MacQ Regional Coal - Chinese coal hidden from shaky spot

Tuesday, 17 March, 2009
ASIA Regional Coal - Chinese coal hidden from shaky spot

We like Chinese Coal but downgrade ASEAN and Australia
We prefer the Chinese Coal sector versus the ASEAN and Australian sector. Our top picks are China Coal Energy, China Shenhua and Banpu.

Reiterate Overweight view on Chinese coal sector due to its relatively defensive pricing outlook, increasing production and net cash balance sheet.

Downgrade Indonesian coal sector from Overweight to Equal-weight given its recent performance, stretched 2010 valuations, long-term project delays, and high correlation with spot prices.

Downgrade Australian coal sector to Underweight given its exposure to coking coal, relatively high-cost thermal production, and hedging risk.

We downgradeIndika Energy and Centennial Coal from Neutral to Under-perform, and PTBA and Bayan from Outperform to Neutral.

Trimming thermal forecast; near-term oversupply concerns
We trim our thermal contract settlement price forecasts by US$5/t to US$70 (2009) and US$65 (2010) on recent negotiations and slight cost curve compression due to the Russian ruble.

Near term the coal market appears significantly oversupplied given increasing production from Indonesia and Australia, buyers delaying negotiations and cancelling shipments, and some contracted volumes being switched into the spot market. Our coal traders believe that spot prices could trade down to US$35–40.

Potential for production cuts to be delayed
Should coal prices collapse in the short term, we think that coal production cuts could take longer than expected, as we think that some producers have high-priced legacy contracts. This could result in high cost producers remaining profitable until these legacy contracts roll off, perhaps until 4Q09 or 1Q10.

Highly correlated spot stocks could come under pressure
Our analysis highlights that the Indonesian and Australian thermal coal stocks have a very high correlation (0.8–0.9) with spot price (despite only selling roughly 20% on spot) versus China Coal (0.3) and Shenhua (0.5).

What would Jim Roger's do? Buy thermal on weakness

Going back to “commodities investing 101”, investors should buy a commodity when the price is below the cost curve combined with demand/supply tightening in the medium term. Should the thermal spot price trade down below the cost curve, we think this will represent a strong buying opportunity.

No need to touch coking coal
Whilst we raise our 2009 settlement for coking coal from US$110 to US$130 on the back of roll over tonnage, we see no reason to be invested in coking coal given the poor steel outlook and prices not trading below the cost curve.