China has an insatiable appetite for power. So far, coal has been the main fuel used to sate the country's demand. And with that, coal miners around the world have shifted into high gear. Only China's overall growth rate is starting to slow and coal supply has outstripped demand. But low prices just make it that much easier for fellow emerging market giant India to get stuck on coal, too.
Long cycles
The lifespan of a coal power plant is between 30 and 40 years. That's one of the reasons why the U.S. Energy Information Administration (EIA) believes China, which is now the world's largest consumer of coal, will see its consumption of coal peak in 2025 at 57% of world supply and only fall off two percentage points by 2040.
And that's despite the fact that China is increasingly concerned with pollution. In fact, Peabody Energy (BTU) uses the U.S. example to explain why China can clean up its act without shutting coal power down: Regulated emissions from U.S. coal plants has fallen nearly 90% since 1970.
(Source: SeaWiFS Project, NASA/Goddard Space Flight Center, and ORBIMAGE, via Wikimedia Commons)
Since China is only just starting to work on cleaning its power supply, look for similar success. And Peabody Energy likes to point out that the U.S. emissions reductions took place over a span in which coal power generation increased by 173%. Thus, there's no reason why China can't have its cake and eat it too.
That should be good news for coal miners like Peabody Energy, but right now the coal market is flooded with supply because everyone knows just how big the Chinese power appetite is. Peabody Energy has lost money in each of the past two years. In fact, after a first quarter loss, it looks increasingly like 2014 will be another full year of red ink.
Margin compression
Peabody Energy's Australian operations, which serve Asia, saw revenues per ton fall nearly 17% year over year in the first quarter. Its gross margin per ton in the division fell even more, dropping to just $0.22 per ton from over $12.15. And the only thing that salvaged even that tiny gross margin was a roughly 4% drop in costs.
In fact, Arch Coal (NYSE: ACI) specifically discussed the problem in its first quarter earnings release: "the seaborne market remains challenged, as oversupply has pressured global prices for metallurgical and thermal coals." The company's operating margin per ton was lower year over year in each of its three divisions, falling from a combined loss of $0.37 per ton to a loss of $1.61 per ton.
Although the absolute difference isn't huge, the percentage increase in the operating margin loss per ton is. Keep in mind, too, that Arch Coal sold 31 million tons of coal in the first quarter, so even small numbers add up quickly and continued price pressure in the seaborn market is a big drag.
There's good news here?
So the coal industry has a price problem right now, and it's taking even the largest and most diversified miners for a ride into red ink. But that's not as bad as it looks for Peabody Energy, Arch Coal, and others. Why? Because supply and demand will eventually even out and fatter profit margins will return. However, along the way, fellow emerging market giant India, among others, is getting foreign coal on the cheap.
That's why Peabody Energy and Arch Coal both like the long-term outlook. But what about the near term? Arch Coal is expecting 100 gigawatts of coal power to come online in 2014 alone. That means, "more than 300 million metric tonnes of incremental annual coal demand this year." And that demand won't go away for the next 30 or 40 years.
And over the next five to 10 years, Peabody Energy thinks India will be a bigger demand growth story than China. It projects that India's demand for seaborn coal will increase 85 million tonnes versus China's growth of 70 million tonnes. Note, too, that India's growth is coming off a smaller base, so the percentage growth is vastly more impressive.
Thank you China!
So, in some ways, Peabody Energy and Arch Coal need to send a big thank you to China. The problem this duo is facing right now because of that country looks like it will set the stage for continued international growth down the line. Coal may be out of favor today, but lower prices will help ensure the industry has a long future.
