Global markets affect domestic prices, exports and infrastructure.
Mason Caperton and Scott Davis are consultants with Ventyx's Energy Advisers Group.
Who knew coal-supply issues in countries far away from U.S. markets could have a massive impact on domestic supply and pricing, helping to increase prices for Appalachian coal by 260 percent in the past year? Despite what might have appeared to be an isolated U.S. coal market, recent events throughout the globe, such as supply disruptions in Australia and South Africa and increasing demand in some Asian countries, have shown that U.S. markets indeed are a major part of the global coal economy. Countries like Australia, South Africa and China are major players in the global coal market on both the supply and the demand side, and while it may not have been seen before, their problems can ripple far beyond any country’s borders.
The global seaborne coal market naturally divides into the Atlantic and Pacific markets. Historically, there has been little supply competition between the two. The Pacific market’s largest coal suppliers are Australia, Indonesia and China. Australia exported approximately 215 million tons of coal into the Pacific market in 2006. Indonesia exported 130 million tons into this market, while China exported 77 million tons. All three countries are major suppliers of the Pacific market and only recently have supply disruptions from these sources been shown to have a major impact on global coal economics.
The Atlantic market’s two main suppliers are South Africa and South America. South Africa exported approx- imately 80 million tons of coal into the Atlantic market in 2007, while South America exported close to 78 million tons. Around 50 percent of South America’s Atlantic market exports flow to European markets, whereas nearly all of South Africa’s exports to the Atlantic flow to Europe.
Recent events—such as flooding in Australia and increasing demand in China (coupled with decreasing exports from China) significantly have decreased the coal supply from the Pacific market, while coal demand continues to grow. The predictable result has been increased prices in the Pacific market. In order to take advantage of high prices associated with this supply scarcity, South African suppliers are exporting more coal into the Pacific market. The increased exports are taking coal supply away from South Africa’s “natural” market, the Atlantic market, and have left a supply shortage in the Atlantic market (particularly Europe), forcing buyers within this market to turn to swing suppliers such as the United States.
U.S. Coal Markets
The U.S. is the second largest consumer of thermal coal in the world (China is number one). Due to its demand for electricity, the U.S. has been a net importer of thermal coal since 2002 when South American imports gained acceptance within the eastern seaboard markets. U.S. thermal imports increased from 9.8 million tons in 2000 to 31.4 million tons in 2006. During this same time frame, exports of thermal coal decreased from 23.9 million tons to 21.4 million tons.
Still, the country is a net exporter of coal due to the metallurgical (met) market. The U.S. exports a large amount of met coal mainly due to increasing demand overseas for use in the steel-making process. In 2007, the U.S. imported only 3.5 million tons of met coal compared to met exports of 29.3 million tons. Despite the significance of metallurgical coal in the U.S. export market, a restricted supply of metallurgical quality coal means that any massive increases in exports from the U.S. must come from thermal coal. There is a visible jump in net exports from 2006 to 2007 (see Figure 1).
South Africa produces thermal coal exclusively, which implies that the supply holes left in the Atlantic’s European market are best filled with thermal coal. This implication bodes well for U.S. exporters. The U.S. is currently the marginal supplier of thermal coal into the Atlantic market, meaning that while the U.S. consumes the vast majority of its domestically produced thermal coal and also imports a great deal, it has the ability to increase exports of thermal coal should prices warrant. Recently the Atlantic market has become tight enough to increase prices to a level where U.S. suppliers realize higher profits by exporting their coal, rather than selling it domestically in many cases. Major increases in exports to European countries in 2007 back this point (see Figure 2).
The supply situation recently resulted in delivered European prices from the U.S. of more than $160/ton, which translates to U.S. FOB mine prices exceeding $100/ton. European deliveries from the Atlantic market are priced at the Amsterdam-Rotterdam-Antwerp (ARA) terminal. In general, if the difference between the ARA spot price and U.S. spot price is larger than the cost of shipping coal from U.S. mines to Europe, then it will be economical for coal to flow from there. Most U.S. exports come from mines in the Central Appalachian (CAPP) and Northern Appalachian (NAPP) coal basins and are transported by rail to ports on the East and Gulf Coasts. The average shipping cost for this trip from East Coast ports was $31.60/ton in 2007, with a 2008 U.S. East Coast to ARA shipping price estimated at $34.39/ton. Including rail transportation for coal to reach export terminals, current shipping costs are approximately $60 to $70/ton.
Based on these shipping rates and current U.S. prices, one might argue ARA spot prices need to remain in the $160-$180/ton range in order for exports to continue to flow freely to Europe. This argument assumes that U.S. prices remain at current levels, which are extremely elevated at the moment. However, current U.S. prices are dependent on ARA prices, not the other way around. This warrants an explanation of the relationship of increasing U.S. exports and domestic pricing.
As coal supply in the Atlantic market has decreased due to the diversion of South African supplies, the result has been major increases in prices within the Atlantic market. U.S. producers have been eager to deliver coal to this market and reap the benefits, showing a preference for increased profits rather than loyalty to their traditional customers, which kept them in business during less profitable times. As more coal is exported, the European supply situation is rippling across the Atlantic to the United States: Supplies from traditional sources have been diverted to non-traditional customers, leaving U.S. supply constrained while demand shows no signs of slowing.
This has resulted in major price increases domestically. All five major U.S. coal-producing basins have seen average price increases since March, 2007, ranging from approximately 60 percent to over 200 percent. Coals being exported—CAPP and NAPP coals—are the coals seeing the most impressive price increases, while other coals have showed smaller, though still significant gains.
Due to Australia’s contribution of met coal to the global market, the global supply crunch also has impacted the met market. For the purposes of domestic pricing, one must take into account mines that might be referred to as “switch hitters.” These are mines that normally supply the domestic thermal coal market, but are able to sell their coal in the met market during times of high demand, despite coal qualities not being optimal for metallurgical purposes when supply is sufficient.
These switch hitters are subject to steam coal contracts that must be honored. However, some met coal currently is being sold at over $300/ton, much higher than “normal” levels. Given this scenario, switch hitters may earn higher profits if they sell their production into the met market. But contracts still must be honored, which means they’ll go into the U.S. spot market and purchase thermal coal to ship to their contract customers. This increases the demand for thermal coal in the U.S. spot market and helps buoy thermal prices to some degree.
Though the met market certainly has the ability to impact domestic thermal prices, the implications of the relationship between global supply and demand of thermal coal (and thus coal prices) and domestic U.S. coal prices are much more extensive. As global supply rebounds, ARA prices will drop. Domestic supply in the U.S. will increase due to a decrease in exports, as well as switch hitters returning to their traditional practices of supplying contract customers with normal production. The result will be a decrease in domestic prices. Thus, even as prices abroad decrease from current levels, the still-escalated price will continue drawing major exports from the United States. High-quality coal producers have tasted the high profit margins in the export market and only severe reductions in price will halt their willingness to sell in the Atlantic market.
Pricing Affects Exports
But how high do export prices need to be to support escalated levels of exports? Utilizing recent mine-cost capacity data, the availability of U.S. thermal-coal production capacity can be determined at varying price levels, and transportation costs associated with moving coal from eastern mines to export terminals can be estimated. For this analysis, the 2008 average Atlantic shipping rate was forecasted to be $34.39/ton, with an average 2008 rail rate of $25/ton to Eastern ports. Based on this analysis, it appears that if the ARA spot price is above $110/ton, then the vast majority of CAPP and NAPP producers profitably could market their coal in the export market. However, if the price drops closer to $105/ton, many of these same producers will be priced out of the market. This assumes current transportation rates remain steady, which is a very restrictive assumption, particularly when it comes to Atlantic vessel rates, but necessary for this analysis.
The statement that higher returns are being made by exporting coal can be proven by examining recent U.S. import and export data. Based on monthly coal imports and export data gathered from the U.S. Census Bureau, it’s apparent that producers are taking increased advantage of the export opportunity. The major increases are obvious in exports over the previous years’ levels that occurred during the end of 2007 and into 2008 (see Figure 3).
Recent jumps in the tons of U.S. coal exported are very significant. U.S. exports were an average of 34 percent higher during the fourth quarter of 2007, compared to the fourth quarter of 2006, while exports during the first quarter of 2008 were 43 percent higher than the first quarter one year prior.
Major increases in exports could spur development of infrastructure necessary for exports, both in regards to export terminals, as well as transportation infrastructure to reach those terminals. However, there are a number of variables that come into play, such as current export capacity, and perhaps more important, investor returns. Current absolute export terminal capacity for seaborne coal is estimated to be 131 million tons a year. However, it’s unlikely that the entire 131 million tons of capacity currently is available. Based on recent export volumes and historical capacity utilization rates, an estimated 70 million tons of export terminal capacity actually is available in 2008. The difference arises because terminal operators very likely have shuttered equipment or altered use profiles. Rail infrastructure also has been shifted away from coal exports due to underutilized capacity.
Take for example the total 2007 coal exports from the four major terminals that supply U.S. coal to European countries (see Figure 4). When total exports are broken out into the higher-valued metallurgical coal and lower-valued thermal (or steam) coal, and looking at total potential export capacity for that terminal (based on historical maximum coal exports), it is apparent that these terminals recently had the capacity to export more tonnage. Much of this capacity likely still is available or could at least be readied while the market still is hot.
With 2007 seaborne exports reaching 40 million tons and more expected in 2008, it is plausible that the United States could reach its maximum export capacity. This does not ensure capital investment in areas that would benefit U.S. coal exports, however. As global supply issues begin to subside, global prices will fall. If prices drop to levels that force U.S. producers out of the major export markets as discussed previously, then investments in export areas may not be utilized in a way that provides reasonable returns.
Railroads and owners of export terminals won’t make large investments unless they’re basically assured complete utilization and thus guaranteed returns. If sufficient returns on investments can be achieved in the short-term, investment decisions may be simple. However, many major capital investments require utilization over a significant time period to provide expected returns, a situation that brings more risk into play as the future of the coal industry is very uncertain and capital-intensive industries such as the railroad industry can’t afford to misallocate resources.
Recent infrastructure improvements to rail lines serving the Powder River Basin (PRB) are a perfect example. Despite market perceptions that rail capacity needed expansion, western rail operators ignored suggestions until western derailments and resulting supply shortages and high prices slammed coal buyers in late 2005. Only then did the railroads take a long-term look at the industry and decide that with CAPP production in an overall decline and sulfur and expansion constraints sure to be a factor in the future for other basins, the PRB was going to be partly responsible for increasing supply to the east. Particularly in times of unforeseen shortages in coal supply, their investments would provide solid returns. Railroads have since invested large amounts of money to improve transportation in and out of the PRB.
Already PRB transportation reliability has improved since these changes have been incorporated, despite a number of unexpected transportation issues in the West. Deliveries on the year are up, and suppliers, consumers and transportation carriers are much more comfortable. And now that more Eastern coal is moving overseas, the West has an opportunity to meet some of that lost domestic supply.
The global energy market now decisively includes coal and all those involved are dependent on outside factors to keep supply and demand in balance and prices under control. Current market dynamics are evidence that when unexpected situations arise, extreme volatility can result. The current market and its ability to sustain itself is dependent on a large number and variety of factors ranging from coal production to transportation rates to the willingness of some entities to make investments in unaccustomed areas such as transportation and export infrastructure.