Coal news and updates

Coal: De-allocation and after

Long-term gains to outweigh short-term uncertainties; metal players to take a hit

After the judiciary’s decision to de-allocate illegal coal blocks, the onus is on the executive to rectify the crisis. The decision underscores the need for reforms. Even as in the short-term India may not experience significant negativity in real economic variables, the negative externalities in the medium-term on the investment cycle outlook may be profound if the government fails to take the necessary steps. We hope some convergence is achieved between the government’s plan horizon and the markets’ expectation of the same to avoid a major disappointment in the medium term.

Another opportunity to harness long-term gains…Long-term gains that can be leveraged out of the coal block de-allocation move outweigh the short-term uncertainties. The stage is set for the government to initiate coal block auctions. The coal sector (and probably the mining sector) can benefit from increased competitiveness, trading mechanisms and global technology transfers if the government uses this opportunity to initiate reforms in the sector. However, the window available to the government is quite small and short-term uncertainties will increase pressure on growth recovery in the absence of structural changes in the sector.

… with short-term uncertainties dampening economic buoyancy: There is unlikely to be much direct impact on retail inflation though on wholesale prices, a 10% increase in coal price will lead to a direct impact of 20-25 bps. The secondary impact of higher coal prices is unclear, given non-linear translation through electricity prices, industrial production, etc. However, the decision is likely to have significant impact on sentiment. In a scenario where investment is yet to recover, retrospective penalties (~R78 bn to be gained by the government) will be a dampener to investor sentiment. More important, the negative externalities from delayed government action is now much higher given that domestic coal production may be hampered, which implies that coal imports may increase. For our estimate of CAD/GDP at 1.7%, we have assumed coal imports worth $18 billion.

Growth recovery hinges on the investment cycle, for which government support is crucial: It is now well understood that investment-cycle recovery has to drive growth. But for the investment-cycle recovery, the government’s help is crucial (financially and through policies). While we are moderate in our growth estimates (5.6% in FY15 and 6.0% in FY16),x our estimates hinge on some positivity from industrial sector revival, which may be at risk without investment-cycle recovery.

We believe coal block auctions are likely only over a one-two year horizon. Consequently, there may be shortfalls in coal production and negative implications for the power and manufacturing sectors. We await clarity on (i) fuel pricing (gas and LPG), (ii) land-acquisition issues, (iii) the Centre’s initiatives on labour reforms and (iv) taxation issues (GST, GAAR).

The Supreme Court on September 24 de-allocated almost all captive coal blocks. Of the 46 blocks which are either producing (40 blocks) or about to start production (six blocks), it cancelled 42 blocks (37 operational and five about to be operational). For these cancelled blocks, the court granted six months to shut down operations. Moreover, players with operational blocks have been asked to pay a penalty of R295 per tonne of coal mined up to 2014-15, which will translate to R100 billion. The four coal blocks which have not been de-allocated pertain to NTPC (Pakri-Barwadih), SAIL (Tasra) and Reliance Power’s Sasan Ultra Mega Power Project (Moher and Moher Amlohri Extension.) Moreover, in its ruling on August 25, 2014, the SC had held that blocks allocated to UMPPs through competitive bidding would not be deallocated. Of the 218 coal blocks allotted so far, only 40 blocks have commissioned as of 2013-14, with a production of 39 million tonnes.

Profitability of metal players to witness a sharp decline: Players who have operational coal blocks will witness a sharp decline in profitability post 2014-15, as they would have to substitute captive coal with imported coal, which is about four times more expensive (as Coal India may not supply domestic coal to these players given its FSA commitments to the power sector). In 2015-16, impacted players in the sponge iron and aluminum sectors are expected to witness a 900-1,000 bps and 300-400 bps decline, respectively, in operating profitability.

Deallocation of mines to have limited impact on operational power projects: The impact of de-allocation of operational coal blocks on 7-8 GW of linked power projects will be limited as these operate under a fixed return model. Moreover, we expect alternate domestic coal supply (albeit at a higher price compared to captive coal) to be provided to these projects as most of these are operated by state-owned utilities. We expect the power purchase cost for utilities to rise, particularly in

West Bengal and Punjab. However, at a pan-India level, the impact would be negligible.

Returns of competitively bid power projects to be hit: Projects of GVK Power and Essar Power, whose coal blocks are under development, will take a hit. These projects have been competitively bid and have a limited scope for passing on fuel costs in their power purchase agreements (PPAs). This will restrict their ability to use expensive imported coal. Moreover, these power projects have either commissioned or are expected to be commissioned over the next few months. In the absence of an alternative coal linkage, we believe that these projects will operate at low plant load factors (PLFs).

Intensity of bidding for de-allocated blocks to determine extent of hit on profitability: From April 1, 2015 onwards, all operational coal blocks will be taken over by the government, which will re-auction them through a competitive bidding process. Till the fresh auctions are completed, these blocks are likely to be operated by Coal India.

We expect players whose blocks are de-allocated to bid aggressively to retain their blocks, given the operational advantages such as proximity to end-use plants, quality of coal and consequent equipment configuration. Moreover, competition from other players operating in the vicinity of these blocks will also be very high as these are operational mines and the cost of imported coal is also higher. Consequently, the extent of impact on profitability of end-users, post-auctions will be dependent on their ability to retain blocks and the price paid for them.

* JSPL – Hold rating with a revised target of R209 (earlier 304)

* Hindalco – Buy rating with a revised target price of R223 (earlier 240)

* Coal India – Hold rating with a target price of R360.

Top picks remain JSW Steel, Sesa Sterlite and Hindalco: The SC judgment leaves certain open issues and questions. At the systemic level, the issue of potential spike in imports is at least partly addressed by the decision to transfer producing coal blocks to CIL. However, coal costs for such blocks would rise considering the need to pay profit margins of CIL. Nevertheless, we see several key open issues:

* Transfer of mines to CIL is unlikely to be a smooth process considering issues of legal documentation, employees and investment made by existing mine-owners for which they would demand compensation.

* Post-transfer, it is unclear whether fresh FSAs would need to be signed with CIL, extent to which CIL is willing to provide coal to current mine-owner and the logistics for supplying coal to other consumers; and

* In the event an auction is conducted and the winning bid is from new companies, issues of compensation for investment by the existing mine-owners would arise.

JSPL to take highest hit; marginal impact on Hindalco: Going forward, we see the risk that all the deallocated mines may not be auctioned, CIL may retain certain producing blocks and supply only part of the current mine-owner’s production. For JSPL (12 mtpa production), the impact is maximum comprising (i) a one-time penalty of R30 bn (R33 per share); and (ii) 8% cut in FY16e Ebitda on estimated increase in coal cost by R600 per tonne.

For Hindalco (2.5mtpa), the impact will be marginal. (i) one-time penalty of R5 billion (R2.5 per share); and (ii) cut in FY16e ebitda by 2%.

Coal India to be prime beneficiary: In one stroke, CIL has been allocated 40 coal blocks producing at 40 mtpa currently and with reserves of 2 billion tonnes. It is not clear if the rest of the cancelled coal blocks of 38 billion tonnes reserves will also go to it.

Source: The Financial EXpress