US has come and gone.
What does this mean for Frontier Markets?
The Frontier Markets we cover have varying exposure to thermal coal. Kazakhstan has the most significant current exposure as it’s the 10th largest producer of thermal coal in the world. 85% of Kazakhstan’s power capacity is dependent on thermal coal, and the country has the 8th largest reserves globally. Kazakhstan can continue for quite some time on this path, it has no pressing environmental concerns from its citizens, its territory is vast, and the coal is cheap. Kazakhstan can continue to rely on thermal coal for the foreseeable future, but the source of this coal will increasingly be government sources rather than private enterprise. That is the key for us.
Thermal coal producers enjoyed 10 years of volatile, but attractive pricing for the commodity. We believe this era is over. $50 thermal coal is the future, given the abundance and the deleterious impact of thermal coal on the environment. The primary drivers of investment within the industry will be state-owned ventures such as Shenhua Coal or Coal India. The figure below outlines the price of thermal coal since 1995.
Thermal coal proponents often cite carbon capture technology as a way to move forward using coal whilst minimizing its negative impacts. Carbon capture projects have been launched around the world but they have yet to demonstrate market competitiveness relative to alternative technologies such as natural gas, hydro, wind, and solar. As solar technology improves it is difficult to envision a scenario where thermal coal prices may remain robust and carbon capture technology would be economical. As a result, we think investors should stay away from this sector, unless their investment is short-term and based on a cogent investment thesis.
There are approximately 105 companies listed globally that are direct plays on thermal coal. Of these, approximately 46 are Chinese-domiciled. Absent these names, the entire market has a capex of only $82bn. There are 5 names in the markets we cover, these are shown in the table below.
Coal is plentiful in most of the world. Most Frontier Markets have not even completed full exploration activities for coal, due to the abundance of coal that is already known and recoverable. It is safe to say that the vast majority Frontier countries could use thermal coal exclusively for electricity generation for at least 50 years without issue. There are very few resources in the world that are as abundant. The challenge for countries that favour using coal for growth, is to balance the demands of a rising populace for clean air and water with the need for electricity to drive economic development.
In our view, Frontier Markets will continue to use thermal coal, but in a polluting and inefficient manner. It is only those with significant economic resources that are able to invest in cleaner coal technologies. Once an economy reaches a stage where it is able to pay for cleaner coal, it is also able to pay for cleaner sources of energy. We believe, therein lies the challenge for the thermal coal industry. We have learned to never underestimate innovation, bu at this stage there is nothing but headwinds in the way for thermal coal.
One point which we always emphasize is to note and acknowledge that thermal coal is not metallurgical coal (coking), which is used for the manufacture of steel. The prospects for met coal remain weak in the short-term, but are significantly brighter than that for thermal coal in the medium/long-term future.