Stability in the cost and supply of metallurgical coke is imperative for the long-term viability of steel producers. For those steelmakers over-exposed to global commodities prices, their profitability can be impacted by external influences such as foreign government policy and political motivations.
This Insight highlights how the supply-side reform in China's domestic coke industry has increased margins on coke production and directly disadvantaged steel mills that procure coke on the seaborne market, pulling down profitability by ~1% EBITDA margin or more.
Low margins and pollution led to China's supply reforms
The recent switch of focus onto the supply-side reform of the coke industry by the Chinese government is driven by the twin concerns of over-capacity, which has led to extended periods of negative margins and greater indebtedness, and pollution.
To illustrate, whilst hot metal production in China fell by ~5% y/y in 2015 Q4, domestic coke production remained strong, dragging margins down to unsustainably low levels as individual producers sought to maintain market share. As a result, in the February 2016 edition of CRU's Metallurgical Coke Market Outlook, we forecasted that coke industry margins would average ~$(2) /t in 2016 and, in the absence of any supply-side reform, margins would remain low over the medium-term. Poor profitability in the domestic market incentivised Chinese producers to divert material to the seaborne market and the increased level of exports and low margins negatively impacted production elsewhere in the world.
In addition, coke production is one of the most polluting stages of the integrated steel making process and the increased emphasis on air quality in China has put this process in the spotlight, whereas previously it had escaped governmental scrutiny.
The combination of unsustainably low margins and heavy pollution left the coke sector exposed to supply-side reform. The sector has now seen 64 Mt/y of coke capacity closed since 2016, equivalent to ~10% of total capacity, of which 26 Mt/y has been permanently shut down during 2018-to-date. CRU forecasts that 32 Mt/y of coke capacity will be temporarily impacted over the upcoming 'winter heating season' period from October 2018 to April 2019. Coupled with on-going environmental inspections during 2017 and through 2018 so far, our analysis shows that capacity utilisation across the coke sector has lifted substantially and this has lifted margins. CRU's base case view is that further closures over the next 5 years must continue at an average rate of 21 Mt/y in order for utilisation rates to increase to levels where coke producers will earn sustainable margins.
Given this, in the August 2018 edition of CRU's Metallurgical Coke Market Outlook, under our base case assumption for closures, we now forecast that Chinese coke sector capacity utilisation rates would rise to ~77% in 2019 and margins would average ~$25 /t, up from near-zero in recent years. Our analysis shows that, if sustained over the medium-term, this level of margin performance would just be enough to allow the coke sector to invest in the necessary environmental controls to reduce pollution and pay down debt. Ultimately, we expect further closures and for capacity utilisation to lift to ~83% by 2022, at which point coke capacity will be ~500 Mt/y, equivalent to a fall of ~23% since 2016; under these conditions, margins are expected to reach ~$40 /t and exports down from current levels.
Importantly, given the higher margins in the domestic market, Chinese coke producers already have less incentive to divert coke to the export market and exports have fallen, whilst the price of export coke above underlying coal costs has lifted. This has disadvantaged those mills that buy 3rd party coke relative to their fully-integrated peers.
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