China Coal – Not Out of the Petrified Forest Yet

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 5th, 2016

China Coal – Not Out of the Petrified Forest Yet

  • Headline of higher Asian coal pricing obscures divergent coal inventory levels within China
    • Significant declines in inventory at the coastal ports
    • Significant increases at inland mines and significant increases overall
    • Inventory overall of 140 million tons is less than 5% of annual consumption and it should be noted that recent work limitations are aimed at cutting production by more than 15%
  • Distinction is key, as products where the marginal producer utilizes inland coal are unlikely to be as affected by a traded higher coal price as products where the marginal producer is coastal-based – unless lower overall production starts to reverse inventories everywhere
    • Logistics are a secondary factor – it is easier to move a liquid or a solid from the inland regions – such as Urea and Methanol than chlorine or VCM
    • Most products under-pressure from Chinese export surpluses are easy to move
  • We identify the Chinese provinces where production of various chemicals/metals is focused
    • Steel mostly coastal while aluminum more inland and trending further
    • PVC mostly inland
    • Urea and TiO2 mixed – more central/coastal than inland
  • The analysis seems marginally more positive for urea and steel, marginally more negative for PVC and aluminum. Yet…
  • The only real bullish pricing argument to be made would be to believe that coastal Chinese coal could remain at an elevated premium to inland coal and US coal
    • This would displace the Chinese inland producers at the top of several cost curves – such as Urea, Methanol and Aluminum – raising break-even pricing and increasing the margin umbrella for others
    • We think this unlikely and unsustainable given the surpluses inland which would move to the coast or offshore to exploit the obvious arbitrage
  • The only stable positive would come from overall China coal inventories falling and prices rising everywhere due to production cuts
    • We would rather own CF, AA and EMN based on valuation should this move occur
    • Without it, CC, HUN, X, and TROX look particularly expensive following recent gains

Exhibit 1

Source: SSR Analysis, Bloomberg, IHS, PIIE

Overview

The investment community is watching with interest as Asian coal prices stage their first sustained price recovery following five years of abrupt declines which have impacted power, metals and chemical prices in China and, where China has surpluses, have impacted prices globally. Exhibit 2 shows the recent history for Newcastle prices and also shows how the recent rally in Asia has not been reflected in the US – cheap natural gas in the US has kept and will likely continue to keep US Appalachia coal pricing low. Eastman is the primary, and may be the only, beneficiary of this change given its large consumption of Appalachian coal to make products that compete globally.

Given that Chinese coal pricing has been blamed for most of the wrongs in the industrial world, perhaps we should be celebrating the recovery in pricing and maybe this is a turning point. The higher pricing is likely driven by a steep decline in Chinese coastal coal inventories in recent months – Exhibit 2. Coal pricing is likely rising on the coast in China as a result. HOWEVER… if you look at overall China coal inventories you get a very different picture – Exhibit 3 – inventories continue to rise, which means a surplus growing more rapidly inland. China’s recent work restrictions to try and cut oversupply have given some observers hope that things will improve and that pricing for many products have bottomed. We don’t think it is that simple.

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Bloomberg, SSR Analysis

Exhibit 4

Source: Bloomberg, SSR Analysis

Unless the production restrictions result in declining overall inventories of coal, and inland coal pricing starts to reflect the value of marginal coastal buyers we believe that the arbitrage will close in the coal derived products areas simply by increasing shipments from the inland locations to the coast and eventually offshore. Inland thermal coal based economics define the top end of the global cost curve for Urea and Methanol – through coal gasification – and for Aluminum and Steel from an energy input perspective. If coastal production costs rise above inland costs, inland production will rise.

Most recent investment in chemical and metals in China has been inland to exploit the low cost and abundant coal. Earlier waves of investment were coastal and based on imported feedstocks. The current situations, and its direction, is summarized below:

Location of capacity (inland versus coastal):

    • Steel – 53% clustered on the Northeast coast
    • Aluminum – increasingly located in the northwestern province of Xinjiang, which houses 40% of China’s coal reserves and has become the top producing province from virtually negligible levels 10 years ago; northern and western provinces already accounted for 40% of capacity in 2012, the last year for which we have complete provincial data
    • TiO2 – main production locations are in the landlocked province of Sichuan and the ocean accessible Guangxi province in the south; secondary locations are clustered on China’s eastern Pacific coast
    • PVC – 55% of capacity located in deep inland provinces – 30% alone in Inner Mongolia and northwestern Xinjiang
    • Urea – Chinese nitrogen production is focused in the coastal northeast and parts of central China; potash dominates in the northwest

Location of Capacities – By Product

  • Steel
    • Production is concentrated in the coastal provinces
      • These areas have been nominally identified for capacity cuts but in 2016 we have seen China fall back on its old ways and restart facilities in the heavily polluted Hebei province, which surrounds Beijing

Exhibit 5

Source: China Metallurgical Industry Planning and Research Institute, SSR Analysis

  • Aluminum
    • Productive capacity increasingly located in the northwestern Xinjiang province, which houses ~40% of China’s coal reserves
      • Concurrently, halting alumina capacity in the former top producing provinces of Shandong and Henan in the east has deemphasized aluminum there

Exhibit 6

Source: CRU Group, Light Metal Age, SSR Analysis

  • TiO2
    • Mainly in Guangxi (coastal access) and Sichuan (more central than coastal) due to proximity of raw material inputs
      • Secondary production locations largely on the coast and seeing government encouragement as sulfate production is phased out and newer capacity is directed toward areas with local downstream industries

Exhibit 7

Source: LookChem, SSR Analysis

  • PVC
    • 30% of capacity in Inner Mongolia and Xinjiang
      • China has built a string of small standalone facilities across the less advanced western region to encourage development in the area while also taking advantage of the proximity to coal resources

Exhibit 8

Source: IHS, SSR Analysis

  • Urea
    • Nitrogen production geographically distributed across a wide north-south corridor
      • Existing production is most concentrated toward the coast in the industrial base surrounding Beijing but projects under construction are mainly north and west of there.
      • The inland coal based producer is currently the clear price setter for the world and while we may see costs rise higher on the cost for a while, we do not believe that it will be sustainable change.

Exhibit 9

Source: Integer, Potash Corp, SSR Analysis

Asia Coal Pricing Has Moved Enough To Matter – But the Limited Moves in Product Prices Suggest That Inland Coal is Calling the Shots

  • Aluminum has been recovering for almost a year – albeit a volatile recovery – but has not moved anywhere near enough to reflect the benchmark coal price
  • The same is true of steel and copper, suggesting that the benchmark coal price is not the benchmark anymore
  • Even with the increase in Newcastle coal pricing, coal remains very attractive relative to crude and the recent rally in crude pricing has helped keep the ratio with coal relatively stable
  • A new wild card – not covered here – is the recent decoupling of LNG pricing from crude – if LNG remains cheap as crude rises, we may see LNG put a ceiling on how high coal prices can rise rather than crude in some parts of the world.

Exhibit 10

Source: Capital IQ, SSR Analysis

Valuation

CF looks most levered to a sustained rise in coal and power prices in China – the discount shown is based on a 14% return on capital, the company average since 2010 and a return that is well below those seen in prior cycles. OLN stands out in this chart, but as we have discussed in recent research looks less attractive from a valuation perspective when we look at tangible capital employed, the very low levels of free cash flow and the high level of debt.

EMN is the other likely beneficiary of higher China coal pricing especially if we do not see any similar moves in US coal pricing. Abundant and cheap natural gas in the US should keep local coal prices low and EMN could see margins expand again in its fibers business if competition in China faces increased costs.

On the flip side – if the benchmark col price rally is short lived, those stocks pricing in a recovery in product pricing as a consequence of higher coal are most at risk Steel low particularly vulnerable. WOR looks most at risk if we do not see a more broad-based inventory reduction and higher coal prices prove to be short-lived, though the focus on value-added products and its pressure cylinders business offer the stock insulation from Chinese competition and diversification from Metals. The bigger problem for WOR is the stagnant industrial economy and its likely impact on demand for products like cylinders (healthcare would be an exception).

Exhibit 11

Source: Capital IQ, SSR Analysis

CC and TROX do not have sufficient history for a return on capital based valuation approach as in the exhibit above, but appear poised to give back some of this year’s significant gains if we see a renewed move lower in Asian coal pricing.

Exhibit 12

Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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