Demystifying the “Scam” in the Captive coal sales

Demystifying the “Scam” in the Captive coal sales

On the 3^rd October 2013, the English language “The Hindu”[1] broke the story on selling of coal from captive mines for profit. While the media has remained uncharacteristically mellow on what would amount to another “Scam” or a second “Coal gate”; it does raise significant concerns on the concept of captive coal mining just when the dust on the “Coal Gate” seemed to be settling a bit. Before we join the media and the opposition parties in the mob lynching process, let us understand the background of the case.

Firstly, Indian government allocates “Captive” coal mines to certain companies so that they can mine and supply specific plants with coal from those mines. Under the Indian laws, they are not permitted to sell coal as only government companies can sell coal.

Secondly, the Indian coal is usually low grade; which implies that it needs to be washed to remove impurities. Apart from the Washed coal, the process also creates byproducts viz. “Middlings” and “Rejects”. The Middlings and Rejects, though lower grade than washed coal, are useful for power generation (on par with E and F grade coal supplied by Coal India).

Certain companies who had been allotted coal blocks for captive purposes were selling these Middlings and Rejects with government permission even though commercial sale of coal is not legally permissible. The Coal Ministry admitted in the parliament that it had permitted Tata Steel to sell over 9 million tonnes during 2009-2012. With permissions to sell 3mtpa, Tata group has the option to sell 40% of its 7 Mtpa production. Jindal Steel & Power Ltd (JSPL) was permitted to sell ~3mt  of “Middlings” during similar period apart from others.

With the permission to see these middlings and rejects, the government has defacto granted a permit to sell coal to these so called “Captive” miners using legal loopholes. Further, it may be noted that this commercial sale of Middlings and rejects infact gives the “Captive Miner” the incentive to run the coal washery inefficiently. Low recoveries of washed coal would result in higher tonnages of coal middlings and rejects – creating a large sustainable coal business.

To be fair, some of the media articles on the subject are quite informative, especially the Hindu article by Shalini Singh which quite eloquently covers the details of the matter. You will read the innumerable articles from the media on the subject and arguments and counterarguments from opposition and the ruling parties; but beneath all the cacophony about the “Scams” and “Coalgate”, It is as simple as this, the law doesn’t allow sale of coals, so a loophole has been found – selling coal in the name of rejects and middling. And the government actively permitted it.

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[1] Largesse for companies from backdoor sale of captive coal, The Hindu, October 3,  2013

Encouraging outward Foreign Direct Investment, just when you need $$$

With the Rupee hitting new lows day after day in the month of July, the Indian Government and the RBI went all out to defend the rupee by increasing the foreign currency inflows and reducing the outflows

In case, the restrictions on the gold imports and out went restrictions on FDI in a lot of industries, All in the name of getting more foreign currency flows to balance out the Outflow of FII money and to balance the enormous current account deficit. So FDI is now welcome in Airlines, in Single brand retail, In defence etc etc. 

But not in mining. In mining, the story is slightly different.   Firstly, Arcelor Mittal announces it is shelving its Orissa Steel project. this follows other projects such as Posco which have been shelved/frozen etc.  Secondly, the Indian steel minister leads a delegation to Canada seeking Iron Ore supplies and Assets. So essentially, while the finance ministry and the Prime ministers office is struggling for ways and means to attract foreign Investment into Indian Industry and in encouraging Exports to earn foreign exchange  and to discourage imports to reduce foreign exchange outflow, the Steel minister is out and about attempting to encourage outbound FDI and Encourage the outflow of foreign exchange.  After lobbying for a large Export duty on iron ore (to subsidise the domestic steel lobbies), and publicly opposing any signs from Indian Government to export iron ore (and earn some valuable foreign exchange), the Steel minister wants India to finance the creation of Jobs in Canada and to shelve out of billions of Dollars of investment into Canadian Iron ore mining companies for the benefit of private steel players in India. 

It is more ironical because India has the 4th Largest resources of Iron ore in the world. A whopping 25 billion tonnes of it which would last for decades and may be even centuries depending upon how much more we keep finding. India used to export over 100 mt in the past years, capable of earning over $10 billion in Foreign Currency each year consistently from Iron ore exports alone. An Industry which is now in Shambles due to arcane laws, judicial activism, a clueless mining industry which cant figure out stake holder management and a short sighted (and seemingly driven by vested interest) "Steel" ministry.


One wonders if maybe next time, We should just send the transcripts of the PMO and Finance Ministers speeches on Foreign exchange rate to the Steel minister. 

When the bean counters rule

Lets face it, the world of business is the world of money. And by corollary, the entire decision making must be driven by money. yeah yeah Net present value, value creation etc are the terms bandied around all the time these days in the environs of the mines (when the cacophony surrounding the "sustainability" isnt drowning out everything)
in the midst of it all we seem to have lost track of what mining is about. the way i see it, it is the extraction of minerals within the earth and turning them into resources which are needed for human consumption aka mining and processing. but the critical part is, it is part of the extraction and processing which is the defining characteristics of mining. So mining is in the digging, its not in the money! as much as money may drive it, it is in the moeny. At the end of the day, mining is an engineering discipline. Something which requires disciplined study of sciences - from geology to chemistry to physics and applying the same to optimally extract mineral resource from the ground. something which people forget (sadly even companies who are into this sector) that there is a significant technical expertise involved in the mining industry. it is the miners and the geologists and the mining engineers who create the real value in a company.

coal-gate redux

its funny when you read your own blog after a while, sometimes it gives a rather "biased" viewpoint of a particular matter when your intention was to create a balanced view of it. Hence  this redux of the coal gate blog.  

Firstly, there have been some more developments in the news flow of the Coalgate with PMO office coming out in support of the prime minister and some loud noises being created by the opposition in this matter. My personal perspective on the whole matter seems to be rather contorted. It appears that the whole debate is rather skewed on this subject. The entire debate is focused at the moment on the "scandal" and "scam" aspects of it when one should be discussing and debating on what is an appropriate and optimum method of allocation of such natural resources.There are multiple constraint to solve this problem to get an optimum solution.

Firstly, what should be the optimum way of granting those resources so that the country gets the maximum return. This constraint has two parts, first of which is in itself a conundrum which has baffled all governments for  centuries - what is the return one is trying to optimize. Is it maximisation of a fixed quantum of money to be received by the government or it is maximisation of a "sharing of profit" with the government. Or is it a maximisation of the oft quoted "social" return including at the least "job creation" or provision of "cheap" resource to the consumers.

The second part is how?. is it through auctions and if yes what should be method of the auction. should it be, pay me a fixed payment to be made upfront such as done in the case of 3G or even some of the metro projects or bridge projects. Or should be through a profit sharing system as done in the Power sector sometimes. Or should it be through a "lowest supply cost" as it is done with the standard bidding guidelines for the power project  (which is theoritically result in the lowest cost supply to the electricity board and by corollary to the consumer). and say one has chose the method of auction, should there additional conditions on "technical qualification" such as experience of running power plants in case of power projects or "setting up of value addition facility" in case of mining. My personal view tends to be to err on the side of having the least number of restrictions (including) allowing people to sell off whatever bids they have won to some other person. The reason is simple linear programming principle - the lesser the constraints, its easier to maximise the return. so for mining companies i would prefer not to have any value addition requirements in any state (why should what is a national resource benefit only that state? not my state?). Secondly, that is especially true of mining and metals, the logistics and other resource constraints will in any case determine the closest place in proximity to the resource(or mineral deposit), resulting in a place which is best suited to exploit that resource. no sensible person would build a steel plant away from an iron ore mine if he could get a place to build it close to it. and no sensible power plant engineer would choose a plant site away from source of fuel (unless constraints by things like land, water etc). so it makes sense for the natural course of things decide the matter rather than putting constraints which could make the plant suboptimal. 

lets take an example, 

lets say the government of India decides to auction of coal blocks to anyone who is willing to setup a coal mine and has the money (that is one constraint i wont let go). and there are no restrictions so lets say a hi8gh flying entrepreneur decides to invest in coal mining projects and bids a big amount of money for taking the mine. he could hire the best technical people in the market and build the mine or he could get some other company to invest in the mine, say find a technical partner who could be happier to be involved after the upfront payment has been made and is more sure of what he is getting into lets say after a bit of exploration has had happened. If the incentive to hoard is reduced by introducing bank guarantees etc, it would also avoid any holdups in development of the assets. 

on the other hand, like it has happened with 3G, there could be situation a lot of money gets thrown into the bidding portion almost killing the industry or bringing it to chronic ill financial health. Its almost in a way the "market forces" weeding out the weak  players perhaps.

We could also have a situation where all the bids are out and then the players try to squeeze out concessions, sort of renegotiate their situation (a likely situation with newbies...sometimes common with age old players who are confident of negotiating their way out of a seemingly aggressive bid or with naive players who are confident but not capable of negotiating their way out)..

ironically, world over the mineral resources are given on the basis of "mining claims" which require nothing other than identification of areas which could contain resource. the claims result in exploration license which is the period where the lessee identifies resources through exploration. if he is successful, he would lodge a mining license application. if not, oh well, entrepreneur took a gamble and it didnt pay  off. globally, you can sell off once you discover a resource, thereby creating an excellent and big market for "junior miners" or junior exploration companies. through this budding entreprenuers (with geological understanding usually) will keep looking for new opportunities, looking for their one in a million jackpot mineral deposit which they could find and sell it one of the major miners or develop themselves into a company. its a system which seems to have worked countries like america, canada, australia which have had a very healthy development of resources.so why dont we just leave the system to work on its own?

so all in all, there are a lot of factors which need to be debated upon and sometimes even experimented with before we figure out the best way to allocate a certain resource.there is no straight answer for this question which seems have been the root question for economics since time immemorial. So we are sure in coal gate, we are asking the wrong question. Its not what went wrong, its how best we do it in the future.

Coalgate

Firstly, the disclaimer. The contents of this blog are the personal views of mine. They are not the views of the company i work for, nor of companies in this sector, nor would they necessarily my views when i am wearing official hat and they definitely dont have an official sanction. Nevertheless.

Recent months have had more than a few "breaking news" stories about "Coalgate" and the implications. Opposition and media have gone hoarse shouting about the crores and crores of benefit  gifted away to the corporates. Personally, well the hype is sickening but let us leave the cacophony of the issue and come straight to the point. Let us start by understanding how are coal blocks allocated and the coal laws of India

historically all coal mining in India has been done by Coal india limited (and some other govt entities). The law provides that coal mining can be done by a lot of entities but trading of coal is prohibited.  So technically you can mine coal if you get a mining lease..which you wont but then theoritically if u get a mining lease you could mine coal but not sell it.

So you had coal india and its subsidiaries mining coal (and no we wont get into the efficiency debates) and selling the coal. unfortunately the demand for coal was much higher than what would be produced by Coal india. So a mechanism was created to "allocate" coal to the industries which needed it. Its a system called "Coal Linkage". Now coal linkage is a system peculiar to India (to my knowledge...though this peculiarity isnt surprising). So if you are an industrialist and you want coal, you make an application to the coal ministry (and to a coal linkage committee). the linkage committee would then "consider" the application onj subjective merits - such as the credentials of the party,. credentials of the project etc and allocate it a linkage. That would mean - x million tonnes of production from X mine of Coal India limted (or its subsidiaries) would be provided to you at the linkage prices. The linkage price is the price charged by Coal india to the industry. Now Linkage price is a tricky subject. The base linkage price makes taking coal from coal india a very economic proposition for the customer. Now that works fine if the customer is a power plant such as NTPC or MSEB who are allowed a fixed return and thereby passing on the lower cost of coal to the ultimate consumer of electricity. Now whether that is a good thing or not is a matter of seperate debate. Nevertheless for a profit oriented industry, that Linkage a source of competitive and financial advantage.
However, coal india failed to keep up the supply in line with the demand for the linkages. So the government turned to the concept of captive mining of coal.

So what is captive mining
Well, if you are an industry which needs a lot of coal. you make an application to the ministry and another committee which allocates captive coal blocks based on a very subjective "merit" of the case. Now if you get alloted a few million tonnes of coal in coal mine. you apply for mining license, environmental clearance, forest clearance and then spend capital expenditure (minign and processing equipments, railway sidings etc) to develop the mine, remove the overburden (waste material) on top of the coal seams and mine the coal. Now indian coal is a extremely bad quality so you may also wash the coal before using it.
you ofcourse cant sell it. you can use it in your power plant or steel plant.
then one needs to consider is what price does the power plant sell. if it does below the market price (in line with the cost savings from coal block allocation or linkage) like say a NTPC or MSEB would, then perhaps it is not a major issue. but if the steel output or power output is  sold at the market price well then the country of india just handed over the profit on a platter to a private steel company or a power company to the detriment of the govt of india and by corollary the tax payers.

So what we have is a situation where a company does get a financial advantage as a result of either linkage or captive coal blocks.

There is ofcourse the other side of the coin too. The quantum of the advantage however needs to be checked in each case as it would depend on the complexity of the mine, amount of coal, amount of overburden, amount of forest, resettlement issues, diversion of rivers and nullahs, capex required for the railway siding etc. all of which affect the cost and timing of the coal production. so not all coal block allocations result in supernormal profits accruing to a company.  what also needs to be considered that mining coal (or even any other mining) is an expensive business. the exploratory drilling in itself could cost millions of dollars. coupled with other expenses, the coal could turn out to be quite expensive. The CAG figures needs to be evaluated in that context. I dont know about coal numbers but when it comes to Iron ore, people tend to overestimate the value of resource. Some people argue. Iron ore price is 100$, cost is 10$ to mine , so you get a profit of 90$. Super normal profit. well, most important 100$ is for a grade., so make an adjustment for indian grade. Secondly 100$ is price at port, so you need to deduct the cost of transportation to the port. Now there in lies the catch, Cost of transportation could range from 10$ to 70$ or more depending on location etc. and that doesnt include any capex or interest expenses.
Same thing works with coal. take a poor quality coal and add to that transport cost and the cost of building railway siding, cost of punitive railway charges etc and your profit could be overestimated by a large margin. And we havent started on the export duty ifany is imposed by govt.

Ok, all those arguments apart, there is still a quantum of profit associated with the allocation of coal blocks to "endusers". but does that imply there is something hanky panky? no not really, it could only be stupid policy. or even more likely, it could be a policy which was fine in a different environment where the coal prices were not that high. and that isnt that far back actually. the commodity price boom has started post 2005. not so much into distant path.

infact what one needs to also consider is the policies of the worlds major coal producers. there you just apply for an exploration license and if you get a license you explore . if you are lucky you strike coal and if you are not well you lost your money. do it a few times and you wil average out to normal profits. india somehow seems to shy away from this concept of exploration for minerals which seems to have worked very well for australia, USA, Canada etc pretty well.

 And one needs to consider the policies applied for oil exploration and 3G. May be just look at only auctions. Agreed large upfront payments could lead to problems, so do a profit share based bid. that should work well earning profits in the future if the prices rise abnormally.
 One also needs to ensure that we have enough competition for the bids( so as to earn as much money as possible for the govt) by not keeping any restrictions. If one puts end use restrictions or any other restrictions on the sale of the output, the bids will be of smaller value and result in a low return to the GOL. Do enough market auctions and there will be enough supply in the market to cause the prices of coal and other commodities to fall.
Lets face it, minign is an industry which has historically done 10 years boom and 30 years of oversupply and depressed prices. the prices would fall eventually coz of oversupply.

and i can go on and on typing. but its enough for tonight. may be will continue with my incoherent blabbering on this topic later

Introduction to valuation

Have jotted down a few pages on how to value mining companies over my few years of dabbling with it. have put them up on a blog in case someone finds them useful. The pages do not claim to be an expert treatise on the subject (and could hv errors), they are just guidelines, eyeopeners, best practices call it what you wish which are essentially tips for the geologists and the miners get a practical intro the valuation and for fin pros to get a practical idea of how to model mines.

will add more details (hopefully) for each of the areas in the years to come.

Alternative Valuation methods

While the various chapters above describe the various aspects of “discounted Cash flow” method of valuation, There are other complementary methods of valuation which a smart valuer should also consider (if only as a cross check). These would include

1. Comparable multiples method - a comparison of valuation ratios of comparable listed firms. For mining companies, the ratios could include EV/EBITDA, Price /Earnings, Enterprise Value/ ton of Reserves and Resources, Enterprise Value/ Ton of Capacity, EV/Sales etc
2. Comparable transactions – similar to the above but considers valuation for the assets which have been recently sold or bought
3. Book value - valuation basis of the value in the accounting books of the assets of the company.
4. Real Option valuation – estimation of the “option” value of the assets under consideration. A method not popular due to its complicated formulas and non intuitive nature.

It is important to consider the comparable multiples and comparable transactions esp for assets which are still in exploration and development stage as typically they trade at values different from the net Present value estimates due to Uncertain nature of the cashflows and potential to add further resource.