War against a foreign country only happens when the moneyed classes think they are going to profit from it. - George Orwell
This is a companion discussion topic for the original entry at http://theharshcouch.com/thc/2015-03-17/
The Harsh Couch - 2015.03.17 Confessions of an English Onion-Eater
wibbly
#1
On Dr Gob’s question re: pricing on long term coal contracts - a long term contract with price that is significantly below the market price (aka “spot price”) can often be a good deal.
For example, power generators will often accept a 20 - 30 year contract where they lock in pricing at, say, 70% the current market rate.
Why would you want to do this?
Commodity prices and demand are volatile, while your operating costs are fairly stable. Coal prices can fall so low you can’t pay your costs. Shutting down a mine is not easy. You could easily end up with an insolvent mine that can’t pay its debts.
As an equity or debt investor in a mine (or power plant), you’d often rather have the certainty that the mine can make low risk, highly certain profits over the long term contract rather than take a high risk, highly uncertain gamble on volatile commodity prices and demand, which involves significant risk that the winds move against you and the mine goes bankrupt in a bad patch.
Also bear in mind who gets the benefit of high coal prices. If the banks have loaned $100m to the mine at 10% interest and:
- Coal prices stay the same, what do the banks get? 10% interest and their money back in 5- 8 years.
- Coal prices go sky high, what do the banks get? 10% and their money back in 5- 8 years.
- Coal prices tank and the mine goes bankrupt, what do the banks get? Nothing.
That is, as lenders, the banks’ upside is capped at the company paying off its debt on the debt terms. The downside is the banks get nothing. The banks get no upside at all from upswings in the coal price.
So, as long as the mine owner can’t/won’t fund the mine entirely itself and is looking for bank financing, the deal is far, far more bankable if the mine has a long term, fixed price offtake agreement which can support the loan.
From the mine owners’ perspective (ie equity’s perspective), they may see this as a choice between:
- High risk, high possible reward, but also good probability of losing everything by selling coal into the spot market (ie at market price); or
- Low risk, lower reward, but very low probability of losing everything by entering into the long term contract
The mine owners will then look at the risk in their overall portfolio of assets, take a long view on the pricing trends for coal (which I’m not optimistic on), take a long view on the credit quality of China and the likelihood the long term offtake contract counterparty will go into default etc, then work out which risk/reward combination they would prefer.
Whether I was a debt or equity investor in this deal, I’d strongly prefer the long term contract on pricing that is significantly below market rates.
I appreciated the >2.5 hour show.
Listening to the podcast for the sections I missed in livecast. Undecided on the censor beeps.