BHP is exploring options to exit thermal coal by divestment. Its thermal coal assets have seen a serious erosion of viability and are on track to deliver an operating loss in 2019-20. Having sounded out the market, initial reports suggest BHP received indicative bids from Yancoal and Adani Australia well below BHP’s expectations.
The 25-30% decline in Newcastle benchmark thermal coal prices over the last year, and more than halving in the last two years, makes any near term divestment problematic, to say the least. Equity market values of pureplay coal companies have been decimated over the last two years, including in both thermal coal firms like Peabody Energy (down 93%) and coking coal entities like Coronado Global Resources (down 72%).
However, the growing momentum whereby financial institutions are increasingly exiting the thermal coal sector in the face of a belated acknowledgement of the 2015 Paris Agreement, and coupled with ongoing double digit annual solar cost deflation strongly suggests this may represent more of a structural headwind than a normal cyclical commodity nature. This is reinforced by the Australian Treasury assuming prices stay at USD 54/t in the medium term.
This report examines the recent profitability trends of BHP’s two thermal coal exposures, the 100% owned 16-19Mtpa Mt Arthur mine in New South Wales (NSW), Australia and the 33.3% equity stake in the 25-30Mtpa Cerrejón mine in Columbia. These two mines are the largest thermal coal mines operating in their respective countries, and both have already been operating for decades, with BHP modelling the remaining mine lives of some 20 and 14 years respectively.
It also examines a key issue for divestment, being the unfunded open-cut coal mine rehabilitation liabilities. While BHP has done some progressive mine rehabilitation in the last two decades, to-date BHP is yet to finalise and relinquish even a single hectare of the huge Mt Arthur mine site.
Divest or retain thermal coal
Investors like the Norwegian Sovereign Wealth Fund are increasingly pressuring BHP to “deal” with this key business risk, given its global significance with respect to scope 3 emissions and growing climate change pressures including more frequent, more extreme weather events.
Should BHP divest this business, sterilise its exposure by spinning it off to existing shareholders (with a few unique twists as safeguards) or retain and sterilise the assets and accept the responsibility of progressively managing the decline and clean-up over the coming two decades?
The report reviews the unintended consequences of several divestment strategies in coal by Rio Tinto, South32, firstly by BHP and then by South32 for its South African coal division, and Vattenfall of Sweden. It also reviews the end-of-life of Rio Tinto’s uranium mining listed subsidiary, Energy Resources of Australia (ERA), as a (largely) positive case study of sterilisation.
A common theme in the divestment strategies examined is that each has involved strategic and/or financial errors of judgement that has resulted in massive hundreds of millions or billions of dollars of capital write-offs.
Absent a buyer for either Mt Arthur or Cerrejón, BHP has a dilemma:
1. Retain and manage the currently loss-making businesses as best they can to maximise net cashflow (minimise outflows) after funding the ongoing stay-in-business capital expenditure (capex) needed to keep the mines efficient and safe and to fund the massive rehabilitation effort ahead, or
2. Spin-off the assets via an in-specie distribution to existing shareholders, ideally retaining a residual controlling interest to allow something of a sterilisation of the exposure without facilitating a tax haven-based vulture fund making a difficult situation far worse by plundering the remaining cashflow, leaving nothing to cover the growing rehabilitation liabilities. Ideally the listed entity should have a board and management team committed to this sterilisation mandate. Further, IEEFA would advocate that a sinking fund be set up to legally quarantine and invest the capital needed for rehabilitation.
Global miners exiting thermal coal
Rio Tinto and South32 have both moved to exit thermal coal mining globally (South32 retains a small exposure via its Illawarra coking coal division in NSW). BHP committed to no further expansion in thermal coal mining in 2019 and has tried to offload both Mt Arthur and Cerrejón during 2020.
Most Japanese trading houses have divested all of their thermal coal mine exposures over the last two years, the latest of which was Mitsubishi Materials divesting their 11% equity holding in New Hope Corporation in February 20208 and Sojitz selling their 10% equity stake in the Moolarben Coal Mine in March 2020.9 This followed thermal coal divestments by Mitsui & Co and Mitsubishi Corporation in 2018. Anglo American in August 2020 confirmed that a spin-off is the preferred option for their thermal coal mines having earlier stated: “We are therefore working towards a possible demerger of our thermal coal operations in South Africa as our likely preferred exit option, expected in the next two to three years, with a primary listing on the Johannesburg Stock Exchange for the demerged business. We will continue to consider other exit options as we engage with stakeholders as part of our commitment to a responsible transition.”
An outright sale of the Mt Arthur mine and its 33% equity stake in Cerrejón would most likely free BHP of legacy exposures. This assumes BHP can find an investor willing to stump up an acceptable price while factoring in both the failure of the world to successfully and necessarily deal with carbon emissions as per the Paris Agreement, and also that a massive deployment of yet-to-be-commercially proven carbon capture and storage (CCS) for coal-fired power plants can be viably achieved to allow thermal coal to remain cost effective against ever-cheaper renewable energy.
Absent this, a spin-off to existing shareholders would allow BHP to economically quarantine the assets, liabilities and cashflow in a separate entity. Retaining a controlling stake below 50% would allow deconsolidation while avoiding abrogating BHP’s legal fiduciary and economic, social and governance (ESG) responsibility to rehabilitate the sites as agreed to when mining was first approved. Any eventual rehabilitation cost shortfall could then be underwritten by BHP, similar in some respects to how Rio Tinto managed it with its listed subsidiary Energy Resources of Australia.
A listed entity spin-off could free BHP to move forward without shirking its stakeholder responsibilities – a good corporate governance outcome, which is likely far better than a divestment to a tax-haven-based private enterprise free of public or investor oversight.
The whole issue of coal mine rehabilitation has been examined extensively over recent years by the NSW and Queensland governments, with NSW receiving a failed Auditor General report. Queensland has moved a long way to address this. But with financial institutions increasingly unwilling to underwrite thermal coal risks, financial assurance is becoming more costly, and less available.
IEEFA advocates that any spin-off of BHP thermal coal include a sinking fund, with the NPV of the rehabilitation liability to be fully funded and put aside in an externally managed investment trust with a long term, medium risk mandate reflective of the 20-30 year timeframe, suitably constrained to ensure future management cannot apply creative arguments to dip into this trust.
A listed corporate structure highly rewards its limited tenure CEO, management and board for generating sustainable profit growth and progressively investing to grow the business. Absent the right incentive, there is little historic precedent to suggest that the same corporate structure is equipped to maximise long term rehabilitation while successfully managing the end-of-life business and progressive staff exit. Kicking the can down the road for the next CEO to deal with this is an unfortunate but regular outcome of a financial assurance system that sees private economic value maximised by the indefinite deferral of rehabilitation costs. The negative net present value is minimised by deferral, avoidance and delay. That after two decades BHP is yet to free a single hectare of mine land as fully rehabilitated at Mt Arthur is proof of this assertion.
A spin-off with an adequately funded sinking fund and a Board committed to learn from the ERA lessons and manage the 1-2 decade terminal decline trajectory of thermal coal would best accommodate all stakeholders (NSW taxpayers, Mt Arthur’s workforce, the local community and investors).
Thermal coal follows oil and gas decline
As per Figure 3.1, the thermal coal export price for 6,300kcal GAR benchmark coal was close to a decade low of USD 53/t as of June 2020. This reflects the combination of dramatic declines in oil and liquid natural gas (LNG) prices as a result of the Saudi-Russian price war and demand destruction globally with COVID-19. The three largest thermal coal import markets globally are reporting major reductions in demand.
In May 2020, Chinese coal imports declined 20% year-on-year, reversing the trend of increasing imports earlier this year. In July 2020, the Chinese Energy Minister announced China will build 85 GW of renewable energy in 2020, a close to record high, as part of China’s ongoing commitment to drive the global energy transition and decarbonisation. Indian coal imports also declined 47% year-on-year as of June 2020. This is a direct result of record high domestic coal mine and power plant coal stockpiles due to electricity demand declining 25% year-on-year during the lockdown. Coal-fired power generation has worn 100% of the demand loss due to its high marginal cost position. The Coal Minister Pralhad Joshi has repeatedly called for India to cease all discretionary thermal coal imports by 2023-24. And Japan in July 2020 proposed it would close 100 of the 140 coal-fired power units in the country by 2030 as part of its commitment to move away from coal and align with the Paris Agreement. Coal lobbyists have tried to distract attention from the terminal trajectory of seaborne thermal coal over the coming two decades, first looking to China, then India, and more recently the ASEAN region to save this highly subsidised, carbon intensive, highly polluting and increasingly obsolete product. Vietnam is the largest and fastest growing ASEAN economy.
In July 2020, the Vietnamese Ministry of Industry and Trade continued to develop the Power Development Plan (PDP) to accelerate the deployment of domestic renewable energy as a way of curbing the energy security and economic risks of continuing to grow reliance on imported thermal coal. This involves a dramatic reduction in previous plans for unbridled growth in expensive new import coal-fired power plants underwritten by subsidised Japanese and South Korean government state capital.
The forward curve for thermal coal is cast as decidedly positive (Figure 3.2). However, the report notes liquidity in the forward market is limited, just a fraction of 5-10 years ago, making this an unreliable forecast. In contrast, the Australian Federal Treasury uses current spot prices of USD 54/t as the best perspective of future prices, given the historic unreliability of forecasts in light of extreme commodity price volatility.
The International Energy Agency’s (IEA’s) World Energy Investment 2020 report highlights final investment decisions for new coal-fired power plants globally hit a decade low of 18 GW in 2019, down more than 75% from the level of new commitments evident in the first half of the decade.
With coal plant closures globally averaging 35GW annually over 2015-2019, and global coal-fired power plant utilisation rates hitting a decade low in 2019, global coal use in the power sector could well have peaked back in 2018.
Coal divestment accelerates
Despite or maybe in acknowledgement of the lessons learnt during the global pandemic, there has been significant global capital momentum away from thermal coal and coal-fired power generation in 2020. This is a reflection of the rapidly diminishing economic merits of thermal coal and the growing understanding that an alignment with the Paris Agreement invariably leaves many coal projects as stranded assets, unable to deliver a viable return over their proposed design life. Indeed, the trend of finance exiting coal has accelerated in 2020, with the number of new or improved policies running at 60% more than the run-rate of 2019.
Since May 2020, 13 globally significant financial institutions have introduced or tightened coal exclusion, divestment or restriction policies, including Westpac, HESTA and First State Super of Australia, Credit Suisse of Switzerland, Societe Generale, BNP Paribas and Natixis of France, Toho Bank of Japan, CDC Group of the UK, Intesa Sanpaolo of Italy, Norges Bank of Norway, DB of Germany and MetLife of the US.
BlackRock also completed its divestment of thermal coal miners in May 2020. And put KEPCO on notice for continuing to invest in new coal power plants. In total, IEEFA has tracked 139 globally significant banks, insurers, and asset managers/ asset owners that have implemented substantial formal coal policies since 2013. This year has seen 48 new or updated policy statements (Figure 4.1).
BHP’s thermal coal exposure
Like Rio Tinto, BHP was one of the world’s largest coal mining companies prior to 2015. In order to shrug-off the many legacy assets acquired through the entirely questionable merits of the Billiton “merger” of 2001, BHP completed the restructuring and spin-off of South32 in 2015, thereby removing its yet-to-be fully stranded South African thermal coal division, plus the Illawarra NSW coal mining assets (a combination of thermal and coking coal mines).
BHP was left with Mt Arthur and a one third ownership of Cerrejón, plus its Queensland coking coal division (owned via BHP Mitsubishi Alliance (BMA) and BHP Mitsui Coal (BMC)) with nine coking coal mines in the Bowen Basin.
Mt Arthur Thermal Coal, Hunter Valley:
BHP owns the 16-19Mtpa Mt Arthur thermal open-cut coal mine 5 kilometres south of Muswellbrook in the Upper Hunter Valley, New South Wales (NSW), including the Coal Handling and Preparation Plant (CHPP) and rail loop.
Figure 5.1 details the summary production and profitability figures reported by BHP since financial year (FY) 2018. The collapse in thermal coal prices over FY2020 has pushed the mine into significant losses, with 2H FY2020 set to be materially worse than 1H FY2020’s earnings before interest and tax (EBIT) loss of USD 94 million.
In October 2018, BHP awarded Thiess a mining services contract to complete end-to-end mining services in the Ayredale and Roxburgh pits (referred to as Mt Arthur South) over five years. Thiess was identified as the preferred contractor, with expertise in existing operations at the southern area of the main pit and terrace mining techniques demonstrated at nearby operations. Under the new contract, Thiess was appointed statutory mine operator of Mt Arthur South, with scope including vegetation clearing, mine planning, drill and blast, overburden and coal mining. BHP remains the mine and lease holder of Mt Arthur South and Mt Arthur North, and the mine operator of Mt Arthur North.
Mt Arthur had a recent run-of-mine (ROM) production of 24-25Mtpa, with an average yield of 73% giving product coal of 17-19Mtpa, although BHP expects this to drop to 16-17Mtpa in 2019-20. This assumes a 77% yield over the remaining life of the mine.
BHP’s FY2019 annual report puts the proven and probable marketable reserve life of Mt Arthur at 21 years (20 years by July 2020), predicated on their non-disclosed long term Newcastle benchmark price and currency assumptions.
While this lack of reserve life disclosure is entirely the market norm, it implicitly suggests that coal remains economically viable, despite double digit annual deflation evident in solar costs over the last decade, and which IEEFA considers likely over the coming two decades. The price assumption also assumes end customer nations do not adequately incorporate a carbon emissions price aligned with the IEA’s global guidelines by 2030 and 2040 such that carbon emission externalities remain unpriced, meaning the product remains viable against zero emission alternatives, both now and over the coming two decades. Global investors are now increasingly concerned these assumptions are not without real risk. BHP’s FY2019 resource statement put the total marketable reserves at 453Mt, with an ash content average of 15.3% and an energy content of 6,050kcal.
BHP’s Mt Arthur mine and the associated equity stake in the Newcastle Coal Infrastructure Group (NCIG, part of the Newcastle coal export port) is held on the books with a net asset value of USD 901 million as of 31 December 2019. But as per Figure 4.1, the mine in FY2020 is gross cash flow negative even before funding sustaining capex, and before the full impact of the 25% decline in thermal coal prices to-date in 2020 is revealed in the full year results in August 2020.
Optimistic valuations of say four times gross cash profits in a peak year like FY2018 would have suggested a price tag over USD 2 billion. Today, the market could be well under $1 billion, even if a strategic buyer with a strong Australian balance sheet can be located. Any buyer would need to be of the view that thermal coal prices are close to a cyclical low. This would appear to be a likely bet, given they are at a decade low and Asian markets will be using coal for several decades to come, notwithstanding the inevitable, unstoppable rise of lower cost renewable energy in the medium term, even in South and South East Asia.
Cerrejón Thermal Coal Mine, La Guajira, Colombia:
In February 2002 BHP Billiton, Anglo American plc and Glencore International AG (“the Consortium”) acquired International Colombia Resources Corporation from Exxon Mobil Corporation. Combined with the acquisition of a 50% mine stake from the Columbian government, this gave each corporation a 33.3% equity stake in the Cerrejón coal mine in La Guajira, Colombia.
In 2002 the Cerrejón mine generated 19Mtpa of thermal coal for export. Having already been in operation for more than two decades, the mine still had an expected mine life of 30 years from 2002 (at that rate of production). The mine has a reserve life of 14 years given a lease expiry of 2034.
In 2011 the Consortium undertook a USD 1.3 billion expansion with the aim of reaching 40Mtpa of output by 2015 based on the expectation that global seaborne coal markets would see strong ongoing volume growth. With the stagnation of global market ever since, this expansion was a total failure.
In August 2019 BHP suggested that Cerrejón would produce some 27Mt in 2019-20, but the 2019-20 operational review showed production down 23% year-on-year, giving an annualised sale of just 21 Mtpa, down 50% on the expected sales forecast a decade earlier (see Figure 5.2).
In hindsight, it would have been a lot easier selling Cerrejón when it was making BHP a USD 300 million equity share of EBIT (meaning the entire mine’s EBIT was USD 900 million (100% share)), than it will be now the mine is operating at below EBIT breakeven. BHP’s 33.3% share is held in the books with a net asset value of USD 828 million.
A review of site rehabilitation at Mt Arthur
Mt Arthur mine has a strip ratio of 7 bank cubic metres (BCM) per tonne of product coal (7BCM:1t), meaning some 15-18 million tonnes of overburden is displaced to generate 1Mt (~16t:1t).
This means mining at Mt Arthur involves shifting almost 300 million tonnes of earth annually for some 40 years, or 11 billion tonnes over the likely mine life. This has daunting consequences for consideration of mine site rehabilitation to limit perpetual desolation of the massive area and toxic water contamination in perpetuity. BHP at some point will need to lodge with a Final Void management plan with the NSW government.
As of FY2020 the mine has a “disturbance” footprint of 4,266 hectares, is disturbing another 300-400 hectares annually and has completed precisely zero hectares of rehabilitation despite operating since 2002, making a mockery of the progressive rehabilitation requirements (Figure 6.1).
Learning from coal divestment case study of South32
When BHP Group announced the spin-off of South32 in 2015, for many months there was debate about how much thermal coal BHP could offload in one go. Clearly investors in South32 argued for the spin-off to not be a coal dumping ground and won the argument. South32 was left with a strong balance sheet and a South African thermal coal division, plus the more attractive Illawarra NSW coal mining assets (a combination of thermal and coking coal mines). BHP was left with Mt Arthur and a one third ownership of Cerrejón.
With the national disaster of Eskom key to the South African economy being dragged into a decade of stagnation and financial distress, thermal coal mining in South Africa has been an international investors’ nightmare, like Mozambique was for Rio Tinto. A total wealth hazard.
In 2017 South32 announced it would seek an orderly exit of its 21-23Mtpa South African thermal coal mining division (half export, half sold domestically to Eskom).
In November 2019 South32 announced it had reached conditional agreement for the sale of its South African Energy Coal (SAEC) division to Seriti Resources (and a Broad-based Black Economic Empowerment consortium), having taken a USD 504 million impairment. The binding sale was announced, netting South32 AUD 9.8 million. To put this AUD 9.8 million in context, South32 committed 8,700 million Rand in capex over 2018-2020. South32 was reported to have also received 49% of the free cash flow generated by SAEC to March 2024 with any payments capped at a maximum of 1.5 billion Rand per year. With coal prices down 25% in 2020 and the business shut during the COVID-19 lockdown, free cashflow is likely to be minimal.
The report was originally published by IEEFA and can be accessed by clicking here