With industry cost pressures not abating and a stubbornly strong A$, settlement of contract prices near current spot prices would be a disaster for many Australian producers. Supply would surely be tempered and the $62bn worth of thermal coal mining projects in feasibility stage and tens of billions of port infrastructure plans would either be scaled back significantly or not happen at all.
Thermal coal markets have faced two big challenges this year. First has been the very strong growth in supply that was accentuated by US producers pricing very aggressively into seaborne markets given domestic woes. Production cuts driven by low prices, however, do appear to be driving a significant adjustment, with inventory in the US coming down.
This problem is most severe for the seaborne market when coal from the US aggressively prices into non-traditional markets like China or Korea, which has been made possible by very low freight rates over the past few years.
However, looking at both Colombia and the US, the flow from West to East does not look particularly alarming, with recent levels failing to reach those seen in 2010.
To be sure, strong supply in the Atlantic is comfortably finding a home in Europe, which is likely to be able to tolerate higher prices given the strong contango in futures prices. This is driven by utilities who are more than happy to pay current prices for coal as its very competitive with gas.
The bigger issue now is the weakness in power generation and coal burn in China. Power production (or even better consumption) seems to give a better guide to the high's and lows of the industrial cycle than the industrial production data. As the chart on the below shows, power generation has been much weaker than the headline IP data would suggest, which gels much more with what happened to commodity prices.
The collapse in pricing has generated a supply response, although so far it has not been enough. The most important marginal supply which competes with the seaborne market is high-cost Chinese supply, which is expensive due to large transport distances, first on trucks, then on ships.
Mine production is now being cut, but the adjustment is slow. Stocks at power plants still remain high and the coal burn weak. Furthermore, producers still have significant mine stocks to work through, meaning supply has lifted without much of an increase in domestic prices.
This is a problem that seems unlikely to be solved in the next 6 months. The trajectory of growth, while better, is not pushing coal burn to very high levels . Infrastructure improvements will continue to crowd out high cost domestic Chinese supply, which won't be required at current levels of demand.
This puts Australian producers in a very difficult position. One hope is that Japanese buyers will lift the premium to spot prices to ensure the quality and brand of coal they consistently purchase. But if they are willing to diversify, Australian thermal coal producers will need to drastically cut costs.
