"King Coal" disappoints investors: recent financial trends in global coal mining

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1 Executive Summary Coal prices are down 40% since 2011: Over the past three years coal prices around the world have fallen sharply. The current free- on- board Newcastle spot price (a key benchmark for Pacific export markets) is 40% below average 2011 prices. Over this period major coal consumers such as the US and China have seen domestic coal prices fall by a similar amount. Though the specific causes vary by market, generally coal prices are under pressure due to (1) lower- than- expected growth in coal demand (or turning negative) due to more energy efficiency, competition from other electricity sources, and regulations to limit air pollution from coal (all amid a context of low- to- moderate economic expansion); and (2) in export markets and China's domestic market, robust supply growth as projects undertaken in response to high prices of a few years ago begin to produce. Undermining profit margins for coal producers: Current prices are eliminating profit margins for a growing number of coal producers. In the seaborne export market, we estimate current spot prices to be below the cash costs of production for nearly one- half of total capacity and to be below the breakeven coal price (which includes capital costs and economic returns) for two- thirds of total capacity. Over half of China s coal producers have cash costs in excess of domestic Chinese spot prices, and throughout the US higher- cost miners (particularly in regions such as Central Appalachia) are currently producing at a loss. and returns for investors in listed coal companies: The current stressed state of coal markets is reflected in the financial performance of publicly- traded coal companies. From Aug , the Bloomberg Global Coal Index of 32 major publicly- traded coal companies declined by 56% while the MSCI World Index (a broad market benchmark) increased by 31%. In the US, over two dozen coal producers have filed for bankruptcy since 2012 (including two companies with over $1 billion in assets); during this period US coal companies have also seen widespread executive turnover, with 11 major producers replacing a CEO, Chairman, or other senior executive. "King Coal" disappoints investors: recent financial trends in global coal mining Key Takeaways Coal prices down 40% since 2011 due to surging supply and slowing (or negative) demand growth Over last three years Bloomberg Global Coal Index of 32 publicly- listed coal miners has lost half of its value, with leading indicators suggesting continued market pessimism Since 2011 US coal sector has seen major bankruptcies and extensive management shake- ups Having grown steadily since 2000, from combined capex of major publicly- listed thermal coal producers actually declined slightly - although remained 3X cash return to shareholders via dividends and share buybacks Major diversified miners Rio Tinto, BHP Billiton, and Vale have been disposing of thermal coal assets To complement our recent Carbon Supply Cost Curves report, this note examines recent financial trends in the global coal industry. Structural decline in thermal coal demand is diminishing the scope for profitable investment in new thermal coal mines. Producers that recognize this - and adapt plans for future capital expenditures accordingly - will serve investor interests. This note seeks to further dialogue between investors and coal- producing companies on the issues of demand risk and capital discipline. Analysts CTI: Reid Capalino Andrew Grant ETA: Mark Fulton September 22 nd 2014

2 Reckoning with a $200+ billion build- up in coal assets: We survey 83 major publicly- listed coal producers, including 60 that produce thermal coal. Since 1990, capital expenditures (capex) and acquisitions by these firms have increased their combined net fixed assets by $214 billion (in real terms); thermal coal assets chiefly in China and the US account for over 70% of this increase (i.e. $154 billion). Thermal coal producers beginning to reduce capex? Crucial engagement issue for investors: Recent investments in thermal coal, however, generally have generated weak returns for shareholders. The reality of weak returns combined with a need to hoard cash in order to maintain already weak credit ratings provide the context for the 60 thermal coal producers in our sample modestly reducing their combined capex from 2012 to Note that combined capex for this group increased each year from 2000 to Cash allocated to the combined 2013 capex of these 60 firms, however, remained roughly 3 times the cash returned to stockholders via dividends and share repurchases. This observation underscores how engaging with thermal coal producers on capital management decisions ought to be a top priority for investors concerned with returns, especially in the context of carbon asset risk. Among diversified producers, Glencore Xstrata buys thermal coal assets while BHP and Rio sell: As a complement to our analysis of pure- play coal producers, we also examine the coal operations of four large diversified mining companies (Anglo American, BHP Billiton, Rio Tinto, and Glencore Xstrata). We note an emerging schism in this group between buyers and sellers of thermal coal assets. Both prior and subsequent to its 2012 $45 billion acquisition of Xstrata (which, at the time of acquisition, generated 25% of its revenue from thermal coal), Glencore has been snapping up thermal coal assets in South Africa, Australia, and elsewhere. In many cases, the seller of those assets has been either Rio Tinto or BHP Billiton. BHP, for its part, is in the process of trying to spin off its remaining South African thermal coal mines into a separate entity (while also notably shifting its coal- related capex away from thermal and toward metallurgical coal). Buying assets at low valuations can be a promising (albeit risky) strategy to generate returns, particularly if the assets in question have low production costs. Analysis in our companion reports, however, concludes that thermal coal is going into structural decline and therefore diversified companies will best serve shareholder interests by reducing exposure to thermal coal. Investors in such companies ought to prioritize engaging with management to understand company plans regarding capex and M&A related to thermal coal. Acknowledgements The analysts would like to acknowledge the contributions of Tim Buckley (Institute for Energy Economics and Financial Analysis), Tom Sanzillo (Institute for Energy Economics and Financial Analysis), and Clyde Henderson (Energy Economics). 22 Sep

3 Contents 1. Coal industry trends - declining prices, squeezed margins, and executive turnover Country- level context on key export and domestic markets Detailed financial analysis of publicly- listed coal- mining companies Analysis of coal operations of four major diversified mining companies Appendix A List of firms included in the Bloomberg Global Coal Index Appendix B Additional detail on our universe of coal mining companies Sep

4 1. Coal industry trends - declining prices, squeezed margins, and executive turnover Recent years have been challenging to the global coal industry. Since at least 2011 the global coal sector has shown significant financial underperformance. The most striking feature of the last few years has been the sharp decline in prices for both thermal and metallurgical coal. Focusing on the roughly 1 billion tonne 1 market for thermal coal exports (in 2013 equal to 18% of global thermal coal consumption), the chart below shows average annual prices for Newcastle export thermal coal, a key benchmark price in the Pacific region. 2 Having fallen sharply and then rebounded from , since 2011 Newcastle prices have been in steady decline. The August 2014 Newcastle spot price of $68/tonne is down over 40% from the average 2011 price of $121/tonne (with the year- to- date average 2014 price down nearly 40% as well). The chart below also shows the spot price of coal from the US Central Appalachian region (CAPP), a key price for coal supplied to thermal power plants in the eastern US. The August 2014 CAPP spot price of $60/ton is down over 30% from the average 2011 price of $87/ton (and down 66% from the average 2008 price of $118/ton). Forward curves show 2018 Newcastle and CAPP prices 10-20% above current spot prices but well below the high price levels observed in 2008 and Figure 1: Annual average prices for Newcastle export steam coal and US Central Appalachian Coal (CAPP), $140/t $120/t $100/t $80/t $60/t $40/t $20/t $0/t Newcastle FOB ($/t) Newcastle FOB Futures ($/t) CAPP ($/t) CAPP Futures ($/t) Note: Values shown are annual averages of free on board (FOB) weekly prices. Newcastle prices in US$/metric tonne and US prices in $/short ton. Newcastle energy content is 6000 kcal/kg; CAPP energy content is 12,500 Btu/lb (i.e. ~6900 kcal/kg) Newcastle price averaged to end in June; for CAPP, it is average of remaining 2014 futures prices. Source: Platts, BP, Bloomberg LP, CTI/ETA analysis Throughout tonne refers to metric tonnes and tons to short tons. Note that 1 metric ton = 1.10 short tons. 2 FOB Newcastle is a price for thermal coal exported out of the port of Newcastle on Australia s eastern coast and typically shipped to China. 22 Sep

5 The price declines described above have also occurred in other regional coal markets 3 as well as in the market for metallurgical coal (where prices have also declined more than 40% since 2011). Though the specific causes vary by market, generally speaking thermal coal prices are under pressure due to (1) growth in coal demand slowing (or turning negative) due to more efficient use of energy, competition from other energy sources, and regulations to limit air pollution from coal (all amid a context of low- to- moderate economic expansion) 4 ; and (2) in export markets, robust supply growth as projects undertaken in response to high prices of a few years ago begin to produce. Paragraphs below provide more detail on these trends. Figure 2: Comparing trajectories of metallurgical and thermal coal prices, (prices rebased to 100) 700 Prices (rebased to 100) Newcastle thermal coal FOB price Japan metallurgical coal import cif price Source: BP, Bloomberg LP, CTI/ETA analysis For coal imported into Northwest Europe, the price averaged at $147/t in 2008 and $122/t in 2008, versus $73/t today and a 2018 forward curve price of $87/t. BP, BP Statistical Review of World Energy June 2014, Coal: prices", 2014, 4 For more discussion of these trends, see our companion paper, Carbon Tracker Initiative (CTI) and Institute for Energy Economics and Financial Analysis (IEEFA), Thermal coal demand: comparing projections and examining risks, September 2014, 22 Sep

6 Declining thermal coal prices eroding profit margins The decrease in coal prices since 2011 has caused profit margins for coal producers to diminish or, in some cases, disappear entirely. Using mine- level data from Wood Mackenzie s Global Economic Model (GEM) database 5, the figure below shows a 2014 supply curve for export thermal coal production capacity (including lignite). For over 1,000 mines with the potential to produce export thermal coal, the blue line shows each mine s energy- adjusted cash costs of production 6 ; the orange line shows each mine s breakeven coal price (BECP), a measure taking into account both cash and capital costs as well as production over the lifetime of the mine of the price that will yield the mine owner a net present value of zero assuming a 10% real discount rate. Figure 3: Significant potential production uneconomic at current prices potential export thermal coal by cash cost and breakeven price (BECP) level, million tonnes per annum (Mtpa) Note: BECP is breakeven coal price; NAR is net- as- received Source: Cost and supply data from Energy Economics, using Wood Mackenzie Global Economic Model; price data from Bloomberg LP, and CTI/ETA analysis 2014 BECP figures are standardized to a Newcastle- equivalent price, which takes into account differences in energy content as well as differences in the cost of transport for export mines in different countries. 7 The 5 Wood Mackenzie's Global Economic Model (GEM) coal database includes detailed cost data for 1,200+ mines, df 6 In this case, costs have been standardized to a net- as- received basis of 6,000 kcal/kg. Note that, in Wood Mac s Global Economic Model, cash costs include both variable and fixed costs. 7 For more discussion of this, see the methodology section of our companion paper, Carbon Tracker Initiative and Energy Transition Advisors, Carbon Supply Cost Curves: Evaluating Financial Risk to Coal Capital Expenditures, September 2014, 22 Sep

7 dashed lines intersecting the cash- cost and BECP curves represent, as of August 2014, the Newcastle spot price (grey line) 8 and 2018 forward price (purple line). Note that the August 2014 Newcastle spot price of $68/t is below the Newcastle- equivalent BECP for 72% of export thermal coal production capacity (i.e Mtpa); for mines in this group, income from selling at a price of $68/t is insufficient to earn the mine owners a 10% return on their investment. The figure also illustrates the August 2014 Newcastle spot price to be below the cash costs of production for 47% of export thermal coal production capacity (i.e. 697 Mtpa); for mines in this group, a price of $68/t is insufficient to cover even the cash costs of production. Assuming that the Newcastle spot price were to increase to the 2018 forward price of $82/t, this would still fail to meet the BECP requirements for 30% of production capacity (i.e. 445 Mtpa) and fail to cover cash costs for 11% of production capacity (163 Mtpa). 9 The table below provides a country- level breakdown of the export thermal coal production capacity that, at a price of $68/t, would be unprofitable on either a cash- cost or BECP basis (or both). On both the cash cost and BECP curve, a majority of production capacity over $68/t exists in China. As the world s largest importer of thermal coal, China currently exports relatively little thermal coal (with the country having become a net importer in 2009); that said, the mines represented on the curve above do have the capacity to produce export- grade thermal coal (should prices justify it). Excluding the 607 Mt of potential capacity in China (currently the world s largest net importer), the percentage of total potential export production with cash costs above the current spot price is 27%; the percentage of total production with BECPs above the current spot price is 61%. Perhaps most striking is the rightmost column in the table, showing production capacity above $68/t (Newcastle- equivalent BECP) as a share of each country s total export thermal coal production capacity. In every country save for South Africa, this share is near or above 50% - and, in Colombia and Russia, approaches 90%. 8 Since August thermal coal spot prices have not increased. On September 3rd, a spot contract for Australian thermal coal was concluded at $66.85/t (FOB, net calorific value of 6,000kcal/kg). This represented the lowest price in five years (i.e. since September 11th, 2009 when a deal was realized at $66.50/t). 9 That a 21% increase in the spot price can cause the amount of out- of- the- money production capacity to decline by 58-77% (depending on use of the BECP or cash cost curve) illustrates the implications of export thermal coal supply having a very flat (i.e. price- elastic) supply curve. 22 Sep

8 Table 1: Breakdown by country of potential 2014 export thermal coal production capacity above $68/t (Aug 2014 Newcastle FOB spot price) Cash Costs Newcastle- equivalent BECP Mt % of total % of country export capacity Mt % of total % of country export capacity Australia % 31% % 49% China % 76% % 88% Colombia 1.7 0% 2% % 85% Indonesia % 20% % 58% Russia % 86% % 89% South Africa 2.0 0% 3% % 39% USA % 27% % 67% ROW 8.4 1% 30% % 80% Total % 47% % 72% Note: Values shown reflect potential capacity, rather than actual exports. China, for example currently the world s largest net importer will in 2014 likely export very little thermal coal. For % of country export capacity columns, values in Total row are weighted averages. Source: Energy Economics, using Wood Mackenzie Global Economic Model and CTI/ETA analysis 2014 Note that the current situation of most export thermal coal mines is slightly different from that suggested by the above comparisons. This is because 60-85% of thermal coal exports (depending on the region) are traded at a price set in multi- month to multi- year contracts, as opposed to at spot prices during a given month. Because resetting of the prices in these contracts tend to lag changes in the spot price, during periods of sustained price declines (as has been occurring since 2011) contract prices may be above the current spot price. Even longer- term contract prices, however, would still be unprofitable for a large chunk of potential production. 10 Moreover, the recent decline in spot prices appears to be reflected in contract prices. For example, on September 3 rd the contract price for South African thermal coal was fixed at $68/t (the lowest price since December 8 th, 2009, when a contract was signed at $66.25/tonne). Finally, though the exact figures differ, the trend described for export thermal coal of declining margins and a growing portion of out- of- the- money production has in recent years also occurred in the major domestic markets for coal (e.g. China and the US) as well as the metallurgical coal market. Sections below explore these markets in more detail. 10 As of August 2014 a contract linked to the average last- twelve- months (LTM) Newcastle FOB spot price would show a price of $73/t; this price would still fail to cover BECP requirements for half of export thermal coal production capacity (i.e. 726 Mtpa) and fail to cover cash costs for 40% of production capacity (593 Mtpa). 22 Sep

9 Take- or- pay rail contracts, government intervention keeps unprofitable production online One of the seeming anomalies of the thermal coal export market is that mines have been very slow to curtail production in response to declining prices. As of May 2014, analysts at Citi had identified only 13 Mtpa of thermal coal mine curtailments (at mines in Indonesia, Australia, and the US) 11 versus our estimate above, even excluding China, of 200+ Mtpa of potential export production capacity with cash costs above the current Newcastle $68/tonne. 12 The seemingly irrational decision of mines to keep producing at prices below their cash costs of production, however, is often the result of fixed cost obligations or government interventions that encourage continued production. In Australia, take- or- pay rail contracts saddle mine owners with high fixed costs irrespective of production, bolstering the incentive to keep production online. 13 In Russia, major curtailments have been discouraged as a result of government interventions to freeze rail tariffs (which, for Siberian mines, are the largest variable cost item) 14 and the likelihood of further assistance to protect jobs in Russia s coal mining sector. Ignoring the possible effects of compensatory government aid (as may occur in Russia), the slowness with which thermal coal production responds to conditions of over- supply and low prices exacerbates the financial harm to producers who find themselves on the wrong portion of the supply curve. Having covered a bit of the industry context, the following section provides more color on recent developments for key exporters of thermal coal. Financial impacts of declining margins After delivering superior returns in the early 2000s on the back of sharp increases in coal prices, recent returns from coal mining stocks have badly lagged the broader market. The Bloomberg Global Coal Index measures the performance of the coal sector by tracking the share prices of 32 large pure- play coal producers. 15 The figure below compares the 5- year performance of this index against the MSCI World Index (a proxy for overall market returns) and the MSCI World Energy Index (which, their larger market capitalizations relative to coal companies, is heavily weighted toward oil and gas companies). While since 2009 the overall market has increase in value by 64% (and the overall energy sector by nearly 50%), the coal sector has declined in value by more than 50%. 11 Citi, "Global Thermal Coal: When Cyclical Supply Met Structural Demand," 15, 13 May From May September 2014 the Newcastle spot price has declined, but note that paucity of mine closures as of May 2014 relative to our estimate of unprofitable potential export capacity - is not chiefly the result a discrepancy in timing. Using the average last- twelve- months (LTM) Newcastle spot price of $73/tonne as opposed to the current spot price of $68/tonne, there is still 200+ Mtpa of potential export production capacity with cash costs above this price. 13 The prevalence of such contracts partly explains why Citi analysts identified only 2.4 Mtpa of Australian thermal coal mine curtailments, even though the Queensland Resources Council recently estimated half of Queensland s thermal coal production (30 Mtpa) to be operating at a cash loss and 20% of total production (12 Mt) to be operating at a loss greater than $14/t. CQ News, "Queensland's Coal Industry to Cut Costs or Close Mines," 28 Mar 2014, in- the- sand- a- thin- one/ /. 14 International Energy Agency (IEA), Medium- Term Coal Market Report 2013: Market Trends and Projections to 2018, 42, 2013, 15 For a full list of firms, see Appendix A. 22 Sep

10 Figure 4: Bloomberg Global Coal Index vs. the MSCI World Index and MSCI World Energy Index, Aug Aug 2014 Index Value (rebased to 100) Aug- 09 Nov- 09 Feb- 10 May- 10 Aug- 10 Nov- 10 Feb- 11 May- 11 Aug- 11 Nov- 11 Feb- 12 May- 12 Aug- 12 Nov- 12 Feb- 13 May- 13 Aug- 13 Nov- 13 Feb- 14 May- 14 Aug- 14 Bloomberg Global Coal index MSCI World Energy Index MSCI World Index Source: Bloomberg LP, CTI/ETA analysis 2014 Though financial performance of the coal sector over the last five years has been particularly poor, the table below shows the coal sector to have also underperformed the broader market on a 10- year-, 3- year, and year- to- date time scale. 16 Current price- to- earnings (P/E) ratios one measure of market sentiment on the potential for future growth in earnings suggest continuing market skepticism about future returns in the coal sector. With earnings here relating to one- year forward earnings, as of August 2014 the Bloomberg Global Coal Index displayed a P/E ratio of 7X versus a P/E ratio of 16X for the MSCI Energy Index and 18X for the MSCI World Index. The above data points suggest that financial markets expect continuing hard times for coal. 16 Partly as a result of fluctuations in commodity prices, coal stocks have also been significantly more volatile than the broader market; since its inception in August of 2003, the Bloomberg Global Coal Index has had annualized volatility of 24%, versus 20% for the MSCI Energy Index and 14% for the MSCI World Index. 22 Sep

11 Table 2: Comparing returns for the Bloomberg Global Coal Index, MSCI World Index, and MSCI World Energy Index Bloomberg Global Coal Index MSCI World Energy Index MSCI World Index YTD - 1.1% 8.0% 2.7% 1 year - 0.1% 15.2% 11.9% 3 year % 13.9% 31.5% 5 year % 49.6% 63.3% 10 year 51.6% 108.3% 66.1% since inception (8/12/2003) 136.6% 167.6% 91.8% Source: Bloomberg, CTI/ETA analysis 2014 One consequence of sustained financial underperformance has been widespread turnover within the executive ranks of coal companies. From January 2012 to March 2014, the figure below annotates the trend of the SNL coal price index) with descriptions of management changes at major US coal companies. For reference, in the next section we undertake detailed financial analysis of a sample of 83 coal companies that includes 15 US companies; of these 15 companies, over the past two and a half years, six of them have replaced a CEO or other senior executive (e.g. President). Moreover, in at least one case, losses related to coal by a major diversified mining company are thought to have contributed to a CEO s departure. 17 Note that this group of six companies includes four of the five largest US coal producers (Peabody Energy, Alpha Natural Resources, Arch Coal, and CONSOL Energy). The growing unwillingness of corporate boards and investors to endure continued coal- related losses highlights what might be termed the CEO risk premium related to coal. As examples of loss- making investments in new coal mines continue to spread, it is plausible that boards and shareholders of companies will significantly decrease their tolerance for investment decisions that assume continued unrealistically high coal prices. The concept of the "CEO risk premium" is directly applicable to much of the detailed company- level financial analysis below. 17 Rhiannon Hoyle, "Rio Tinto to Sell Mozambique Coal Assets for $50 million," Wall Street Journal, July , tinto- to- sell- mozambique- coal- assets- for- 50- million Sep

12 Figure 5: Recent management changes at US coal companies Source: SNL Financial 22 Sep

13 2. Country- level context on key export and domestic markets To give a sense of the current export landscape for thermal coal, the table below provides detail on the top five country exporters of thermal coal. Two points emerge from this table. First, after adjusting for differences in energy content and transport costs, average Newcastle- equivalent BECPs of these countries exist within a relatively tight range (with Russia, the highest- cost supplier, having an average cost only $16/tonne higher than South Africa, the lowest- cost supplier). 18 As discussed above, this flatness of the supply coal serves to limit margins for even lower and medium- cost suppliers of export thermal coal. Second, the ownership structure for export thermal coal mines varies considerably by country. Whereas mines in Indonesia are overwhelming owned by pure- play, publicly- listed coal companies, mines in Colombia are overwhelmingly controlled by publicly- listed diversified mining companies such as Anglo American, BHP Billiton, and Glencore Xstrata (companies that also have a significant presence in Australia and South Africa), while Russian mines are largely controlled by a combination of diversified miners and state- affiliated enterprises. Table 3: Detail on top five country exporters of thermal coal 2014 thermal coal export capacity (Mt) % of global thermal coal export capacity (excluding China)* 2014 weighted average Newcastle- equivalent BECP (USD/tonne) # of major pure- play publicly- listed companies that export thermal coal** Combined market cap of those companies (billion USD) Australia % Colombia 89 10% Indonesia % Russia 96 11% 82 1*** 0.8 South Africa 76 9% Total % *China excluded because, despite substantial potential export capacity, since 2009 the country has been a net importer of thermal coal. **Excludes diversified mining and metals companies, which have a particularly large presence in Colombia, South Africa, and Australia (and, to some extent, in Russia). Applies threshold from our sample by including only companies with a market cap of $200 million or more (as of August 2014) *** Southern Kuzbass Coal Company produces primarily metallurgical coal. Source: Energy Economics, using Wood Mackenzie Global Economic Model and CTI/ETA analysis On the basis of energy- adjusted cash costs (i.e. not adjusting for differences in transport- related costs and price differences in end markets), Colombia and Indonesia move noticeably down the cost curve, and the spread between the lowest and highest- cost supplier widens to $30/tonne. 22 Sep

14 Indonesia - reckoning with oversupply No country has seen a greater impact from growth of the seaborne thermal coal market than Indonesia. Since 2000 Indonesia has increased its exports of hard thermal coal more than 7 times to over 400 Mt in Though the country accounts for less than 6% of global coal production, its share of the export thermal coal market is 40%, largely due to its status as the top supplier of thermal coal imports to both China and India. 20 As a result of continued investment in new supply, from Indonesian thermal coal exports grew by an average of 30 Mt annually. The Indonesian thermal coal export story, however, has recently entered into a somewhat gloomier chapter. Declining prices for both export and domestic coal - partly a result of the phenomenal supply growth mentioned above - are pressuring margins for Indonesian producers. Of the 11 large publicly- listed Indonesian thermal coal producers that we later analyze, in 2013 seven had EBIT (earnings before interest and taxes) margins in the single- digits. In August 2014 Standard & Poor s declared PT Bumi Resources (one of Indonesia's largest producers) in selective default owing to failure to make payment on a $375 million convertible bond. 21 Times are even tougher for smaller miners producing low- energy content coal, which Citi analysts estimate could account for up to 30% of Indonesia's total coal production. 22 Indonesia's government is attempting to alleviate excess supply by capping total 2014 coal production at 397 Mt, versus total 2013 production of 421 M, albeit with little success to date. 23 Growth in export supply is also projected to decline to less than 20 Mt annually from Such changes, combined with the recent weakening of the rupiah, may bolster short- term profits for Indonesia's coal miners. Longer- term, however, there are significant hurdles to profitably expanding Indonesia's thermal coal production. These hurdles relate to the (1) low energy content of much of Indonesia's remaining thermal coal and lignite reserves (which necessitates discounts in selling price; (2) location of future mine developments, which typically will be further inland (hence increasing the capex requirements for railing this coal to Indonesian ports); and (3) potential Chinese bans on imports of low- quality coal (which China is considering as a way to reduce air pollution from coal). 24 As Indonesia's existing mines are replaced by costlier new developments and domestic Indonesian thermal coal demand more than doubles, our supply analysis estimates that through 2035 profitable Indonesian thermal coal exports may average only 207 Mtpa 25 (which, ignoring differences in energy content, is less than half of Indonesia's 2013 exports). Given the looming consolidation in Indonesia's coal sector, ownership of profitable Indonesian coal mines is likely to be limited to a shrinking number of players. 19 In all country discussion notes that historic totals on thermal coal exports are not energy- adjusted and, if from the IEA, exclude lignite. Yoga Rusmana and Fitri Wulandari, "New Rules in Indonesia Require Exporters to Have Licenses," Bloomberg, July , 24/new- rules- in- indonesia- require- coal- exporters- to- have- licenses.html. 20 IEA, Medium- Term Coal Market Report 2013, David Yong, "Bumi makes second- attempt to avert $375 million bond default," Bloomberg, Aug , 11/bumi- makes- second- attempt- to- avert million- bond- default.html 22 Citi, "Global Thermal Coal: When Cyclical Supply Met Structural Demand," /new- rules- in- indonesia- require- coal- exporters- to- have- licenses.html Note that enforcement of this cap will be complicated by the presence of up to 60 Mt of unreported Indonesian exports suggests- cap- on- coal- use- import- curbs- in- draft- air- pollution- law/articleshow/ cms 25 CTI and ETA, Carbon Supply Cost Curves: Evaluating Financial Risk to Coal Capital Expenditures. 22 Sep

15 Australia - record numbers of delayed or cancelled projects Recently overtaken by Indonesia as the world's largest exporter of thermal coal (on both a tonnage and energy- adjusted basis), Australia's supply of thermal coal has nonetheless been growing strongly. From Citi predicts Australia's thermal coal supply to expand by 29 Mt (40% of global supply growth over this period), as "brownfield" expansions of existing mines (approved during periods of $90/tonne+ prices) are completed and producers with take- or- pay rail contracts seek to lower unit costs through increased production. 26 More notable is the Australian growth that has not occurred - as projects planned in earlier years are delayed or abandoned as a result of declining prices, infrastructure bottlenecks, and rising prices. As of 2010 Citi tabulated 55 thermal coal projects in Australia (mostly "greenfield" projects) with a combined capacity of 368 Mt (i.e. 2.6X Australia's 2010 thermal coal exports of 140 Mt). As of May 2014, however, only 15 projects (representing 74 Mtpa of capacity) had been completed, while 28 projects (representing 177 Mtpa of capacity) had been delayed or abandoned (with the bulk of the remaining projects having received approval but not yet commenced construction). 27 To put that into perspective, the combined capacity of delayed/abandoned projects since 2010 nearly equals Australia's entire 2014 thermal export capacity. Table 4: Planned projects in 2010 v Current Progress by Volume (lhs) & planned projects in 2010 v Current Progress by Number (rhs) Project Status Thermal Capacity (Mtpa) % Project Status # of Projects % Delivered 75 20% Delivered 16 29% Construction 16 4% Construction 2 4% Approved/Committed 77 21% Approved/Committed 3 5% Ongoing 25 7% Ongoing 6 11% Delayed % Delayed 15 27% Abandoned 63 17% Abandoned 13 24% Total % Total % Source: BREE and Citi Research A primary barrier to expanding Australia's thermal coal exports is that current export levels are already stressing port and rail infrastructure in the states of Queensland and New South Wales (where 95%+ of Australia's coal is produced). 28 The need to build new infrastructure increases capex requirements and return hurdles for new projects - a point that our companion case study on the Galilee Basin brings into sharp relief. Leaving aside the financial burden of new transport infrastructure, capex for many Australian greenfield projects is rising as a result of the shift toward progressively deeper and lower- quality coal seams. Producer strip ratios measure the ratio of waste material to coal extracted. The figure below shows that from Citi, "Global Thermal Coal: When Cyclical Supply Met Structural Demand," 6. From , Citi estimates that Australian supply growth will decline to 16 Mt. 27 Citi, "Global Thermal Coal: When Cyclical Supply Met Structural Demand," CIBC, "Rio Tinto: To Be, Or(e) Not to Be," 57-59, June Sep

16 2014 strip ratios have been steady increasing for both metallurgical ( met or coking coal) and thermal coal - for thermal, coal from a ratio of 8:1 in 1990 (i.e. 8 tonnes of waste to one tonne of coal) to 10:1 by 2000 to 12:1 by 2010 and now at 14:1. 29 Because Australia s shallowest coal seams closest to the coast have all been mined, cost of producing thermal coal is substantially higher today than it was even five or ten years ago. Despite increased focus of producers on operating efficiencies, costs may stay high (relative to historical standards) just as prices wrestle with structural downward pressure. Figure 6: Queensland coal mining "strip ratios" by product, FY91 - FY14E Source: Queensland ROM Longer- term, Australia resembles Indonesia in having substantial potential new capacity that would be, largely, uneconomic at current prices. Assuming a price threshold of $75/tonne that emerges from our supply- demand analysis, over the next 20 years Australia's potential export capacity is Mtpa. 30 The capex requirements of potential greenfield projects, however, preclude profitable development unless future prices stabilize near $100/tonne or above. Our companion supply analysis examines the implications of this for the many companies (including Whitehaven Coal, New Hope Coal, Yancoal Australia, Adani, GVK, BHP and Glencore Xstrata) with potential exposure to greenfield Australian thermal coal mines. Russia - all about rail If for Australian producers rail costs are an issue, for Russian producers they arguably are the issue. Russia's main thermal coal export mines are in the Kuzbass region of western Siberia. The low mining costs of these mines are offset by extreme rail haul distances (4,750 km to Murmansk and 5,450 6,000 km to Pacific coast ports); these distances lead to railway tariffs of up to $30/tonne, and all- in rail transport costs (railway tariff, fuel, and railcar rental costs) of up to $40-50/tonne. Aside from having to contend with long haul distances, 29 For comparison, current strip ratios for Indonesia's four largest coal miners - who, it should be noted, typically mine coal of much lower energy content - range from 4.4:1 to 10.7:1. Citi," Global Thermal Coal: When Cyclical Supply Met Structural Demand," 32, Figure CTI and ETA, Carbon Supply Cost Curves: Evaluating Financial Risk to Coal Capital Expenditures. 22 Sep

17 Russia's rail infrastructure has been beset by persistent underinvestment. The IEA estimates an investment gap of $1.4 billion per year from leading Russian authorities in 2011 to declare 7% of Russia's entire railway system to be a bottleneck, hampering transport. 31 The IEA further projects no medium- term improvement on this score. The primacy of rail costs in Russian coal production makes the country's thermal export supply curve extremely flat. Recent prices have put Russia's export coal mines under considerable financial duress, leading some mines to close or curtail production, and the government to temporarily freeze rail tariffs. Through 2035, our companion supply analysis estimates that a price of $75/tonne would allow the profitable export of up to only 16 Mtpa (i.e. less than half of the country's 2014 potential export capacity - 80%+ of which, as noted above, does not appear profitable at current prices even on a cash- cost basis). 32 In the short to medium term, however, there is the possibility for government aid (intended to protect jobs and local economies) to keep Russian production above this 40 Mtpa level. Colombia Colombia is distinct from the other four exporters reviewed here in (1) supplying primarily to the Atlantic rather than Pacific market (in 2012 Colombia sent over 70% of its exports to Europe and over 20% to North and South America); and (2) having production concentrated in a few large, low- cost, surface mines, such as Cerrejon and El Descanso (which are largely controlled by multinational diversified mining companies). Our companion supply analysis estimates that over the next twenty years these two mines have the potential to achieve combined average annual production of over 70 Mtpa, with Colombia as a whole having the potential to produce closer to 80 Mtpa. 33 Over this period Colombian exports may also increasingly go to Asia, as expansion of the Panama Canal enables more cost- effective shipping of Colombian coal to China. South Africa In response to the emergence of the Pacific thermal coal export market, over the last decade South Africa has pivoted from sending less than 20% of its coal exports to Asia in 2003 to sending 85% in South Africa has, in particular, become an important supplier to the Indian market (which, like China, accepts lower- quality coal than do many European importers). Thanks to its competitive positioning on the global cost curve, our companion supply analysis estimates that with a price of $75/tonne South African potential thermal coal exports may decline to 56.4 Mtpa (relative to 2014 capacity of nearly 80 Mtpa). 35 Despite competitive supply costs and a 30 billion tonnes of remaining reserves 36, however, expansion of South Africa's thermal coal exports is constrained by (1) relatively limited remaining coal reserves in the traditional mining areas around the Witbank Coalfield; and (2) infrastructure bottlenecks (i.e. rail links to the Richards Bay Coal Export Terminal) that hamper development of other coal reserves such as those in the Waterberg coal field. 31 IEA, Medium- Term Coal Market Report 2013, CTI and ETA, Carbon Supply Cost Curves: Evaluating Financial Risk to Coal Capital Expenditures. 33 CTI and ETA, Carbon Supply Cost Curves: Evaluating Financial Risk to Coal Capital Expenditures. 34 IEA, Medium- Term Coal Market Report 2013, CTI and ETA, Carbon Supply Cost Curves: Evaluating Financial Risk to Coal Capital Expenditures. 36 BP, BP Statistical Review of World Energy June 2014, Coal: reserves". 22 Sep

18 US domestic coal market: Declining demand and prices leading to bankruptcies and weak share prices 37 The past five years have been a rough time for US coal producers. 93% of total US coal consumption occurs in the electric power sector. 38 Since 2008, coal consumption by US power plants has declined as a result of: 1. The economic recession and increases in energy efficiency eliminating growth in US electricity consumption (with retail electricity sales actually declining at a CAGR of 0.2%); 2. The shale- driven decrease in natural gas prices, with Henry Hub prices falling from an average of over $9/MMBtu in 2008 to under $4/MMBtu in 2013 and leading utilities to increase gas- fired generation at the expense of coal- fired generation; 3. Absence of development of new coal- fired plants (owing to weak economics and regulatory pressures) and closure of existing plants; 4. Increasing generation from wind and solar resources; and 5. Implementation of US Environmental Protection Agency (US EPA) regulations on air pollution from power plants, specifically the Mercury and Air Toxics Standards (MATS), the National Ambient Air Quality Standards, and the Clean Power Plan limits on carbon pollution. 39 From net electricity generation from US coal- fired power plants declined at a 4.4%, resulting in a level of 2013 US coal consumption that was 17% lower than the 2008 level (i.e. 839 million metric tonnes in 2013, versus over 1 billion metric tonnes in 2008). Summing the projected impact of renewable and gas- fired plant growth, coal plant retirements, and the EPA s Clean Power Plan to reduce carbon pollution from existing power plants, Bernstein Research estimates that by the end of the decade coal burn by US power plants will decline by as much as 228 million short tons (i.e. 207 million metric tonnes) 40 ; this decline is equal to one- quarter of 2013 consumption of coal by US power plants (or roughly one- third of 2013 US coal production). The projected decline in US coal burn is expected to result largely from closure of existing generating capacity - with the US EPA projecting retirement of nearly 180 GW of coal- fired power generation capacity between now and For more in- depth discussion of challenges facing US coal industry, see Tom Sanzillo and Cathy Kunkel, "NYC and NYS pension funds should divest coal stocks: A shrinking industry, weak upside, and wrong on climate change," IEEFA, May , content/uploads/2014/05/nycnys- pension- funds- should- divest- coal- stocks- IEEFA- Final58141.pdf 38 US Energy Information Administration (EIA), "US Coal Consumption by End- Use Sector, ," 39 For more discussion of these regulations, see CTI and IEEFA, Thermal coal demand: comparing projections and examining risks, Appendix C. 40 Bernstein Research, "Bernstein Energy & Power: The Coming Sea Change in Power Sector Coal and Gas Burn and Its Implications for Demand," September The White House Press Office, "Presidential Memorandum - Power Sector Carbon Pollution Standards", June , press- office/2013/06/25/presidential- memorandum- power- sector- carbon- pollution- standards. US Environmental Protection Agency (EPA), "EPA Fact Sheet: Clean Power Plan," pollution- standards/fact- sheet- clean- power- plan- overview. 22 Sep

19 Figure 7: US Total coal consumption and average annual CAPP spot price, Million tons USD per ton Electric Power Sector Other US Central Appalachian coal spot price index Source: Prices are for CAPP 12,500 Btu, 1.2 SO 2 coal, FOB. Source: EIA, CTI/ETA analysis 2014 Negative demand growth has led US coal producers to curb production, with annual US coal production falling 16% from 2008 to 2013 (i.e. from over 1100 million short tons in 2008 to 984 million short tons in 2013). 42 Major US coal producers continue to shutter excess capacity, with Alpha Natural Resources (currently the seventh largest US coal producer by market cap) recently announcing plans to close eleven mines in West Virginia. 43 These cutbacks in production, however, have been unable to prevent a decline US coal prices, with August 2014 spot prices for US Central Appalachian coal declining to $60/ton from an average 2008 price of nearly $120/ton. Moreover, despite an uptick in US coal consumption in the first half of 2014 as a result of a severe winter and a short- term spike in natural gas prices, headwinds for US coal producers are likely to continue. As detailed in our companion report on coal demand, 44 each of the trends listed above - flat electricity demand due to increasing energy efficiency initiatives, plus increasing generation from natural gas and renewables - will continue or accelerate over the rest of this decade. Moreover, existing and forthcoming EPA regulations on air pollution from power plants may result in the closure of 90 GW of coal- fired plants by 2025 (nearly one- third of the US coal fleet). 45 The supply- demand dynamics outlined above have led to serious financial dislocations for US coal producers. Recent years have seen 26 US coal companies go into bankruptcy (chiefly in Kentucky and West Virginia), including once major producers such as James River Coal and Patriot Coal Corporation (each of which, at the 42 EIA, "US Coal Production, ," 43 David Conti, "Emerald coal mine in Greene County to close next year," Trib Live, Aug , emerald- alpha#axzz3cakxkkgo. 44 CTI and IEEFA, Thermal coal demand: comparing projections and examining risks. 45 Bernstein Research, "Bernstein Energy & Power: The Coming Sea Change in Power Sector Coal and Gas Burn and Its Implications for Demand," September Sep

20 time of their bankruptcy filings, claimed over $1 billion in assets). 46 Those producers that have remained solvent have suffered significant declines in market value. 47 The table below illustrates that (excluding Foresight Energy LP, which went public in mid- 2014) from April 2011 to August 2014 the market capitalizations of the 13 largest US coal producers declined by an average of 29%; for reference, over this period the S&P 500 increased by almost exactly the same percentage. Such trends have resulted in coal holdings underperforming the broader market during this period. 48 Table 5: US coal companies' market capitalization changes, Apr Aug 2014 Source: SNL Financial Potential for US thermal coal exports Analysis of the US domestic coal market above noted how declining US coal demand increases the incentive of US producers to export thermal coal to foreign markets. During the past few years this dynamic has already come into play. From US thermal coal exports more than doubled to over 50 million tonnes and $4.3 billion in revenue 49, before declining in 2013 (and, data suggest, continuing to decline in 2014). 50 A majority of 2013 thermal coal exports from the US went to Europe (chiefly the United Kingdom, 46 Darren Epps, "Bankruptcies continue to rock coal companies in '13, but hope for the survivors," SNL, Dec Taylor Kuykendall, "Coal industry market value contracting again after brief rebound", SNL, Aug Tom Sanzillo and Cathy Kunkel, "NYC and NYS pension funds should divest coal stocks," for example, report that since 2011 the New York State Common Retirement Fund Holdings has lost $108 million in share value via its holdings of the four largest US coal stocks (Alpha Natural Resources, Cloud Peak Energy, Arch Coal, and Peabody Energy). 49 EIA, "U.S. Coal Exports by Year, Quarter, and Customs District, (Quantity: short tons / Revenue: dollars)," Note that the 50 million tonnes number is not normalized to any specific energy content and so, strictly speaking, cannot be directly compared to numbers in our supply- demand analysis below. 50 Platts, "US coal exports total 6.5 million st in July, down 18%," Sep , reports that "the 1.6 million tons of thermal coal that the US exported in July 2014 (most recent data available) was down 36.9% from July 2013." Note that 1.6 million short tons is 1.45 metric tonnes. 22 Sep