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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Iron And Coal Could Have More Suffering Ahead

Iron And Coal Could Have More Suffering Ahead

It’s no secret that it is a hard time to be in the coal business. First, coal miners have been hit hard over the last decade by the increasing numbers of power plants switching from using coal to using natural gas for power generation. Then over the last year, as the magnitude of China’s slowdown has become more apparent, steel prices have plummeted.

By virtually all reliable metrics, Chinese steel mills are sitting on vast amounts of inventory and there is a serious supply glut in that market. As a result, metallurgical coal prices used in producing steel via coke have started to suffer as well. None of this is news, but what is only now starting to become obvious is the desperation of miners in all commodities around the world.

Recently, India announced that it was resuming exports of its low grade iron ore to China. India had stopped exporting its iron stock due to a combination of factors from the State’s imposition of a 30 percent export tax to illegal mining and environmental concerns in the Goa province and elsewhere. Related:The Race To Develop The Ultimate Battery

These problems have now been rectified and the county appears ready to jump back into the international ore export game … and its timing could not be worse. Not only is India starting to export iron ore again but, up until recently, nearly three-quarters of the country’s mines had been closed including virtually all of the 330 mines in the mineral rich state of Goa. As recently as last December, 590 of India’s 776 iron ore mines were closed. This made India reliant to a much greater degree on iron ore imports. Now, not only is that source of demand for international producers of ore gone, but the situation has reversed.

Iron ore prices have plummeted drastically, and so India’s low grade stock will command substandard prices compared to high grade material available from Australia, but even at these levels, the Indians are still very interested. Indian ore will likely cost several dollars less per tonne than comparable higher grade Australian ore. In this environment of crimp profits and cramped prices, that won’t matter to Chinese steel mills. The same thing could end up playing out in coal. Related: Canada’s Oil Sector Cautiously Optimistic About Late 2016 Recovery

Mining is a business with very high upfront sunk costs. It costs a lot to set up a viable mining operation, but once those funds are spent, the marginal cost of extraction for each pound of minerals is limited. here has been a twenty year boom in mining investment driven by massive levels of Chinese demand and that country’s drive to build 200 different cities of a million people or more. Now, after much of the easy urbanization has been completed across the country, and China is shifting from an investment-led economy to a consumption-led one, there is simply not enough demand left to keep all of the extant mining infrastructure going. That has been a major factor in the plunging prices of steel stocks like U.S. Steel (X) and suppliers to the industry from Cliffs (CLF) to Mesabi Trust (MSB) many of which are trading at levels associated with extreme business risk and financial distress. Related: Is Iran Opening A “Secret Passage” To Asia For Russian Crude?

India’s move to export more iron ore at cut rate prices could presage the same thing happening in the coal markets. Price competition for coal suppliers has become increasingly desperate in recent months, with Japanese buyers now reportedly paying less than $95 a ton for metallurgical coal. In particular, Australian mine owners are desperate to sell product abroad since internal demand does not come close to rivaling supply. If substantial quantities of Indian iron ore start to supplant Australian iron ore, then Aussie infrastructure costs like shipping and wages will likely fall. As that happens, Australian coal costs may fall prompting suppliers there to lower prices even more in an effort to take market share from U.S. coal producers.

Regardless of how fast any of that plays out or the magnitude of potential Aussie price cuts, one thing is clear; coal and iron ore markets look set to remain hypercompetitive (and mostly unprofitable) for at least the next year.

By Michael McDonald of Oilprice.com

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