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Coal companies desperate to dump port capacity

It’s easy to get caught up in the hype when times are good. Whether it be tech stocks, banks or, heaven forbid, even tulips: rising prices are the party no one wants to miss.

About two years ago the party was coal. China was growing faster than anticipated, the Aussie dollar was low and the price for coal jumped. Naturally, supply surged as big miners like BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) increased their exposure to coal, while many other companies snapped up whatever was on offer.

With the sudden increase in production the problem became finding rail and port capacity to move the coal and ship it off to export markets. Coal producers scrambled to obtain space at ports, especially in Queensland and NSW, signing long term ‘take or pay’ contracts.

The contracts agree to move a set volume of coal at a set price and are often valid for 10 years which gave the ports secure finance for their own expansions. Wesfarmers (ASX: WES) signed such an agreement in September 2011 as the company was looking to increase exports from its Curragh mine.

However the subsequent drop in coal prices and a scaling back in coal production to curb costs has left coal producers forking out huge money for contracted port space they cannot fill.

As UK coal analyst Brent Spalding notes, “we have a situation where we have substantial growth in [Australian] port capacity, and not the tonnage to fill it.”

And the losses are huge.  A report commissioned by the Australian Coal Association estimates half the coal being exported through Newcastle is being sold at a loss. The Wall Street Journal has reported that Yancoal Australia (ASX: YAL) is facing costs of up to $55 million on its port and rail contracts.

Meanwhile Morgan Stanley have estimated that 40 of 71 thermal coal mines in the Coal Association report have cash operating costs above the US$87 a tonne price of coal, posing a serious threat to the viability of operators.

The price of Australian thermal coal is down 16% over the last year and the Australian Coal Association says 9,000 jobs have been lost from the industry nationally in 15 months. A fall in the Australian dollar could be a saving grace for an otherwise savaged industry.

Foolish Takeaway

The lesson for investors is perhaps not that resources should be avoided, but rather to ensure they seek out the lowest cost producer, with the best economies of scale. This is usually either the big players like Rio or BHP, or niche companies that have a specific strategic advantage.

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Motley Fool contributor Regan Pearson does not own shares in any of the companies mentioned in this article.

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