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Peak Coal in Terminal Decline?

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Peak Coal in Terminal Decline? September 2017 Long-term Thinking - Energy For Investment Professionals Follow us @LGIM #Fundamentals FUNDAMENTALS Peak coal: in terminal decline? Our forecast of a long-term structural shift away from coal could have dramatic implications for investors. Once the bedrock of the global than the already dire predictions up almost a third of all primary energy system, coal’s position looks of some forecasters. We think coal energy consumption and a ever more threatened by the energy will be displaced from the current substantially greater share of revolution. Earlier this year, the UK energy mix at an accelerating pace. electricity generation markets.1 was able to meet its total electricity More worryingly for coal investors, demand for twelve hours without we estimate that the independently- In emerging markets, coal has an needing to switch on a single coal traded coal market, also known as even greater share of the energy generator, something not seen since the ‘seaborne’ market, is going to mix, accounting for nearly 40% of 1882. Just 50 years ago, over 1000 be disproportionately affected as consumption. Setting aside the mines were operating. Now only ten key consumers increase their self- environmental costs, coal is an remain and face yet further closures. sufficiency. Crucially, we believe this extremely abundant resource with a With the British government aiming outcome is likely even if policy makers quoted reserve life of 150 years, or to completely eliminate coal use in are unsuccessful in implementing three times more than that of oil or just eight years’ time, we look at an effective global carbon price gas, and an extremely high ratio of whether the drastic decline of coal in mechanism, although the introduction energy return on energy invested. the UK is a window into coal’s future of one would accelerate this process. Compared to alternative sources of around the world. fuel, it has also generally been cheap WHERE IS COAL TODAY? to procure as many of the major coal Our view is that the outlook for Thermal coal remains a dominant consumers have large domestic coal may actually be even worse source of energy globally, making reserves. With this in mind, it is easy to see why coal has been such a Figure 1: Coal is still a major source of global energy use popular source of energy. It is also 3% easy to understand why countries, 7% 5% particularly in the emerging world, Oil 33% have been so reluctant to take the Natural gas hard (and often expensive) decision Coal to move away from coal. Nuclear energy 28% Hydro electric Renewables 24% Source: LGIM Analysis, BP 1. For the purposes of this outlook, when we are using the term ‘coal’ we are referring to thermal coal which is used to warm homes and generate electricity. Metallurgical coal, which is used in the steel making process, looks a lot better in fundamental terms but is much smaller by volume. September 2017 Long-term Thinking - Energy ASIA DETERMINES COAL’S Figure 2: China dominates coal consumption FUTURE Coal is a global commodity, albeit 11% with many regional and isolated 23% local markets. To understand the 12% Americas future of coal we have to focus Europe on the world’s largest consumer, 3% Africa and Middle East China. China Asia Ex-China India is also a significant import 51% market, overtaking China in 2014 (Figure 3). However, this is because China’s domestic coal production Source: LGIM Analysis, BP is far larger, with India’s total coal consumption equal to just 20% of China’s. Figure 3: Chinese and Indian imports remain high BURNING COAL COMES WITH SUBSTANTIAL NON-FINANCIAL 200 COSTS Coal may be cheap to burn but the 150 consequences are costly. Not only does coal contribute more than oil and gas to climate change through 100 CO2 emissions, it also creates substantial air quality and pollution issues. No country has had to deal 50 Coal Imports (million tonnes) more with these problems than China. 0 2001 Any frequent visitor to China 2011 2010 1997 2009 2013 2014 2015 2016 2003 2004 2005 2006 2007 2000 2008 2012 2002 1999 1998 cannot help but notice how poor China India the air quality has become. If you travel into the industrial north Source: LGIM Analysis, Credit Suisse or the developing west, it can be very unpleasant. In January this year, the Chinese Ministry of Environmental Protection from significant air pollution in late March, Beijing closed its last published data conceding that over issues. This problem might once coal plant situated within city limits 60% of Chinese cities were suffering have been ignored, but no longer: following constant public pressure. 2 September 2017 Long-term Thinking - Energy THE GOOD NEWS – REDUCING Figure 4: Forecasters hold very different views CHINA’S DEPENDENCE ON COAL of future Chinese coal demand IS PROVING RELATIVELY EASY Predicting how fast Chinese 3500 3000 coal consumption will decline in 2500 absolute terms is difficult to do with 2000 any confidence. Three independent 1500 forecasters have dramatically 1000 different views, as can be seen in 500 Figure 4. That said, all agree that we 0 have either passed, or are close to, 2014 2016 1992 2012 2018 1990 1994 1996 2020 2024 2026 2030 2034 2004 2006 2000 1998 2010 2022 2028 2032 the peak of Chinese demand. 2002 2008 BP Actual (Hard Tonnes Equivalent) Forecaster 1 China stands apart from the rest Forecaster 2 BP (Implied) of the world in that, according Source: LGIM Analysis to our estimates, almost 50% of Figure 5: The rapidly decreasing cost in solar its demand for coal is for power and the remaining half for heat, 300 burned in small-scale industrial and 250 residential boilers. Contrast this to the US, where about 93% of all coal 200 consumed is for power generation. 150 We see both sources of Chinese demand being displaced over time 100 and on multiple fronts. Price in $/mmbtu (Real) 50 0 The first is replacing coal-fired 2007 2009 2011 2013 2015 boilers with electric-powered energy sources. Even if coal power Henry Hub US Bitumous Coal Brent LNG Solar plants generated this electricity, we Source: LGIM Analysis, Bernstein estimate that coal savings would still be about 15% because of how On the power generation side, reducing coal demand. Plant inefficient small-sized boilers are. huge falls in the cost of renewables efficiency is judged on a scale from (Figure 5), scale advantages of the ‘sub-critical’, the least efficient, to The second is to replace coal-fired domestic nuclear industry and the ‘super-critical’ and the imaginative boilers with gas boilers. There is cheapening of imported gas have superlative ‘ultra-supercritical’. an increased cost associated with encouraged the replacement of coal- Over 50% of Chinese coal plants displacing coal with gas. However, powered generation. We believe that still remain sub-critical. However, as we learned from recent meetings many investors are underestimating while it is unrealistic to assume with a leading Chinese city gas how fast the Chinese power this improves dramatically in a distributor, government subsidies generation sector is going to shift very short period of time, the on- to encourage such switching are away from coal to alternative energy going gradual modernisation of the increasing. For example, a new and sources such as solar. Chinese fleet can potentially reduce very generous policy to encourage coal consumption materially. That even non-urban consumers to Finally, we believe that coal power said, the domestic availability of switch fuel is now in place in parts plants’ technical improvements are sufficiently high grade coal may be of northern China. increasing efficiency and therefore a limiting factor. 3 September 2017 Long-term Thinking - Energy SEABORNE COAL – A BALANCING Figure 6: Seaborne coal price has largely tracked ITEM FOR ASIAN CONSUMPTION the Chinese domestic price While a decline in total coal consumption in China is good 120 news for the environment, the implications for investors’ 100 portfolios is less rosy. 80 The bulk of coal exposure in typical portfolios is to the internationally- traded market (seaborne), as opposed 60 to the Chinese domestic market. The seaborne market is essentially 40 a ‘balancing item’ for Chinese and Jul 16 Jul 15 Jul 13 Jul 14 Oct 16 Oct 15 Oct 13 Oct 14 Apr 17 Apr 16 Apr 15 Apr 13 Apr 14 Jan 17 Jan 16 Jan 15 Feb 13 other Asian power generation Jun 17 markets. As a consequence, prices Seaborne Coal Chinese Coal for the seaborne market very closely Source: LGIM Analysis, Bloomberg, rebased to 100 as at 1 January 2013 track the Chinese domestic price (Figure 6). meet domestic demand (especially tonnes of seaborne coal? Indeed, The difficulty for investors is that premium coals) but this dynamic as Figure 7 shows, China has been as China’s demand for coal has begs an important question: a net exporter of coal in the past. If declined in recent years, it has when coal demand starts rapidly China ceases to be an importer of opened up significant domestic declining and the spare capacity in thermal coal, then this could swing spare capacity. China currently China grows, will China continue the seaborne supply/demand imports a large amount of coal to to import more than 100 million balances by about 15%. Figure 7: Peak coal demand (consumption) leaves significant ‘spare capacity’ 100 2500 50 2000 0 1500 -50 -100 1000 -150 500 -200 -250 0 2001 1981 1991 2007 2002 2008 1983 1987 1997 2012 1982 2010 2011 2013 2014 2003 2004 2005 2006 2009 1985 1995 1996 2000 1984 1986 1993 1994 1999 1988 1992 1998 2015 1989 1990 China Coal Balance (Hard Tonnes Million Equivalent) Coal consumption (RHS) Source: LGIM Analysis, BP, Jefferies Research 4 September 2017 Long-term Thinking - Energy WHERE COULD WE BE WRONG - Figure 8: Coal leverage has moderated, in contrast to independent THE PROBLEM OF DEBT AND THE power producers (IPP) CHINESE POLICY RESPONSE 2016 was a year that made structural 325% coal bears like us look a bit foolish.
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