The price of thermal coal has fallen 51% since peaking in January 2011. Secular factors like permanent demand destruction in developed countries won’t go away. And are we seeing China and India turning away from coal?
Since peaking in January 2011, the price of thermal coal has fallen 51% (Chart 1). Like any commodity, price is driven by the simple dynamics of supply and demand and supply has clearly continued to outpace demand (Chart 2). We highlight nine reasons for this imbalance and suggest some of these factors are secular as opposed to normal cyclicality.
1. Global production is not coming off-line fast enough. As is the case in Australia where approximately 40% of all seaborne coal is unprofitable, producers are forced to keep selling at a loss in order to fulfil previous shipping commitments. This is an unfortunate position for producers but will ultimately correct itself once they run out of money or demand picks up.
2. Japan has ramped up consumption (which is actually supportive of prices) but this is only transitional demand until it restarts more nuclear power plants and builds out the 65 gigawatts of solar they have approved over the past two years – incidentally this is greater than Australia’s total installed capacity of all types of power.
3. Ending a multi-generational trend, electricity consumption in the developed world has either stopped growing or is in outright decline. The weak global economy has undoubtedly reduced power consumption but some of the demand destruction is also the result of increased energy efficiency, increased distributed generation and behavioural changes – we wrote about this previously here.
4. Domestic coal is not so welcome at home anymore. This is best seen in the US where in the past 10 years, they have gone from exporting approximately 20 million tonnes to about 55 million tonnes at the end of 2013. Tightening legislation required existing power plants to upgrade their emission equipment with some owners simply electing to close the facility as the upgrade was too expensive. With the latest US Environmental Protection Agency (EPA) rules on mercury becoming enforceable on March 2015, the next major round of closures will further destroy coal demand. This coal is finding its way into the international coal markets further expanding the gap between supply and demand.
5. The EPA has also just released legislation targeting the reduction of carbon emissions from existing power stations. Featuring heavily in its “building block” compliance approach is coal to natural gas switching. With domestic natural gas prices so low, it is expected this will result in another round of accelerated closures of non-compliant coal-fired power plants. The legislation is also expected to essentially prevent the construction of any new coal-fired plants in the US. This should push even more coal into the international markets.
6. For its next decadal goal, the EU has targeted a 40% reduction in greenhouse gas emissions from 1990 levels by 2030. A cut of this size will naturally force out the highest emitters or at the minimum prevent their growth. Amongst the highest emitting fossil fuels, coal will continue to be friendless in Europe.
7. A more punitive price on carbon will make the EU’s goal more easily achievable. At this time, carbon prices have been distorted by unintended policy decisions but in time it is expected the “right” structure will be found. When this happens, we expect the cost of coal pollution will dramatically increase the cost of coal-fired electricity and allow other, low emission technologies to better compete.
8. India’s new Prime Minister Narendra Modi is very much pro-solar having strongly supported renewable energy when he was Chief Minister of Gujarat. Calling for solar power to bring electricity to 400 million people is ambitious without equal. This goal tacitly recognises that India has failed to bring its people out of energy poverty using conventional methods. Building a new grid that has distributed generation at its core is a unique opportunity for this country as they should be able to avoid some of the of legacy issues faced by the developed world as they incorporate greater amounts of renewable energy.
9. China announced that it would ban coal-fired power from Beijing by 2020. While some market commentators have highlighted that coal consumption in China is so strong that this amounts to a token gesture, we suggest that China has a long history of experimentation before making up its mind. It is more instructive that China is taking such extraordinary steps to deal with air pollution that high emitters should heed the warnings coming from the government. Ordinary Chinese citizens are fed up with the pollution and coal is an obvious target for their frustrations. Given that China is also experimenting with carbon pricing, are the world’s biggest producers of solar power (and a close second or third in wind) and have made pollution abatement a priority, we might be seeing the beginnings of a major structural shift in China’s generation mix.
In summary, thermal coal faces many secular challenges as end markets are fundamentally changing the way they regulate and consume coal. Its position as the cheapest form of power generation is insufficient to offset the growing acceptance that price is not the only deciding factor.
Coal prices will continue to face downward pressure because clean air today and a more sustainable tomorrow are worth more than all the coal from Newcastle.
Nathan Lim is a portfolio manager with Australian Ethical Investment