The real reason why GVK and GMR are buying mines abroad

Snapping up coal mines overseas has become a visible trend among Indian power and infrastructure companies.

The most recent example is that of GVK Power and Infrastructure, which said it had bought a major coal resource and infra development project of Australia’s Hancock Coal for $1.26 billion. It is possibly the largest acquisition by an Indian infrastructure company.

GVK aims to produce 84 million metric tonnes of coal every year, and production is initially scheduled to begin in 2014 at 30 million tonnes. “We have a feeling that the project development cost can be significantly brought down to $7 billion… This can happen through cost optimisation and outsourcing a range of activities such as coal washing and laying rail tracks,” GV Krishna Reddy told Bloomberg.

[caption id=“attachment_87295” align=“alignleft” width=“380” caption=“When promoters hold stakes in power companies in India and a mining company abroad, the key danger to look out for is transfer pricing. Reuters”]  [/caption]

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In August, GMR Energy, one of the units of GMR Infrastructure, announced it would acquire a 30 percent stake in Indonesian firm PT Golden Energy Mines Tbk for as much as $550 million in cash. Insufficient supplies at home have led many companies to look to Africa, Indonesia and Australia for the necessary fuel.

However, neither GVK Power nor GMR shares have caught fire due to these purchases. In fact, an IDFC Securities report states that" the acquisition of Hancock’s coal and infrastructure assets exposes GVKP’s shareholders to some significant risk. The risk is especially enhanced since the company’s financial position is already coming under stress from increasing debt from the acquisition of higher stakes in Mumbai and Bangalore airports. Moreover, the risks from the Hancock acquisition are not offset by a compensating equity stake in the assets. While the GVKP stock has corrected sharply over the past few months in anticipation of, among other events, the Hancock deal, we see no material upsides from current levels."

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The logic for purchasing energy assets abroad is simple: you can secure long-term supplies, and possibly a bit more cheaply than now, since there is a domestic shortage of coal.

However, there is a downside to it, too. Three, in fact.

One if the possibility of the host country insisting on coal being sold at market prices - by imposing an export duty to realise greater revenues for the exchequer. Then, there is the question of investment: when you buy a coal mine abroad, you have to service the loans taken with domestic profits. The third issue is the probability of opaque transfer pricing.

When promoters hold stakes in power companies in India and a mining company abroad, the key danger to look out for is transfer pricing - the ability to price coal low and booking higher returns in the power company in India, or vice-versa. Since the promoter controls both ends, there is no guarantee on how the India-listed company will fare if coal prices are jacked up or reduced due to promoter convenience.

Put another way, backward integration by power companies into coal mines abroad works for promoters. But whether the domestic company will benefit directly is an open question. The promoter has the option of making money from coal or power, or both.

A combination of stifling policies as well as infrastructure is to blame for this forced strategy shift by power companies: domestic coal shortage and the need to import costlier coal for power plants.

Coal India, which has the world’s biggest reserves, has been persistently hampered by lack of environmental clearances, preventing it from fully producing to its optimum capacity; even if it does, getting the output to the power plants is another challenge because of the lack of railway rakes.

The result: companies have to rely on other sources, including imports. Total coal imports in 2010 were 55 million tonnes (mt), which is 13 percent of total supplies. That is likely to climb to 186 mt, or 31 percent of total supplies, over the next four years.

And imports are undoubtedly more expensive. Taking into account all the grades of coal, the difference between global prices and CIL’s prices - for long-term contracts - is estimated to be around 50 percent. Worse, internationalprices are soaring: coal prices are currently hovering around $120 per metric tonne, up 25 percent over the past one year. But desperate power companies that rely on coal to power their thermal power plants need to secure supplies at a decent price to make their projects viable, so they’re going ahead with supply deals.

In other words, companies have no choice but to buy mines abroad to secure coal supplies. As a corporate strategy, that’s not a bad thing to do. But they almost always will have to contend with rising costs eventually.

Once countries realise that their natural resources are leaving their mines at prices that may favour importers, they will automatically impose duties to raise their resource prices to match global levels. Indonesia, for instance, did just that when it imposed export duties on coal leaving that country. It’s a move that will affect 13 Indian independent power developers, according to one media report, including projects of Tata Power and Adani Power, among others.

Coal is not the only natural resource facing local supply issues; iron ore supplies have also been constrained.A current export ban on iron ore because of illegal mining in Bellary, an iron ore mining hub, has forced steel companies - iron ore is one of the key inputs of steel-making - to look for alternative - and costlier - sources of ore, despite the country having abundant supplies of the mineral. Here too, policies that added to the cost of mining from Bellary is what gave rise to illegal operations from the region in the first place. The Supreme Court then clamped down on those operations because of environmental degradation concerns.

So, companies may be forced to look abroad in this segment, too. Yet, the economic viability of importing such natural resources may not necessarily work in favour of acquiring overseas assets in the long run.

So, while it may seem nice on paper, buying mines abroad is not always the best way out.