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Will winners curse the coal block auctions?

Usually, companies are rational beings with profit as their guiding motive. In the first phase of the coal block auctions, however, that rationality is being questioned. The bidding has been termed “aggressive”, and even the auctioneer—the government—has said it believes bids could be lower in subsequent phases. What are companies thinking? Are they overpaying in panic, gouging profits and taking on excessive debt in the process? Or will they be proved prescient in the long term, as assured coal supplies contribute to higher output and profit, even if absolute margins are lower? Their hope has to be that locking in coal costs will let them benefit over the lifetime of the mine. Rating agency Crisil Ltd has even put out a worried note saying that it is monitoring these aggressive bids. The answer to these questions, though not fully clear at this point, has two parts to it. One is for the so-called non-regulated sectors comprising all segments other than power generation. Here, bidding seems to have been benchmarked to Coal India Ltd’s electronic auction coal price. Industries such as steel, aluminium and cement will see higher coal costs. Their cost of production will increase as a result. Coal costs contribute to one-third of production costs of steel and cement companies, according to Crisil. Though this ratio is 10-15% for cement companies, an analyst with a domestic brokerage says that this can increase to one-third if one adds the coal costs associated with captive power. The companies that were buying coal from the open market and have secured coal blocks can be expected to benefit. But those who had blocks and are having to re-bid for them will see costs increase. Even then, if the final cost of coal is cheaper than imported coal, they will still retain a cost edge. For example, according to Motilal Oswal Securities Ltd, the landed cost from the Kathautia block for Hindalco Industries Ltd would be about Rs.3,500-4,500 a tonne (including extraction cost, royalty, final bid price and freight), which is high but cheaper than the landed cost of imports. The brokerage hasn’t changed its estimates for Hindalco after its winning bid, as it had already factored in the market price for coal in its numbers. While costs may go up, metal prices are linked to the landed cost of imports and not to costs. Therefore, higher coal costs could translate to lower margins. Companies will focus on more efficiency and sell more value-added products to shore up margins. And, some of them also need to secure other raw materials, potentially from auctions or iron-ore and bauxite mines in future. That could clear all input-related obstacles that are hindering output at present.

The second part of the answer to coal block bidding is with respect to the power companies. Coal blocks which have been auctioned so far to power companies have seen aggressive bidding. In some cases, bidding starts as a reverse auction—i.e., firms bid at a discount to a ceiling price. But in all the cases so far, reverse bidding moved into forward auction—i.e., firms cited a 100% discount to the ceiling price and were then prepared to pay the government some money over and above that. For firms which have bid a negative Rs.470 or so per tonne, it means that they will show coal cost as Rs.0 per tonne and pay the government Rs.470 per tonne. Now, power tariffs are a sum of variable charges—basically the cost of fuel, transportation charges and so on—and fixed charges. By citing energy costs as zero (or near zero since there might be royalty, taxes, etc.,), these firms are essentially willing to absorb the hit or try to recover it by hiking fixed costs. What does it mean for power tariffs? In the case of firms which already have existing power-purchase agreements (PPAs), other things remaining equal, power tariffs might come down. But such firms might not find it easy to hike fixed costs within the ambit of the existing PPAs. For firms which will negotiate new PPAs—they will necessarily have to, since only 15% of power produced can be sold through merchant sales—this might not be a constraint. However, as analysts from JM Financial Institutional Securities Ltd point out, any “cap on fixed cost will be negative for coal block winners as higher fixed cost recovery will be necessary for them to make the project financially feasible”. The impact on the winner’s profitability, again, depends on a number of factors. For instance, power plants which are located next to the coal blocks will be better off since they will save on transportation costs. Plants which have already recovered their investments or have low debt are better off. The impact of a bid has to be considered on a case-by-case basis, including the aforesaid factors and the mining potential and coal quality. That may also explain why the stock prices of the winners have reacted differently. CESC Ltd’s stock lost 12.2% after the auction win, while JP Power Ventures climbed 4.72%. Secondly, consumers who might enjoy lower power tariffs in the interim shouldn’t rejoice. If firms continue to bleed after offering to pay so much for the coal blocks, they could well petition electricity regulators for compensatory tariffs, points out Ambit Institutional Equities. The end result is a situation that looks very fluid. Once all the auctions are complete, a better picture should emerge. Firms will also be questioned by investors on the logic of their bids. Their answers will be judged and, as time passes, their wisdom, or the lack of it, will become evident. A happy outcome will be if coal prices rise sharply from their current levels and if demand for power zooms as the economy grows. Since these firms have locked in to their costs, they will benefit. But what is certain is that coal users are in uncharted waters. Investors should adjust their expectations accordingly.


source: http://www.livemint.com