Cost-plus Pricing Limits Profits from Anglo's Coal

Anglo American sells 60% of its South African coal output to the state-owned power utility on less-than-ideal prices, making export volumes much more profitable

Daniel Rohr, CFA 7 January, 2011 | 10:02AM
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Anglo American's (AAL) coal operations are divided into two segments: thermal (based in South Africa with operations there and in Colombia) and metallurgical (based in Australia). Each business contributed roughly 10% of group revenue in the 12 months to June 30, excluding operations Anglo intends to sell. While the firm is coping with currency headwinds that are likely to swell US dollar-denominated unit costs in the back half of the year--both the rand and the Australian dollar have appreciated versus the US dollar in the second half of 2010--strong export market pricing for both thermal and metallurgical coal should offset some of the ill effects of currency movements.

The South African thermal coal industry is fairly concentrated on the supply side, with the top five producers accounting for 81% market share. Anglo ranks as the largest producer, accounting for about one fourth of the country's roughly 260 million tons of annual output. Anglo is followed in the league table by large-cap notables like BHP Billiton (BLT), Xstrata (XTA), and Sasol (SSL). Anglo's South African thermal coal business primarily serves the domestic market. Of the roughly 60 million tons Anglo produces annually, about 60% are sold to Eskom, the country's state-owned power utility, about 10% to other domestic buyers (Sasol and other industrial customers), and 30% to export markets. Owing to differences in coal quality (higher-grade export coal commands higher prices) and less-than-ideal contractual arrangements (all Eskom volume is priced on a cost-plus basis), Anglo's South African export volume tends to be much more profitable than its domestic volume.

Europe has historically been the primary destination for Anglo's export volume from South Africa, although the Continent's share has been dropping because of a number of factors, including competition from Colombian producers, weak European natural gas prices, and rising Asian demand, particularly from India, which now accounts for roughly 30% of Anglo's export volumes. Given India's geographic proximity to South Africa and favourable economic growth trajectory relative to Anglo's European customer base, the subcontinent's seaborne coal demand will be a key driver of Anglo's thermal coal results in the coming years.

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Daniel Rohr, CFA  is a senior equity analyst at Morningstar.