Royalty flush II Risks to NSW coal royalties from Adani and Galilee Basin development

CoalindustryanalystsestimatethedevelopmentofQueensland’sGalileeBasinwillreducecoalpricesby

25%andreduceNSWcoalexportsby80milliontonnesperyear.ThiswouldreduceNSWcoal

royaltyrevenuebyover$10billionto2035.TheNSWgovernmentandcoalindustryshouldoppose

thesubsidisationoftheGalileeBasin.

Discussionpaper

RodCampbellJuly2017

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RoyaltyFlushII 1

Summary

ResourceanalystsWoodMackenziewerecommissionedbythePortofNewcastletoestimatetheimpactofGalileeBasinminesonthecoalpriceandvolumesproducedbyminesintheHunterValleyandpartsofQueensland.

BasedonWoodMackenzie’sanalysis,thedevelopmentoftheGalileeBasinwillreducethevalueofNSWcoalroyaltiesbyAUD$10.2billionto2035.

WithoutthedevelopmentoftheGalileeBasin,WoodMackenzieestimateNSWcoalexportswouldincreasefrom170milliontonnesperannum(Mtpa)to230Mtpain2035.Bycontrast,iftheGalileeBasinproduces150Mtpa,WoodMackenzieestimatethroughputatPortofNewcastlewilldeclinetounder150Mtpain2035.

WoodMackenzieseethepriceofcoalincreasingfromcurrentlevelstoUSD$89pertonnebythelate2020sifGalileeBasinisnotdeveloped.WithGalileeBasindevelopmentpricesareforcedtounderUSD$60inthemid-2020sbeforerecoveringtoUSD$63pertonnein2035.

InpresentvaluetermsthisrepresentsreductionsinNSWroyaltyrevenueofbetweenAUD$2.8and7.7billiondependingonthediscountrate:

PresentvalueofNSWroyaltyrevenuereductionwithGalileeBasindevelopment

Discountrate

Presentvaluereductioninroyaltyrevenue(AUD$millions)

2% -7,7834% -5,9777% -4,08510% -2,842

TheNSWgovernmenthopesthatthehighercoalqualityofcoalinNSWrelativetothatAdanihopetoproducethissubstitutionfromoccurring.ThisiscontradictedbyWoodMackenzie’sanalysisandmarketdatathatshowsthatpricechangesinonegradeofcoalarealmostimmediatelypassedontoothergrades.

TheNSWGovernmentandNSWcoalindustryshouldstronglyopposethedevelopmentoftheGalileeBasin,particularlywithsubsidyfromfederalandQueenslandstategovernments.

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Introduction

Basiceconomictheorysuggeststhatanincreaseinsupplyreducesthepriceofacommodity.Lowerpricescanforcesomesuppliersoutofthemarket.

Giventhisbasiceconomics,TheAustraliaInstitutehaslongarguedthatgovernmentassistancetotheQueenslandcoalindustryrepresentsathreattotheNewSouthWales(NSW)coalindustry.1FederalandQueenslandStateGovernmentplanstosubsidiselargenewthermalcoalminesintheGalileeBasin,suchasAdani’sCarmichaelproposal,wouldseemalmostcertaintoaffectNSWthermalcoalproducersintheHunterValleyandbeyond.

Despitethislogic,theNSWMinisterforresourcessays:

TheNewSouthWalesGovernmentiscomfortableandisnotconcernedaboutongoingcoalexports.2

TheMinister’sreasoningechoesNSWTreasury’sanswertoaQuestiononNotice:

1. WilltheAdaniminingdevelopmentintheGalileeBasinaffect:a. NewSouthWalescoalexports?Ifso,how?

Answer-

1. NSWproduceshighqualitycoalthatisexportedmainlytoJapan,Korea,ChinaandTaiwan.TheNSWGovernmentdoesnotexpectasignificantimpactonthetradedcoalpricesorNSWcoalproductioniftheAdaniprojectisapproved.3

NSWTreasuryappearstohavedonenoquantitativeorotheranalysistosupportthisconclusionneitherhastheFederalDepartmentofIndustry’sOfficeoftheChief

1SeeforexampleCampbell(2014)NSWminersarefightingthecanetoadfactor,http://www.dailytelegraph.com.au/news/opinion/nsw-miners-are-fighting-the-cane-toad-factor/news-story/897fbe098ef105c940a87d1011cfbc61;Campbell(2015)AweekoffailureandopportunityfortheNSWMineralsCouncil,https://www.australianmining.com.au/features/a-week-of-failure-and-opportunity-for-the-nsw-minerals-council-opinion/

2Harwin(2017)AdaniCarmichaelcoalmineproposalimpact,https://www.parliament.nsw.gov.au/Hansard/Pages/HansardResult.aspx#/docid/HANSARD-1820781676-73138/HANSARD-1820781676-73150

3AnswertoQuestiononNoticefromJeremyBuckinghamMLC,providedbyBuckingham’sofficeviaemaildated7April2017.

RoyaltyFlushII 3

Economist.4Surprisingly,theNSWMineralsCouncilhasnotengagedatallonthistopic,statinginitially:

WesupportastrongAustraliancoalindustrythatcancompetewithothercoal-producingcountriesintheglobalmarketforcoal.WeexpectthestrongandgrowingdemandforourNSWcoaltocontinuefordecades.5

Moresurprisingstill,theNSWMineralsCouncilseemstosupportthesubsidisedAdaniproject:

MrGalileesaidtherewerehugeknock-onexportopportunitiesforNSWcoalproducersiftheminewentahead,andthestrengthofthesectorlayin“maintainingstronglong-termtradingrelationsaroundtheworld”.

“IftheAdaniprojectisblockedforspuriousreasons,weriskdamagingthatemergingtradingrelationshipwithIndia.AndthatputstheexportopportunitiesforourNSWproducersatriskaswell.”6

ThepositionsoftheNSWMinisterforResources,NSWTreasuryandNSWMineralsCouncilareinstarkcontrasttoothersinthecoalindustrysuchasGlencore,whichstatedin2015:

Bringingonadditionaltonneswiththeaidoftaxpayermoneywouldmateriallyincreasetherisktoexistingcoaloperations.7

Wearestrongbelieversthatifaprojectcan’tgetawayonitsowneconomicmerits,itshouldn’tbedeveloped.8

4DepartmentofIndustry,InnovationandScience(2017)EconomicsLegislationCommitteeANSWERSTOQUESTIONSONNOTICEIndustry,InnovationandSciencePortfolio2016-2017AdditionalEstimates2March2017QUESTIONNo.:AI-88,http://www.aph.gov.au/Parliamentary_Business/Senate_Estimates/economicsctte/estimates/add1617/Industry/index

5McCarthy(2017)StephenGalilee'santi-coalprotestcommentsonaQueenslandmineraisequestionsaboutsilenceoverHunterimpacts,saycritics,http://www.theherald.com.au/story/4407729/nsw-minerals-council-criticised-over-selective-mine-comments/

6McKennaandKelly(2017)Adanicollapsewouldhurttradingrelationships:mineralscouncil,http://www.theaustralian.com.au/national-affairs/state-politics/adani-collapse-would-hurt-trading-relationships-minerals-council/news-story/fb26e0ae3b453343d0e25b0638dbf36b

7Robbins(2015)Glencorewarnsontaxpayersupportfornewcoalprojects,http://www.smh.com.au/business/mining-and-resources/glencore-warns-on-taxpayer-support-for-new-coal-projects-20151007-gk3h5y.html

8Loussikian(2015)GlencoreexecPeterFreyberginswipeat‘unprofitable’Adani,http://www.theaustralian.com.au/business/mining-energy/glencore-exec-peter-freyberg-in-swipe-at-unprofitable-adani/news-story/d80ab3be3a7b5b1a77b1e07aebc0e5ae

RoyaltyFlushII 4

SimilarsentimentshavebeenexpressedbyQueenslandcoalminersoutsideoftheGalileeBasin,withQueenslandResourceCouncilchiefIanMacfarlanestating:

It'sacompetitiveworldandsomeofourmemberssee[asubsidisedloantoAdani]asgivinganadvantagetooneoftheircompetitors…9

InMay2017theABCreportedconfidentialindustryanalysisthatestimatedtheAdaniprojectwouldreducecoalpricesby$3.80pertonneandreduceoutputthroughthePortofNewcastleby11milliontonnesperyear.10

PossiblyinresponsetotheABCreport,thePortofNewcastlecommissionedwell-knownresourceanalysts,WoodMackenzietoestimatetheimpactofthedevelopmentofGalileeBasinminesontheHunterValleyandpartsofQueensland.TheWoodMackenzieanalysisexpectsfargreaterimpactsontheNSWcoalindustrythantheearlieranalysis.UnderascenariowheretheGalileeBasinproduces150milliontonnesperannum(Mtpa):

HunterValleythermalcoaloutputwouldfallbysome86milliontonnes,or37percent.11

TheWoodMackenzieanalysisdoesnotestimatetheimpactofGalileeBasindevelopmentonNSWcoalroyalties.However,basedontheirestimatesofimpactsonNSWcoalvolumeandpriceanestimatecanbeeasilyderived.

9Probyn(2017)BillShorteninbindoverAdanicoalmine,http://www.abc.net.au/7.30/content/2017/s4652955.htm

10Long(2017)Adani'sCarmichaelminewilloverloadcoalmarket,causeglobalpricestofall,reportshows,http://www.abc.net.au/news/2017-05-09/adanis-carmichael-mine-will-cause-global-coal-price-drop-report/8505564

11Long(2017)GalileeBasinmineswillslashcoaloutput,jobselsewhere,WoodMackenziesays,http://www.abc.net.au/news/2017-07-06/galilee-basin-mining-project-will-reduce-coal-output:-research/8682164

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Wood Mackenzie scenarios

WithoutthedevelopmentoftheGalileeBasin,WoodMackenzieestimatecoalexportsthroughthePortofNewcastlewouldincreasefromcurrentlevelsofaround170milliontonnesperannum(Mtpa)toaround230Mtpain2035.Bycontrast,iftheGalileeBasinissubsidisedintoproducingupto150Mtpa,WoodMackenzieestimatethroughputatPortofNewcastlewilldeclinetounder150Mtpain2035.

WoodMackenzieseethepriceofcoalfromNewcastleincreasingfromcurrentlevelstoUSD$89pertonnebythelate2020sifGalileeBasinisnotdeveloped.WithGalileeBasindevelopmentpricesareforcedtounderUSD$60inthemid-2020sbeforerecoveringtoUSD$63pertonnein2035.

ToestimatetheimpactonNSWroyalties,weassumethatthecurrentexchangerateof$1USD=$1.31AUDcontinuesindefinitely.12

Wealsoassumearoyaltyrateof8%.InNSWroyaltyratesvarydependingonthetypeofmine.Opencutminesattractan8.2%rate,whileundergroundis7.2%and“deepunderground”is6.2%.AsthebulkofNSWproductionisfromopencutmines,withdeepundergroundminesproducingverylittle,theaveragerateislikelytobecloserto8.2%than7.2%.

12www.xe.com,accessed12July2017.Inverse1AUD=0.76USD.

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Table1:ImpactonNSWroyaltiesunderWoodMackenzieGalileeBasinmodellingscenarios

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035

Volume no Galilee (million tonnes

167

174

171

172

178

183

183

183

179

185

190

193

205

219

227

227

228

230

234

232

Price (USD/tonne)

66

79

66

63

63

61

61

62

65

65

67

79

89

89

89

89

89

89

89

89

Total coal revenue ($USD million) 11,107

13,638

11,236

10,742

11,229

11,087

11,170

11,334

11,518

12,111

12,810

15,250

18,152

19,402

20,161

20,170

20,253

20,440

20,775

20,553

Royalties at 8% (USD millions)

889

1,091

899

859

898

887

894

907

921

969

1,025

1,220

1,452

1,552

1,613

1,614

1,620

1,635

1,662

1,644

Volume w Galilee (million tonnes)

167

174

171

172

178

183

183

182

162

164

162

158

157

157

150

150

150

150

150

146

Price (USD/tonne)

66

79

66

63

63

61

61

61

58

58

58

60

63

63

63

63

63

63

63

63

Total coal revenue ($USD million) 11,107

13,638

11,236

10,742

11,229

11,087

11,152

11,056

9,429

9,597

9,497

9,546

9,922

9,881

9,451

9,458

9,458

9,458

9,458

9,182

Royalties at 8% (USD millions)

889

1,091

899

859

898

887

892

884

754

768

760

764

794

790

756

757

757

757

757

735

Royalty difference

-

-

-

-

-

- -1 -22 -167 -201 -265 -456 -658 -762 -857 -857 -864 -879 -905 -910

AUD Royalty difference at current USD Exchange rate

-

-

-

-

-

- -2 -29 -219 -264 -347 -598 -862 -998

-1,122

-1,123

-1,131

-1,151

-1,186

-1,192

Source:WoodMackenzie(2017)PortofNewcastlethroughputscenarios,TAIcalculations.

Table1showsthatundertheWoodMackenzienoGalileescenarioNSWcoalexportvolumesincreasefromcurrentlevelstoover230milliontonnesperyear.Pricesarealsoexpectedtoincrease(innominalterms)tonearly$USD90pertonne.Accordingly,royaltyrevenuefromexportswillincreasetoover$USD1.6billion(approx.$AUD2billion)peryearby2030.

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BycontrastWoodMackenzie’sGalileeBasindevelopmentscenarioseesexportsthroughthePortofNewcastledeclineto150milliontonnesperyearasNSWsuppliersareforcedoutof(orpreventedfromentering)themarketthroughthe2020sfollowingthebeginningofGalileeBasinproductionin2023.Thisalsoforcespricesdownbyaround25%,toapproximately$USD60/t.ThisseesNSWroyaltyrevenuefalltounder$USD800million(approx.$AUD1billion)peryearafter2023.ThedifferenceinroyaltyrevenuebetweenthetwoscenariosincreasesgraduallyasGalileeBasinproductionrampsupandNSWproductionisdisplaced.Indifferencereaches$1billionperyearin2030increasingtoalmost$1.2billionperyearin2035innominalAustraliandollartermsatcurrentexchangerates.ThedifferentestimatesofroyaltyrevenuearegraphedinFigure1below:

Figure1NSWcoalexportroyaltyrevenuewithandwithoutGalileeBasin

Source:WoodMackenzie,TAIcalculations,exchangeratefromxe.com12July

ThetotalreductioninroyaltyrevenueintheperiodmodelledbyWoodMackenzieis$AUD10,224million.Inpresentvaluetermsthereductioninroyaltyrevenuevarieswiththediscountrate,asshowninTable2below:

Table2:PresentvalueofNSWroyaltyrevenuereductionwithGalileeBasin

Discountrate

Presentvaluereductioninroyaltyrevenue(AUD$millions)

2% -7,7834% -5,9777% -4,08510% -2,842

0

500

1000

1500

2000

2500

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

2034

2035

AUDmillions RoyaltiesnoGalilee

RoyaltieswGalilee

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Discussion

COAL QUALITY SomesupportersoftheNSWcoalindustryhaveclaimedthatNSWexportswillnotbeaffectedbytheGalileeBasinduetoNSWcoalbeingofhigherquality:

ThecoalwithintheAdaniCarmichaelcoalminehastargetedproductionof

approximately25percentashcontent,representingamuchlowervaluecoal

thanthatofNewSouthWalesexportqualitythermalcoal,withlessthan15per

centashcontent.ThequalityofcoalfromtheAdaniCarmichaelcoalmine

representsamarketsegmentthatgenerallyconstituteslessthan3to5percent

ofexportsofcoalfromNewSouthWales.13

TheAdaniproposalandmostGalileeBasincoalwouldgenerallyproducelowerqualitycoalthanNSWbenchmarks.However,itisimportanttonotethatWoodMackenzie’sanalysisis“energyadjusted”,takingintoaccountthedifferencesinenergyvalue,althoughperhapsnotalldifferentaspectsofcoalspecifications.

Intheshorttermcoalqualityislikelytobeanimportantdeterminantofwhobuyswhattypesofcoal.However,beyondshortrunconsiderations,coalbuyersandsellersoftenblenddifferentgradesofcoaldependingonwhatisavailableandwhatisrequired.Buyerscanadjustthequalityofcoaltheyuseinthemediumtermandoverthelongerterm,powerstationsarebuiltorrefittedtousewidergradesofcoal.

Alltypesofcoalaretosomeextentsubstitutesforeachother.Thiscanbeseenfromthewaypricesfordifferentgradesofcoalmoveinverysimilarpatterns,asshowninFigure2below:

13Harwin(2017)AdaniCarmichaelCoalmineproposalimpact,https://www.parliament.nsw.gov.au/Hansard/Pages/HansardResult.aspx#/docid/HANSARD-1820781676-73138/HANSARD-1820781676-73150

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Figure2:Highqualitycoking,otherqualitycokingandthermalcoalprices

Source:DepartmentofIndustry(2017)ResourceandEnergyQuarterly

ThequalitiesofcoalinFigure2differfarmorethanNSWthermalcoaldiffersfromGalileeBasincoal,yetitisclearthatallthreeareaffectedbythesametrendsandthatamajorchangeinthemarketforoneaffectstheothers.ThiscanbefurtherseeninFigure3below,whichplotsthepriceofNewcastle’slowergradeandhighergradebenchmarkcoals:

Figure3:Priceoflowerandhighergradethermalcoal

Source:Cooper(2012)Newcastle5500coalversusFOBNewcastle6300:May7-August8,2012,https://www.platts.com/news-feature/2012/coal/coaldata/index

NotethatFigure3plotsthesetwopricesonamuchnarrowerrangeofpricesandovermonthsratherthanyearsasinFigure2.Betweensimilargradesofthermalcoalany

0

50

100

150

200

250

Mar–12 Mar–14 Mar–16

High quality cokingOther quality cokingThermal coal

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differenceinpricemovementsisatopicofimmediateinterestforthecoalindustryduetotheclosenessofthesubstitution.MuchofthesourcearticleforFigureYdiscussestheincreaseinpriceforNewcastle6300attheendofthetimeserieswhileNewcastle5500staysflat.

BasedonthedatashowninFigures2and3above,itisunlikelythatthedifferentspecificationsofNSWthermalcoalfromGalileeBasincoalwillpreventsignificantimpactonthepricesreceivedbyNSWcoalproducers.

COMPARISON WITH ORIGINAL ROYALTY FLUSH InApril2017TheAustraliaInstitutepublishedestimatesoftheimpactofGalileeBasindevelopmentonNSWcoalroyalties.14OurmethodologywasdifferenttothatofWoodMackenzie,beingbasedonestimatesoftherelationshipsbetweentheprice,supplyanddemandofcoal.WecomparedscenariosofnoGalileeBasindevelopmentwithscenariosinvolvingdevelopmentof:

• OnlytheAdaniCarmichaelproject• Adani’sandGVK’sprojects• FulldevelopmentofGalileeBasinproposals,intotal300Mtpa.

OurAdaniandGVKscenariototals120Mtpaofnewcapacity.Ourcentralestimatewasthatthisnewcapacitywouldreducecoalpricesby7.5%,reducingNSWroyaltyrevenuebyAUD$96millionperyear.WithfullGalileeBasindevelopment,weestimatedNSWroyaltyrevenuewouldreducebyAUD$240millionperyear.Bycontrast,WoodMackenzie’smodellingsuggests150MtpawouldreduceNSWroyaltiesbyover$1billionperyear.

ThekeyreasonforthisdifferenceisWoodMackenzie’smodelincorporatestheeffectofNSWproductionbeingforcedoutofthemarketduetolowerprices,whileourestimatesassumedNSWmineswouldbeabletocontinuetocompete:

AkeyassumptionintheseestimatesisthatNSWcontinuestoproduce200

milliontonnesofcoaleachyear,regardlessofthechangeinprice.Inreality,

someNSWmineswillrespondtolowerpricesbyreducingproduction,going

into‘careandmaintenance’orclosingpermanently.Thisreductionin

productionwouldfurtherreduceNSWcoalroyaltyrevenue.

14Campbell(2017)Royaltyflush:RiskstoNSWcoalroyaltiesfromAdaniandGalileeBasindevelopment,http://www.tai.org.au/sites/defualt/files/P384%20Royalty%20Flush%20-%20Risks%20to%20NSW%20coal%20from%20Adani.pdf

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WoodMackenzie’smodellinganticipatesthattheimpactofloweringcoalpriceonroyaltieswouldbefarlessimportantthanthereducedvolumeofcoalthatNSWproducerswouldbeabletoprovideattheprevailingcoalprice.

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Conclusion

BasiceconomicsshowsthatthedevelopmentoftheGalileeBasinrepresentsamajorthreatfortheNSWcoalindustry.Partsoftheindustryarestartingtorealisethisthreat,commissioningdetailedanalysisfromwell-knownanalystssuchasWoodMackenzie.

Otherindustrysupportersareignoringthislogicandanalysis.TheNSWResourceMinisterhopesthatmarginaldifferencesincoalqualitywillprotectNSW,whiletheNSWMineralsCouncilhopesthatundefined“knock-oneffects”willhelpNSWminers.

Hopeisnotastrategy.UnlesstheyengageinthisdebatetheministerandtheMineralsCouncilwillhurttheindustrytheyclaimtorepresent.WhileitwillbepoliticallydifficultthesepartiesneedtoopposethesubsidisationoftheGalileeBasintoservetheinterestsoftheNSWcoalindustry.