A scathing new report out today outlines just how risky some of the world's largest coal export projects are. Funnily enough, they're not the risks environmentalists care about - the fact that they're going to be built inside the great barrier reef for instance. No, what the report is concerned with are the risks to the billions in investment at stake if the projects go sideways. If I had my money on the line (which I might if US Ex Im Bank President Fred Hochberg uses US taxpayer dollars to subsidize this boondoggle ) I'd pay attention because the report doesn't come from just anyone, but from financial industry heavyweights Tom Sanzillo (former New York State Comptroller) and Tim Buckley (former head of Australasian equity research at Citigroup).
Before we get into the risks outlined in the report let's start with the project as the developer (GVK) sees it: India has 300 million people without electricity, the country is facing a supply crunch of epic proportions), and the government is hell bent on building a massive pipeline of projects. GVK is well suited to help fuel this pipeline and alleviate the supply crunch by developing one of the world's largest integrated coal mine, rail, and export project in nearby Australia.
Seems pretty cut and dry, what exactly has these analysts so worried? Leverage, leverage, leverage. It turns out GVK is trying to pull a fast one on Australian investors by getting them to pony up the cash for the project to cover the holes in their own balance sheets - which are enormous. Check out the graph below comparing the projects costs ($10 billion) with the current market capitalization of GVK ($243 million). That combined with net deb t of ~$2.7 Billion and GVK faces a whopping 1,149% debt to market ratio. For the financially illiterate - it's a financial crisis waiting to happen.
Normally this kind of analysis drives me crazy because the 'rational' market rarely prices in such risk. Instead institutions like the Ex Im Bank provide a rubber stamp and average citizens are on the hook for crazy financial decisions. Turns out GVK is the exception to the rule. Check out how much their stock price has tanked in the past year. For those counting that's 80% below the Indian market index.
One of the biggest reasons for the crash is likely the fact that despite claiming to be a "leading global infrastructure owner, manager and operator" GVKPIL (a shell company created to hide the company's debt - more on that later) has no experience operating any business outside of India. Worse, it has never successfully built and operated a coal mine - ever. That's right, the company planning to develop the world's largest vertically integrated coal export project smack dab in the middle of the Great Barrier Reef has no experience doing anything like this. This should turn out well.
But there's a coal supercycle, never ending demand shall save this from catastrophe right? Not quite. Under existing financial assumptions, the Alpha Project's cost of coal production is likely to render the project uneconomic. The Newcastle FOB thermal coal price is currently around US$88/t, 30% below the peak seen in 2008. This leaves little headroom to move against a largely debt-funded US$10bn project proposal with a cash cost of production estimated to be at least US$70/t. Why does this matter? Because GVK is claiming production costs of US$55/t. Add to that Australian mining history which suggests capital cost blowouts of over 20% are likely, and you have a lot of lost cash.
So why the hell would any investors even consider this project? Well they could hope that their pal Fred Hochberg at the US Export Import Bank bails them out given their obsession with coal projects. But even with their support the project looks ugly. That's why GVK built a complicated structure just for this special project (see below). What they've done is essentially hide their debt by creating a couple of shell companies (GVKPIL) and GVK Coal Developers whose job it is to lure the Australian company Aurizon Holdings into bed. Because once cash rich Aurizon signs up GVK has someone to bankroll the project - and all their debt.
It's ironic because the first time I wrote about this project I was disgusted that the US Export Import Bank would be involved with a project whose environmental impact would be so large Australia's federal environment minister Toney Burke called its review a 'shambolic joke.' Now I'm disgusted any self respecting investor would give this proposal the time of day. After this report finds its way to Aurizon I'm guessing they'll personally thank Tom Sanzillo and Tim Buckley for saving them billions.