Opinion
Last updated: 8th Nov 2011
Below will be an analysis of the status of the Russian coal industry and the opportunities and risks for foreign investors.
The Russian coal industry is particularly interesting as there are no restrictions on foreign investment in the coal industry as there are, for example, in the oil and gas sector.
Despite well flagged issues regarding investment in the country, Russia has a degree of financial stability that could be envied by many European countries. As a consequence of its substantial oil and gas revenues (Russia is now the world’s number one oil and gas producer) Russia has achieved relative fiscal stability in an otherwise unstable world. The targeted fiscal deficit for this year is -1.5% of GDP and foreign exchanges reserves amount to around USD480bn (November 2010), approximately equal to the level of gross external debt. The Government started to refill the Oil Reserve Fund earlier this year.
Although a major producer for its large domestic market (coking coal for Russian steel producers, Magnitorgorsk, Severstal, Metalloinest, Evraz, Novolipetsk Steel, Mechel and thermal coal for around 20% of electric power generation), Russia lags other coal producing and exporting areas such as Australia and South Africa. In terms of hard coal production, Russia is currently only the sixth largest producer of coal in the world after the China, the USA, India, Australia, and South Africa largely as a result of underinvestment in extraction in the past two decades since the collapse of the Soviet Union.
Hard coal production 2010 (m tonnes)
PR China 3,162
USA 932
India 538
Australia 353
S. Africa 255
Russia 248
Indonesia 173
Kazakhstan 105
Poland 77
Colombia 74
Source: IEA 2011
By comparison, in 1988 Russia produced 415m tonnes of coal, 1.7x the current level.
Russia is also well behind Australia in terms of total coal exports and behind Indonesia in terms of thermal coal exports.
-Please see attached file for graphs.
The leading coal importers are the BRIC countries of China and India, both of which can be supplied from the Russian Far East or West Siberia, as well as Japan and South Korea.
-Please see attached file for graphs.
Nevertheless, Russia is by far the world leader in coal reserves with the country containing an estimated 6 trillion tonnes of geological coal resources including 375bn tonnes of geologic reserves (proven recoverable reserves) or an estimated 20%-30% of the world’s total. It is rich in reserves of both anthracite and lignite thermal coal types and also coking coal used in the production of steel and other metallurgical processes. Coal reserves are widespread and it is instructive to consider coal production located in three broad regions:
1. European Russia west of the Ural mountains
2. Western Siberia, or the area between the Ural mountains and Irkutsk near Lake Baikal.
3. The Russian Far East.
The Kuzbass region based around Kemerovo in western Siberia is the largest producing region of both thermal and metallurgical coal types. Production is also concentrated in the Donbass region in European Russia, near the border with Ukraine. Large reserves have also been discovered in Yakutia, Primorsky Krai, Chitinsky Oblast and other parts of the Russian Far East which are all potential suppliers of coal to satisfy major Chinese, Japanese and Indian demand for coking coke and thermal coal for electric power generation. The design of new coal-steam powered combined cycle electric power generators , as well as Japan’s decision to abandon nuclear power construction in favour of other forms of electric power generation have improved the outlook for thermal coal.
The outlook for coking coal is already strongly positive, especially in the emerging economies.
Consolidation of Coal Assets: the Strategy of Major Russian Coal Miners
In the early 1990s, the Russian coal mining industry emerged from state control under the Soviet Union in a fragmented condition and starved of capital. Towards the end of that decade a period of consolidation commenced, led by large Russian companies such as Mechel (coal and steel producer, large greenfield coal project, Elga in Russian Far East), SUEK (consolidated by MDM bank, planned IPO in 2011 postponed), and Raspadskaya Coal (second largest coking coal producer, mining GZh quality, semi-hard coking coal – suffered a major explosion at its flagship Central Siberian mine in 2010), all now major Russian mining companies. The strategy of Mechel and SUEK was to accumulate as many assets as possible which could be mined by open cast methods at a low capital cost. The strategy was then to expand production through open cast production to generate sufficient funds to repay the debts that had been contracted to pay for the assets.
This has only been partially successful; significant cash flow has been generated but all three companies remain heavily indebted, lacking cash for investment, and vulnerable to a downturn in international coal demand.
Acquisition Strategy
The view of North Star Corporate Finance is that there are interesting opportunities to invest in the Russian coal industry at this juncture, before full consolidation of deposits and prior to the emergence of major competitive sources of investment. NorthStar recommends acquiring at least 51% of any company in order to avoid the circumstances of high profile problems with significant shareholders (e.g. BNP-TNK). Investments are often made through offshore holding companies (typically Cyprus registered companies because of the existence of a double taxation treaty) whether these investments are made by foreign investors or Russians investing back into Russia.
Acquisition Approach
At present, the number (and size) of attractive coal deposits that can be extracted through open pit mining represents around 5x the number and size of assets currently under open cast mining extraction. This offers significant opportunities even in areas with well-established transport infrastructures.
The large Russian mining companies cannot compete effectively for new mining assets at present. They are burdened with significant amounts of debt from old mines, which have been mortgaged to raise the funds for mining operations and development. Moreover, some are at risk of a gap between the market value of the mines and the security given for the assets, leading to demands for margin calls.
There are still assets available in the best locations. Almost all the coal geology in the Far East, for example, can be based, initially, on open cast operations and further development of the transport infrastructure in the region is a declared priority of the Russian Government.
Foreign investors can therefore position themselves in the best areas and be in a position to buy up assets sold by the Russian mining companies when/if they need to sell assets to raise cash.
In NorthStar’s view, the investment strategy with the greatest upside potential is be to acquire greenfield asset/new licenses in close proximity to open cast mines owned by Mechel/SUEK/ Rapadskaya where the transport infrastructure is already in place.
The critical success factor for Russian mining is effective Russian-foreign mining management and skilled labour teams and strict financial controls. NorthStar has created experienced Russian teams of management and local labour necessary to operate and manage the mines in remote areas, using their longstanding connections in Russian coal mining and sales. This can be replicated many times through our strong contacts in the industry.
Regional Examples: An Assessment
Russian Far East: High Grade Coking Coal
The licence to own and operate a 140m tonne mixed coking and thermal coal deposit can be acquired for around Rs.130m. Investment in an additional Rs150m in project scoping, license registration, development of the mining plan and economic analysis will double the value of the mine even before the start of mining operations. (An investment of USD5-6m giving an asset valued at USD10-15m even before the start of mining operations). Open cast mining can raise production to 2m to 3m tonnes a year, with part of the production (thermal coal) sold to Russian electricity companies in the Far East, where there is currently a deficit of coal supply. Coking coal can be exported to Japan, China, South Korea and India via the Russian Far Eastern ports of Khabarovsk and Vladivostok. There is also a significant advantage in investing in the Russian Far East in so far as there is no gas associated with the deposits. This means that safe deep shaft mines can be sunk to retrieve coal (often higher quality coal) once the open cast operations have started to generate steady cash flow with low risk of explosions or other safety problems.
There are fewer operating mines in the Russian Far East than in the Kuzbass region as the area is less extensively developed. One opportunity is a high grade coking coal mine (Kzh or CoFa and K or Co grades) of approximately 70-100m reserves in Yakutia, the centre of future coal development in the Russian Far East. The mine is profitable, based currently on open cast extraction and producing approximately 50,000 tons of high grade and thermal coal grades a month. There are good rail transport links to the Russian Far East ports and elsewhere in the region. Coal is sold to Russian power generation companies and exported to China. There is potential to improve the coal volumes and quality by sinking a shaft mine into the highest quality seams and by constructing a washery. Full geological and financial details are available.
Kuzbass Region (Kemerovo in Central Siberia) : Acquire a Small, CF Positive Operation
The Kuzbass is Russia’s largest coal producing area, with significant potential for further development. The problem is one of the political incumbency which means that significant foreign investment is unlikely to occur in the near future. NorthStar believes, however, that this may change after the forthcoming Parliamentary (December 2011) and Presidential (March 2011) elections and therefore NorthStar advises that the investment strategy should be to acquire a small and expandable working mine with positive cash flow, in order to be in a position to make significant investments in the regions when conditions become more favourable.
European Russia/ Rostov Region: High Grade Anthracite Mine
Coal mining in European Russia has less long-term development potential than in either the Kuzbass or the Russian Far East but it has the advantage of being located close to the Black Sea seaborne trade and major customers (Turkey, India and the Middle East). NorthStar recommends to these investors to acquire a high grade anthracite mine (grade A coal following the Russia definition*). This is located near the Russian port of Rostov on the Don. The mine has approximately 300m tonnes of anthracite reserves. It requires investment in a new mining shaft and is capable of producing 5m -6m tonnes of anthracite a year (possible after 4-5 years of progressive expansion).
Transport infrastructure
The main transport system for coal is the Russian rail network which transports the coal in cars or gondolas (which can be leased from RZD, the state-owned Russian Railroads, or owned by the mining company itself) from the mine (with significant differences in freight rates) to either the Black Sea or Far East Ports. Transport can take from a few days from European Russia to more than a week from the Kuzbass or the Russian Far East depending on the location of the mine.
Payment and financing availability
Payment for the coal is typically either on delivery at the mine or CIF home port or FOB Russian port if there is an integrated transport solution from the mine to the port. Leading Russian banks such as Sberbank or VTB can provided lines of credit in roubles, with the terms depending on the specific circumstances.
Footnotes:
Russia is also a surplus iron ore producer with a significant mineral base.
Approximately 50% of the country’s output comes from the Kursk region, southwest of Moscow, where Russia’s three largest open pit mines are located. The region is rich in magnetite ores that comprise the Kursk Magnetic Anomaly (KMA) formation, one of the largest known occurrences of iron ore in the world.
The second largest producing area is in Karelia and the Kola Peninsula, in the north of Russia across the border with Finland where approximately 20-25% of the country’s iron ore is currently mined. Around 15% of iron ore is mined in the Urals Region, east of Moscow, but the mines (especially the largest, Kachkanarsky) are gradually being depleted. As in the case of coal, there is significant potential in the Russian Far East.
Nick Van Den Brul
Partner
Northstar Corporate Finance
