Displacing high-cost Chinese thermal coal

Chinese thermal coal prices have remained comfortably below previous assumptions of marginal cost of ~RMB700t+ @ QHD port for 5500kcal coal, and are currently trading at RMB620t.  While this could be a function of lengthy mine destocking, data suggests that thanks to weak demand, some improvement in rail infrastructure to ports and strong seaborne supply, this high cost supply is currently not needed.  This is presents big risks to long term assumptions on seaborne thermal coal prices.

It is tough to get decent statistics on Chinese coal production, but we think looking at domestic coastal shipments is useful as this is the most marginal supply in the Chinese market.  After diving dramatically in the middle of 2012 as prices crashed, supply has picked up, albeit to weak levels seen at the end of 2011.

While we are yet to get the December numbers, there is a significant difference between shipments from different ports over the year.  The largest port of QHD is down ~17mt compared to 2011, with Tianjin (which receives a lot of coal by truck) loosing ~10mt.  Huanghua, on the other hand, saw shipments rise 15mt thanks to new rail infrastructure from China's largest producer, Shenhua. Looking at all the major ports in North China, domestic shipments fell 18mt to 587mt.

While domestic shipments were lower, imports were substantially higher in 2012.  Deciding what to include as thermal coal imports differs amongst analysts, but including some anthracite, steam and other coal, imports were up a chunky 38mt.  If including the lignite data (which is hard to reconcile with exports) import growth was even more explosive.

So while domestic coastal shipments were weak, the strength of imports meant that total supply to importing provinces in China was up ~20mt (or even stronger if including lignite).

Furthermore, incremental supply that came in below the most expensive coal in China was even stronger thanks to incremental rail supply to ports.  This could be ~30-50mt.

While supply was up in 2012, demand from importing regions was down.  There are significant regional divergences in coal burn, depending on access to hydro, rain conditions and industry exposure.  Looking at importing regions, the coal fired generation should be down ~2% in 2012.  This equates to a loss of ~20mt of coal burn over the year.

These numbers may sound insignificant to a coal market which is ~3.5bn tonnes.  But the rise in supply into China at sub-marginal cost levels and the loss of demand is potentially enough to displace the highest cost coal, which is essentially coal from small mines trucked long distances from ports, then put on a ship and sent down the coast. I think there is ~70-100mt of this coal.

Given we have ~70mt of extra low cost supply and 20mt less coal burn, it makes sense that there is no need for this high cost coal. Subsequently there is no reason for the coal price to adjust upwards while this is the case and explains why prices have remained lower than expected.

Will this remain the case next year?  This crucial depends on the recovery in demand.  Currently the bounce back in looks to be about as large as expected in terms of growth rates, but because demand has been so much weaker than previously thought in 2012 it is off a much lower base.

As an example, say at the start of 2012 we were thinking that coal burn would by 7.5% in 2012 and 6% in 2013.  Now the reality is that its -2% in 2012, but 6% still looks likely for next year.  In this scenario, coal burn is 100mt lower in 2013 relative to our 2012 forecast.

Furthermore, there should be some additional growth in lower cost supply, both from the seaborne market and from domestic Chinese ports.

This means that thermal coal prices will remain weaker than previously thought, unless demand bounces back much more rapidly towards previous forecasts of coal burn.

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