Credit Suisse Thermal Coal

Thermal coal prices have rallied significantly over the past three months, with the increase underpinned by several factors, some of which are likely to prove transitory, while others are likely to continue to push prices higher over coming years.

The move over the past month has been primarily driven by unseasonal weather, both on the demand side (the cold snap in Europe) and the supply side (heavy rain in Australia, Indonesia and Columbia). While these weather-related events will leave the market considerably tighter than if they had not occurred, given the higher burn in Europe and the rundown of mine and port stocks in the Southern Hemisphere, in part the impact is likely to prove transitory. The market has to date shared this view, with the increase in near-dated futures significantly greater than longer-dated prices – although it should be noted that Q4 futures have also moved decisively higher

More fundamentally, however, over recent months it has become apparent that the marginal cost of production in many countries is increasing rapidly. This is most apparent in China where the expansion of capacity has required digging deeper in the current mines and the exploitation of resources in more geographically challenging and remote areas such as Inner Mongolia. Chinese costs have also been impacted by continued strong wage growth and the return to a slow appreciation of the renminbi.

China is likely to have a significant influence on the seaborne prices of thermal coal over coming years, with Chinese consumers effectively arbitraging differences between the Chinese and seaborne price. This relationship is shown clearly in Exhibit 31, with freight-adjusted Newcastle prices moving very closely with the domestic Chinese price since the global economy began to recover from the great recession in early 2009.
Forecasts In the short term, spot thermal coal prices are likely to remain heavily influenced by climatic conditions. While longer-term weather forecasts should be treated with considerable skepticism, the most likely outcome appears to be that the wet conditions in Australia and the cold snap in Europe will persist for some time. Given this assumption, it is likely that near-term prices will remain under pressure before easing a little in Q2 2011 as the current weather pattern subsides.

Moving into the second half of 2011, however, there are several factors that are likely to support continued strong prices.
• Although the weather disruptions are likely to subside, they should leave the market significantly tighter than previously expected.
• The cost escalation in China is likely to persist. While government moves to cap Chinese contract prices are likely to have some impact (given that a large share of coal
production is still state owned), the impact on the spot market is likely to be less pronounced.
• The rebound in Chinese thermal coal energy production into the new year (as the short-term energy targets are relaxed) is likely to increase the call on thermal coal, both from domestic and international sources.

We expect the Newcastle spot price (FoB) to remain at around the current level in Q1 2010, fall a little in Q2 as the impact of the weather disruptions passes, but then to move gradually higher again over the second half of the year as continued cost increases overlap with a rebound in global demand. We are more bullish than both the Bloomberg consensus of market analysts and current futures pricing for 2011.