Slowing U.S. coal production due to slumping U.S. power generation and rampant coal-to-gas switching has cut into the earnings of mining equipment maker Joy Global (NYSE: JOY), with the company hoping for some rebound in 2013.
The Milwaukee-based Joy is a worldwide leader in manufacturing, servicing and distributing equipment for surface mining through P&H Mining Equipment and underground mining through Joy Mining Machinery.
Net sales in the fourth quarter fiscal quarter (ended Oct. 26) increased 19% to $1.6bn compared to the same period last year, the company noted in a Dec. 12 earnings statement. Operating income was $326m, or 20% of sales, in the fourth quarter of 2012, compared to operating income of $296m, or 22% of sales, in the fourth quarter of 2011. Fourth quarter bookings decreased 5% to $1.3bn in fiscal 2012 compared to the fourth quarter of last year, but were up 22% sequentially from the third quarter.
“During 2012, the markets served by the Company weathered a series of conditions and events that slowed the demand for the Company’s products,” the company said. “Early in the year, the U.S. thermal coal market experienced a significant loss of coal demand to natural gas for power generation. By early summer, U.S. economic growth remained sluggish and lingering sovereign debt issues pushed Europe to the brink of recession. With weakness in both of its main trading partners, China exports began to soften and its economic and industrial growth decelerated. China consumes the majority of the world’s mined commodities, which has a disproportional impact on commodity demand. Additionally, growth in steel production has been flat for the year and this limited demand upside for iron ore and metallurgical coal.”
This slowing demand occurred while new mines were coming on line and some mines, particularly in Australia, were returning to production, the company noted. A supply surplus resulted that has pushed the prices of many commodities down to the marginal cost of production, which has reduced miners’ cash flow available for reinvestment in things like new mines and mining equipment and reduced the number of projects that meet the necessary economic threshold to get developed.
“In the U.S., weak demand for electricity combined with a plentiful supply of natural gas reduced natural gas prices to historically low levels,” Joy said. “The share of power generation from coal dropped from 43 percent to 33 percent by April of 2012, reducing the demand for thermal coal in the U.S. by approximately 100 to 120 million tons. Natural gas has since risen above $3.50 per million BTU’s, and coal recovered its share back to 38 percent of power generation by September. The economics of power switching enable coal from the Powder River Basin to compete when natural gas prices rise above $2.50 and enable coal from the Illinois Basin to compete when natural gas prices rise above $3.00. However, thermal coal from Central Appalachia is not competitive until natural gas prices rise above $4.00 per million BTU’s and therefore it has the lowest prospect of recovering lost volume for power generation.”
This shift is reflected in the demand for coal-fired power, with year-to-date generation from Central Appalachia coal down 40% while generation from the rest of the U.S. is down only 10%, Joy pointed out. “Thermal coal volumes in Central Appalachia are expected to decline over time until it becomes primarily a metallurgical coal producing region,” it said. “Volumes will continue to shift to the Illinois Basin and Powder River Basin. Cutting conditions and operating costs improve as production migrates west, and this will reduce the Company’s revenue potential per ton of production. Although some volumes can be recovered to provide further upside through time, the Company is planning for U.S. coal to be a structurally smaller and significantly dislocated market.”
China leads the way down, hopefully should lead the way up
The slowing of economic growth and industrial production in China has reduced the demand for thermal coal used in power generation there. By the third calendar quarter, demand growth was almost flat with the prior year while domestic production continued to increase, and stockpiles rose to maximum levels at the domestic transfer port of Qinhuangdao, Joy said. Domestic production was curtailed as prices dropped below $95/tonne, creating a competitive advantage for seaborne coal. The reduced volumes of China domestic production have adversely affected demand for products from Joy’s IMM subsidiary. Domestic production has been further curtailed by holidays with respect to the regime change in China. Although the reduction in domestic production created support for imports, it was not enough to overcome the additional supply returning to the market from Australia and from U.S. producers looking for export markets. As a result, seaborne thermal coal has remained in surplus with prices depressed.
“Weak pricing conditions have combined with rising costs to reduce the profitability of mining in Australia,” Joy added. “Australian costs have been driven up by a series of factors, including resource extraction taxes, carbon taxes, elevated demands in labor negotiations, extended regulatory review, and a strong local currency. Production has been reduced in higher cost mines and closures have been announced for several older mines that are near the end of their planned life.”
Despite this depressed outlook, there is the potential for upside, Joy reported. “Natural gas prices in the U.S. have been improving and should continue moving toward the cost of replacement, which the Company estimates is above $4.00 per million BTU’s. As a result, power generation should continue switching back from natural gas to coal, but it is not expected that all of the volume losses will be regained. However, the upside can be extended by utilizing the greater excess capacity available in the coal-fired generating fleet. Exports from the U.S. will be at their second consecutive record level in 2012, and customers are investing in port expansions that can double export capacity over the next five years.”
There are signs of improvement in China. For example, fixed asset investment for infrastructure grew 30% year on year in September, largely aided by the government’s $157bn of stimulus focused on infrastructure. Electricity demand is a more discrete measure of economic and industrial activity, and it rebounded 6% in October over last year after recording only minimal growth for all of the third calendar quarter.
India’s coal imports are up 18% and reached 64 million tonnes in the first half of its fiscal year beginning in April, Joy noted. However, Coal India’s production is behind last year and stockpiles at 60% of India’s generating stations have fallen to less than a week of supply. Imports are expected to continue to fill the gap and are on pace to reach 140 million tonnes for the full year.
Japan and Europe cut back on nuclear, look to coal to fill the gap
Japan and Europe are moving more power generation to coal-fired units to offset the impact of high natural gas prices in the international markets. Japan is also using more coal to make up for nuclear problems related to a flooded nuclear plant. Coal-fired generation is up 26% in Japan, and is up 14% in Europe despite economic contraction in the Eurozone. Germany, which is moving away from nuclear, has 36 GW of power generating capacity planned, and two-thirds of that will be coal fired, Joy noted.
Due to slowing demand for steel, steel mills began reducing their inventories of iron ore and met coal. This lower demand temporarily drove down prices to below $90 per dry tonne for iron ore and to $140 per tonne for met coal, both below their marginal cost of production. “We believe the destocking phase is completing and the price for both commodities is improving,” Joy said. “China produces 40 percent of global iron ore, and is the high cost, swing producer. As a result, iron ore has corrected more quickly than met coal and is trading in the vicinity of $120 per tonne, which is the estimated cost of China production. This pricing level limits China production, but provides healthy margins for the major seaborne producers. Metallurgical coal prices rolled over in the fourth quarter, but are to improve in 2013.”
Despite the potential for upside, the outlook for Joy’s mining equipment remains weak for now. The company’s customers have experienced reduced cash flow, and with mine capacity in excess of current demand, only the highest quality, lowest cost mines can justify investment. Although customers are completing the projects they have under construction, they are cautious and patient on starting new projects, Joy noted. There is a preference for projects that have low execution risk and a relatively quick start of production. These are generally brown field expansions and green field projects that are near existing mines.