What's next for Queensland's coal sector?

Matt Anderson, Director - Research and Consulting Commodity Insights

The last 18 months have produced a highly unusual operating environment that has tested the resolve of Queensland coal producers.

On the one hand, despite rising costs due to the high inflationary environment of the last two years, record coal prices during 2022 have strengthened the balance sheets of many producers.

Despite the Queensland Government's short-sighted royalty raid on Queensland coal profits, and the fact that costs and inflation were already very high, many coal producers still find themselves in a financially sound position which allows management a degree of flexibility and the opportunity to de-leverage. However, the move toward decarbonisation in Australia has made it difficult for producers to explore external growth options within the industry.

To date, 2023 has seen coal prices retreat, but they remain high relative to historical prices, and this is particularly true with metallurgical coal. Given this dichotomic environment, there are two key concerns that Australia’s coal producers face:

• What does the future hold in terms of price and demand?

• Given this outlook, what are the best options to deploy cash held within the business after a stellar 2022?

What does the future hold?

Ardent advocates of climate change will paint a picture of renewables totally powering our societies, and coal demand falling away as a distant memory. A cursory glance at coal market data and forecasts eviscerates this claim.

Coal prices have skyrocketed as overall demand has stayed strong, and the lack of investment has strangled the supply side. Our view is the medium to long term looks very healthy for coal producers in Australia.

In the short to medium term however, there are various broader macro issues at play that could negatively affect markets, with some pundits interpreting the recent retracement of copper prices as a bearish signal for coal markets.

A slowing economy in China and the un-inversion of the US yield curve in 2023, (which has historically been a reliable indicator of oncoming recession), point to a potential global economic slowdown through 2024/25.

Against this backdrop, costs within Queensland’s coal sector are indeed escalating (predominantly from inflationary and volume pressures, in addition to the onerous new royalty regime). This, in turn, is leading to a ‘margin squeeze’. In this context, the current macro environment should be focused on reinvestment in the sector (i.e., a supply response). However, the lack of greenfield (inorganic) projects suggests that if we enter a new downward cycle on the current trajectory, producers will need to be mindful of margin pressures.

History tells us that producers will optimise mining operations, defer capital expenditure and undertake cash preservation strategies. This will have a flow-on effect throughout the sector, from plant operators to mining services.

The coal producers that can maintain a strong financial position in the short term, whilst continuing to invest in organic growth options, will reap the rewards.

How should capital be deployed?

Historically, mining companies have the option of growing the business organically (using capital expenditure to extend existing operations, investments in technology etc.) or inorganically (e.g., M&A or ‘greenfield’ development). In terms of organic growth options, decarbonisation policies adopted by the Australian government mean that banks are increasingly reluctant to fund new coal projects.

This, in turn, restricts the options available to coal producers, but ironically, has also come at a time when many producers are flush with funds, given the substantially higher revenues of 2022 and the sticky coal prices of 2023. Many of these companies are effectively forced to return money to shareholders at this point in the form of dividends and share buy-backs because many are finding inorganic investment options limited.

In recent times, Australian miners have gone through a de-leveraging phase, where paying back debt has been an attractive option in the rising interest rate environment. Overall debt to EBITDA levels has fallen considerably, indicating a risk-averse mood amongst mining companies, but also reflecting the fact that there are fewer inorganic options available. Not to mention the onerous regulatory approval process that is holding up 28 coal projects nationally (12 of these are in Queensland).

The healthy balance sheets have also become an attractive target for the government, which resulted in an excessive royalty rate imposed on Queensland’s coal producers in 2022. This has effectively made the state the highest-taxed coal-producing region in the world , and greenfield projects are already being shelved in the state (i.e., BHP has explicitly stated there will be no greenfield investment in Queensland, putting the Saraji East project into question, and has recently divested two Queensland coal assets – Blackwater and Daunia). Glencore has also indicated that the development of its Valeria project is in doubt following the increase in Queensland’s royalty rate.

Where the focus lies

Through necessity, this type of environment has seen many producers focus on organic growth – but this doesn’t come easily. For example, the Queensland state government took over a decade to approve New Hope’s New Acland Phase 3 project (which was restarted in 2023).

Despite a tough regulatory environment, many mining companies see the growing supply gap and are using strong balance sheets to position for the future. However, given the lack of growth options at present (especially in the coal and gas space) many mining companies remain in somewhat of a late-stage mode where they are ultimately dividend machines for shareholders.

Although some inorganic growth options remain (e.g., Whitehaven Coal’s acquisition of Daunia and Blackwater coal mines; Thungela Resources' acquisition of the Ensham coal mine; Peabody’s acquisition of the Wards Well tenement), these M&A transactions are a product of the prosperity of the coal sector in general rather than the attractiveness of Queensland as a stable mining jurisdiction.

Five-year outlook

Our view on coal markets up to the end of the decade remains bullish given that coal continues to be the backbone of energy and steel production globally. Our demand outlook is far healthier (i.e., more pragmatic) than the populist viewpoint, and investment in coal continues to be difficult - which constrains supply in the medium to long term.

Both these factors suggest price tailwinds, particularly when looking beyond a short-term horizon. Demand for electric vehicle uptake further adds to this story, which is contributing to increased electricity demand forecasts over the coming decade.

Our overall outlook remains very positive for the much-maligned coal industry, and we think the thermal price is approaching the bottom given the current supply-demand setup. The economics of producing electricity using coal cannot be denied, and decarbonisation policies continue to mismatch supply with pragmatic demand. The coal producers that can maintain a strong financial position in the short term whilst continuing to invest in organic growth options, will reap the rewards. 