Indo coal – 2011 and beyond - Merrill Lynch

How to play Indo coal in 2011
We see a short-term trading opportunity for Indonesian coal in the next two months given a strong tailwind from coal prices. But we expect a correction in 2Q on a potential 4Q10/1Q11 earnings miss and coal price softening (as most deals are likely settled by then). That should offer a good entry point for long-term
investors (considering inflation should also peak in 2Q). With no big change in supply-demand for the next two years (which means it’s still largely a seller’s market), the pricing cycle seen in 2010 will likely repeat. Further, strategic partnerships with foreign investors will continue in 2011.

China’s Q2 imports weakness an opportunity
If the arbitrage stays closed, China could resort to running down stocks past this winter rather than import at high rates. Thus, China’s coal imports might take a bit of a breather rather than accelerate from the record levels in December. However, we expect China to return to the seaborne market strongly in H2. Supply issues are supportive (1) with a very tight coking coal market; (2) Indonesia’s trade office banning exports by coal traders; (3) sizeable coal tenders still seen coming from India at the current coal price; (4) unpredictable weather in Indonesia; and (5) Colombia’s export issues with the ongoing strike at Cerrejon.

Disappointing earnings an exit point for some investors…
In our view, for 2011, costs are the most at risk to miss, followed by price and then volume. We see a surge in costs because of the higher oil price/consumption, higher stripping ratio given improved coal reserve economics, and longer overburden distance. Price expectations could overshoot on some contracts carried over from last year, various types of index-linked contracts, and lower domestic prices. We believe the application of the HBA price for coal under DMO could send domestic prices lower by US$30/t.

… but good entry point for long-term value investors
We believe coal supply demand will likely remain tight for the next 2 years. We are apprehensive about the ability of Indonesia, currently the world’s largest coal exporter (36% share), to greatly ramp-up coal volume. Our recent trip to mines/firms validates our concern. Land acquisition (for expansion/dumping overburden) and permit delays present the top hurdle. Moreover, we think production holdups in China/Australia clearing won’t be cleared for another 2 years. China’s rail expansion will likely complete after 2012 while synchronization of port/rail capacity upgrade in Australia will likely complete only in 2013). The strong coal fundamental should attract long-term investors.

Which coal stocks to buy
Our pecking order: ITMG, ADRO, Indika, SAR, PTBA, BUMI, BYAN. To address the share-price volatility, we advise investors to stick with NPV to value Indonesia coal stocks (though it might overshoot/undershoot with a rise/fall in coal prices).