Wednesday, February 17, 2016

Coal Prices Bottomed: China Metals & Mining Market Insight

Key Takeaway: Coal Prices

Jefferies Hong Kong Limited believes coal prices have bottomed. QHD coal prices have increased Rmb19/ton from 4Q15 lows. Certain mine mouth prices have also ticked up. Low prices and “supply side reform” are quickly eliminating capacity. However, with demand plummeting and low-cost capacity still restricted, we believe prices will not materially recover. Output, however, should optimize towards efficient but currently restricted producers like Shenhua (1088 HK, BUY, PT: HK$16.75).

China Metals & Mining Market

Real capacity cuts? Maybe… The State Council declared that China will eliminate 500 mtpa of coal output capacity in three to five years and consolidate another 500 mtpa into larger, more efficient producers. According to China’s Coal Association, the country has the capacity to produce 5.7 Btpa, of which only 3.7-3.9 Btpa is currently utilized. Lopping off 500 mtpa from 1,800-2,000 mtpa of excess capacity may be more meaningful than it appears if uneconomic production is eliminated, allowing low-cost mines (currently restricted) to operate at more optimal utilizations.

Only three provinces needed. In 2009, Shanxi-Shaanxi-Inner Mongolia supplied ~38% of China’s raw coal. With the build-out of railways, production expanded in the three provinces… but then coal demand peaked in 4Q13. Raw coal demand has fallen ~17% since then. Shanxi-Shaanxi-Inner Mongolia now supply ~61% of China’s raw coal. We believe this percentage will rise as coal demand is further whittled away by cleaner substitutes and as low-cost production becomes unrestricted in the three provinces.

Production still restricted

In 2014, China implemented production restrictions for large-scale miners in Shanxi-Shaanxi-Inner Mongolia as prices plummeted. Rapid production growth in Shanxi-Shaanxi ceased while Inner Mongolia output declined 24%. We believe the goal was to “soft land” the coal price, buying time to sort out unemployment and financial liabilities. Premier Li Keqiang’s visit to Shanxi touting “supply side reform” suggests that a plan now exists to cut-off capital to uneconomic producers while providing aid to laid-off miners. We believe this will allow restricted production to resume.
Won’t help prices. Will optimize output. Buy Shenhua

Eliminating uneconomic output while unleashing low-cost production will not help prices. It should, however, reallocate output to low-cost miners, which should then benefit from increased volumes and economies of scale. As the lowest-cost producer and a victim of restricted production, we believe Shenhua will benefit from China’s coming production optimization.

This report was shared by Laban Yu *, Equity Analyst, Howard Lau *, Equity Analyst, Elaine Lai *, Equity Analyst from Jefferies (Japan) Limited.

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