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Cases import of coal2 case study
1. Import of coal: A case Of Jampur Cement Ltd.
Background
Forces Welfare Group is one of the biggest conglomerates of Pakistan. It was established in
1971. With over 35 projects, it claims to be present everywhere in the country. Many of the
companies of the group are listed on different stock exchanges in Pakistan. FWG owns
financial institutions (bank, insurance, leasing), industries (Cement Factories, sugar factory,
pharmaceutical, shoes), real estate and services. One of the projects of FWG is Jampur
Cement Ltd.
Jampur Cement Ltd was established in 1993. It has a plant near village Bahter, Wah. The
factory started its operations in 1994 at a time when cement industry was going through
tremendous change. Privatization of cement industry was under way and new factories
were also being established as the demand for cement was increasing day by day. Many
other cement factories popped up in the area. Now, almost seven factories are working in
the similar area within a radius of 50 miles. JCl despite decrease in sales in recent year,
managed to earn more profit than previous year. Financial analysis of last 4 years is given
on appendix A.
Dilemma of Jampur Cement Ltd.
Since the industry faces a situation where sales price will be fixed by mutual consensus, the
cost of production will be the most critical factor of profitability. Energy cost is a major
component of total cost of production. Since cement plants use both furnace oil and
electricity, any increase in prices of these two products is detrimental to profitability of
industry. Ever since 1995 ,however , there has been more than 60% increase in the price of
furnace oil.
In Feb 2010, some of the private cement companies started reducing cement prices which
lead to a price war among the cement producers. Companies with furnace oil as an heating
element started to feel the pressures and started incurring losses. Need for immediate
conversion to coal option became more imminent.
Realizing important developments in cement industry and its important implications for
future, a apex meeting was called by Mr. Saqib Shahab, CEO of company since 2000.
Saqib Shahab worked for nearly 25 years in oil sector at different managerial positions and
he joined the Jampur Cement Ltd. with utmost repute and ability. Saqib Shahab , being a
man of astute observation, wasted no time to realize the important developments in
industry and its important implications for future of company. Raising to the heights of
eloquence , he was successful to impressed upon the minds of considerable majority of
directors who before of the opinion that this proposed project would invite unnecessary
expenditures and hurt the control line of company’s raw materials in future . Conversion
from furnace oil to coal, “a necessity pill for company”, he said. He knew that statistical and
operational facts lie at the heart of any convincing game therefore he came up with the
following enduring facts.
2. Cement is made from a mixture of calcium carbonate (generally in the form of limestone),
silica, iron oxide and alumina. A high-temperature kiln, often fuelled by coal, heats the raw
materials to a partial melt at 1450°C, transforming them chemically and physically into a
substance known as clinker. This grey pebble-like material is comprised of special
compounds that give cement its binding properties. Clinker is mixed with gypsum and
ground to a fine powder to make cement.
Coal is used as an energy source in cement production all over the world at different pace
and frequency. Large amounts of energy are required to produce cement. Kilns usually burn
coal in the form of powder and consume around 450g of coal for about 900g of cement
produced.Coal for cement industry is selected very carefully because if it is impure or has
hardness above recommended HGI (Hardness Groove Index), it can lead to increased cost
of production.
Traditionally furnace oil has been used to heat up the kilns. Furnace oil has an excellent
chlorophic value (ability to generate heat). In late nineties, price of the furnace oil started
creeping up. Not seeing any positive signs for furnace oil price, some of the private cement
factories have already taken lead to convert to coal and JCL should not wait to see the
worst situation if pricing war continues for years, he said. Board of directors gave their
approval for transmission of furnace oil to coal in next meeting. JCL initiated the conversion
process in July 2009 and expected to complete the same in May, 2010. The cost of new
project estimated Rs 75 million financed through long term debt, and .21 million tonnes
yearly was the forecasted amount to consume by the company.
“Merely getting acceptance was not a big deal, tough realties are likely to come and I will
lead from the front”, he whispered with himself while inspecting the project one day.
Company had to terminate its contract with suppliers majorly from Middle East. Their old
tested suppliers could no longer supply the new different commodity. New markets for this
commodity has to be explored with non tested suppliers, future consumption of coal in near
future around the globe with pricing mechanism , coal near substitutes and their future
aspects were his serious considerations. He anticipated that if company wants to pursue
flexible growth plans then company will in need of unrestricted and continual supply of
inputs with strong ability to recognize the pricing discovery of inputs. Element of energy
always play very crucial role for cement industry. Person with right exposure to given
situation having strong operational and financial sense was need of the time. Shahab long
pondered over for the right person and finally invited Mohsin Ali from United States to take
the helm of affairs for this crucial issue. Mohsin Ali had a chemical engineering degree from
a Pakistani University and he latterly won financial analyst’s certification from US, and he
was working for a oil company for two years in US. One of Shahab’s friend recommended
Mohsin, as he knew him as a colleague. Convincing and motivating people had always
been good qualities of Shahab. He conveyed to Mohsin in straight ward that he is expecting
that he will consider right suppliers of coal and favored derivative contracts for the company.
He was directed to write a detailed report for the said concerns. Mohsin had to work from
the scratch because there was no glaring practice in the industry. Mohsin started to note
important facts and for this he travelled within and outside the country. He collected
following important information for the report.
Cement Industry And Dilemma of Coal for Cement Industry In Pakistan
Pakistan cement sector achieved landmark in 2009 that demonstrates continue significant
progress in cement exports. Now Pakistan is ranked 5th in the world’s cement exports after a
huge increase of 47 percent in exports during last fiscal year 2009.According to the Global
3. cement report, China maintained first position with 26 million tonnes in exports, while Japan
got second position by exporting 12.6 million tonnes of cement. Third largest cement
exporter in world is Thailand with around 12 million tonnes, followed by Turkey which
exported 11.6 million tonnes of cement. Pakistan now at 5th position has left Germany
behind by exporting 11 million tonnes of cement during last fiscal year. Germany now
stands at 6th position with 9 million tonnes exports.Cement market experts told that
Pakistan secured 5th position because of high demand of cement in nearby countries and
by capturing new markets such as African countries, Qatar & Iraq.. Coal counts for as one
of the biggest cost items in cement production. The cement industry is likely to consume 2.8
to 2.9 million tonnes of coal in the current financial year, importers have brought around 2.6
million tonnes of coal for cement companies. By contrast, in all of the previous fiscal year,
thenindustrymhadfusedk2.22lmillionktonneskofgcoal.
Pakistan imports coal mainly from Indonesia, South Africa and China. It has also imported
coal from Australia and Russia, but in smaller amounts. it is expected that the country would
import over 3 million tonnes in the next fiscal year, as the cement industry keeps expanding.
The coal import would have been much higher, but bhatta (Brick Burners) owners have now
started to buy local coal because of the high prices of imported coal. Previously, they
bought 0.3 to 0.4 million tonnes from importers. Since the price of coal rose, that demand is
novlongernthere.
Import of coal into the country had started increasing a few years ago because of growing
demand by the cement and sugar industry after switched their plants from fuel oil to coal to
reducebcostnofnproduction. Pakistan has around 178 billion of coal reserves, with the
reserves in Thar at an estimated 175 billion tones. Pakistan produces 3.2 million tonnes of
coal every year, but most of it is not up to par. As local coal mines are not mechanized,
minersnhavebtobgog500-1000gfeethdeep,whichmincreasesncostkofgproduction.
A coal-washing plant, imported from the United Kingdom, has recently been set up at
Dhabeji at a cost of Rs 150 million, with a capacity to purify 2,000 tonnes per day. Both local
and imported coal is being washed in the plant, making local coal consumable for
industries. Three more plants are currently being installed in Punjab. Coal-washing plants
ensure that the coal has fewer impurities, which reduces the production cost of cement
industry. Cement makers have to use expensive imported coal because the locally available
coal does not meet their specific requirement. Coal is the cheapest source of thermal
energy used in industrial sector, having the potential to replace other expensive fuels such
as furnace oil. Local coal has a higher sulphur content than imported, rendering it unable to
produce the required heat level. This makes it acceptable for power plants, but not for
cement plants. In addition, local coal suppliers often fail to deliver at the appointed time.
There are three countries in the world having reserves sufficient for next 250 years;
Pakistan, India and China. Mohsin noted that for near next years, JCL had to look outside.
World Coal Market
Global reserves of coal are limited. There are few countries of the world who have
considerable reserves of coal. These countries include U.S, Russia, China, India, South
Africa, Indonesia, Australia and Pakistan. These countries collectively count for more than
70 % of the world coal reserves. China that accounts for as a country with huge coal
reserves also stands as the biggest consumer of coal. China in fact is now importing coal
4. from Indonesia. Recently a white paper by Chinese Govt. has shown that China will
continue its dependence on coal despite concerns by Environmentalists. South Africa is
exporting coal for cement industry but is a bit expensive option for Pakistan. South Africa is
the world’s second largest coal exporter, after Australia, as well as second lowest cost
producer, after Indonesia.
Indonesia seems an attractive option for coal importers as the cost of coal is relatively lower
when compared with South Africa and Australia. Indonesian coal miners are entering in long
term contracts with Philippine and Chinese companies and are heavily booked for orders.
With 30-35 major players of coal in the country, negotiating power of the buyer erodes.
There are lot of small miners in the country who sell cheaper and are ready to enter short
term contracts but problem with them is that usually they fail to deliver on time. They also
are usually indulged in illegal mining which can result in coal seizures.
China and Japan are given priority by the Indonesian coal exporters as they afford to quote
FOB plus premium, where as Pakistani Importers are left behind with only three choices:
look somewhere else or quote high or buy inferior.
Risk Mitigation
JCL had both short term and long term derivative contracts germane to oil purchase. This
practice successfully allowed JCL to focus on growth. Mohsin had experience of working
with forward contracts in US, where Airlines, construction players, energy industry and
many others, are in a common practice to into enter short term agreements. This
mechanism is used for risk mitigation purpose. Forecasting the price of coal is dependent
on many variables. These include; supply uncertainties, transportation inefficiencies,
international coal demand, regulatory constraints, labor disruptions This practice is known
as hedging and generally allows coal buyers and seller to fix a price on their transactions
and protect themselves from price volatility. A large portion of the coal paper market
comprises of purely non -speculative players such as banks and hedge funds, while the
other market participants will not just limit themselves to hedging and will take on
speculative positions as well. The global volume of commodities contracts traded on
exchanges increased by a fifth in 2010, and a half since 2007, to around 2.5 billion million
contracts. Speaking for coal, trading on coal exchanges (OTC) in China and India has
gained in importance in recent years due to their emergence as significant coal consumers
and producers. China accounted for more than 60% of non-exchange-traded contracts in
2010, up on its 40% share in the previous year. Indonesia and South Africa had also a good
structure of over the counter coal exchanges.
He proposed in his report that company should go for derivatives and forward contract he
proposed perhaps he was confident and well versed with such type of derivatives. Lead
time must be consistent with oil supplies that are 23 days. He proposed china and
Indonesia as best suppliers of coal with mode of transaction in US dollar. He submitted his
report a week before to important meeting held on 23 September 2010.He collected
important information germane to price discovery and for hedging of currencies. This can be
seen in Appendix B where exchange rate is given. Inflation rate and T-bill is provided in
Appendix C. He assessed spot prices for both china and Indonesia given in Appendix D.
5. Discussions on Meetings
Meeting was attendant by all important officials of the company. Various other proposals put
forward by other officials. Serious criticism was on Mohsin’s report was raised by Mr. Asad ,
CFO of the company for last 2 years and made very important decisions since his
employment. He called for spot transactions rather than forward contracts and he
emphasized look inward rather outward. He said coal is less volatile product than oil called
for no need of hedging with either type. Derivative contracts could not be trusted and it
could invite massive losses to company in future. Company could encounter serious
inventory problems if it looked outwards. Importers of coal in the country should be of prime
importance as company efficiently could not deal with import of coal. Manager of operations
raised concerns on quality of local coal and emphasized. Import manager raised concerns
on limited diversification proposed that company should diversify its coal line across other
countries to ensure unrestricted and continual supplies of coal to meet energy requirement.
Despite serious discontent, decision was made to go for forward contracts for the said
countries: China and Indonesia.
Required
Q1.You are a financial Officer and want to give full support to the Mohsin’s Report of JCL
who wants to import coal. Keeping in mind above stated facts and how will you derive the
price of forward contract? Can forward contracts can effectively work for Risk mitigation.
Q2. You are required to structure an import plan in view of stated facts. You should also be
able to discuss your proposed transaction structure and defend your arguments. You can
raise international issues, domestic realities any issue you deem fit regarding replacement
of plant and its impact on financial health of JCL.
Q3. Why is Mohsin recommending both commodity plus currency forwards? Discuss with
structured arguments?
Q4. Discuss the rationale of each information provided in Appendix B,C and D. Do you think
any important information is missing in pricing of Forward contract?
Q5. How do you come to see arguments provided by Mr. Asad ? Give your arguments in
given scenario?
Q6. A contract contains 1 tonns , the spot prices are given in Appendix D. Assume that all
investment is equally divided for both china and Indonesia. Mohsin entered into 3 contracts ,
2 contracts on quarterly basis for both countries and one for yearly basis for both countries.
(i)Calculate the forward contract of each contract both quarterly basis contracts and yearly
basis contract.
(ii)Suppose after one year actual prices is provided, evaluate your forward contracts with
actual prices. Furthermore evaluate quarterly contracts on monthly basis and yearly
contract on quarterly basis.(iii) Firstly transaction currency is dollar then calculate with
domestic trading country, is this make any difference. Calculate total gain or loss on
contract.
7. Appendix B
Exchange Rates of 2010
US dollar-Pak Rupee Exchange Rate
January 83.78213 July 84.71948
February 84.26166 August 84.53023
March 83.71303 September 85.08733
April 83.51372 October 85.20455
May 83.72564 November 84.93345
June 84.53081 December 85.1546
Chines Yuan-Pak Rupee Exchange Rate
January 12.28441 July 12.51995
February 12.35317 August 12.47422
March 12.28031 September 12.62509
April 12.25307 October 12.79406
May 12.27938 November 12.78622
June 12.41102 December 12.81952
Indonesian-Pak Rupee Exchange Rate
January 0.00905 July 0.00939
February 0.00901 August 0.00945
March 0.00916 September 0.00951
April 0.00924 October 0.0096
May 0.00913 November 0.00959
June 0.00923 December 0.00955
Appendix C
projected
inflation
T-bill
rate
Interest
Rate
US 3.60% 4% 6.31%
PAK 13.50% 12.69% 13.98%
CHINA 5.50% 5.58% 6.40%
INDONESIA 6.25% 5.90% 7%
The rates are calculated on average basis
8. countries M1 M2
China 133 130
Indonesia 128 124
China 137 135
Indonesia 135 120
FOB and transportation cost of Indonesian Contract
time is not of very varying nature for each country.
Appendix D
M2 M3 M4 M5 M6 M12
130 130 124 120 116
124 125 123 120 117
135 132 133 125 121
120 127 128 124 121
FOB and transportation cost of Indonesian Contract is 2 $ more for each contract . And lead
time is not of very varying nature for each country.
M12
Spot Prices123
122
125 Actual
Prices132
2 $ more for each contract . And lead