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Fascinatingly Negative Point Of View From A Bernstein Report On The China Coal Situation

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Peter Epstein: The following commentary is entirely from a Bernstein Research report, "ASIAN COAL & POWER: CHINA'S NEWEST (& BEST INFORMED) COAL BEAR....the China Transport & Distribution Association" Report dated, March 7, 2012...

"With no official steel, cement, coal, power or industrial production numbers released for January, we have no data on Chinese industrial output for 2012. But over the last week, we got something better: the China Coal Transport and Distribution Association, (CCTD) released its 2012 estimates for coal consumption by the power and cement sectors. MIIT put out a forecast for steel output, and the China Coking Industry Association, (CCIA) added its estimate for coking coal consumption. The surprise (to us) is that these organizations are now more bearish than we are. In short, 2012 coal oversupply could be worse than we thought."

"There are three primary factors that drive coal consumption in China: thermal power, steel and cement. We forecast decelerating growth for all three. Consequently, our coal consumption growth in 2012 falls from 416M tons in 2011 to ~195M tons in 2012. Interestingly, the decline we forecast is not as sharp as CCTD, MIIT & CCIA estimates, which imply coal consumption growth of 40M tons less than our numbers."

"We are forecasting thermal power production growth of 5.4% in 2012 (+10.9% in 2011), steel production growth of 7.8% (+9.2% in 2011), and cement production growth of 4.3% (+10.4% in 2011). The CCTD estimates coal consumption growth by the power sector of 4.5%, and a 1% drop in coal consumption by the cement sector. The MIIT estimate for steel production growth is 6.7%."

"There is only one factor that drives coal production capacity growth in China: fixed asset investment in coal mining in the preceding two years. Based on fixed asset investment in coal mining in 2010 & 2011 (both record years with a 2-yr CAGR of 25%+), we estimate incremental production capacity of over 400M tons. The CCTD estimate for incremental production capacity this year is 400M tons. On CCTD's numbers, China will have 250M tons of excess coal production capacity in 2012."

"It takes roughly 18-24 months to build a coal mine in China and roughly 3-5 years to build a railway line. The lack of railway infrastructure and mining capacity has been a known problem in China for at least the last 5 years. Both transport and mining investment has increased dramatically over that period. In 2012, "long coal" is effectively "short China's ability to build infrastructure". Thermal coal prices have fallen 9-13% in China over the last four months as production and transport capacity growth has outstripped demand growth. We expect that downward pressure on coal prices will continue in 2012 and into 2013 because of seasonal and cyclical factors but, more importantly, structural factors."

"Combining recent CCTD and MIIT estimates of power, steel and cement production for 2012 implies coal consumption growth of 153M tons. By comparison, we look bullish with our 195M tons estimate. We are bearish on Chinese thermal coal prices, we expect prices to fall 5% in 2012 versus the 2011 average and we expect a further 10% fall in 2013."

"We expect coal consumption in China to increase by ~195M tons this year and production capacity to increase by more than 400M tons. This delta will continue to create pressure on imports and pricing."

"However, given our bearish views, it is only prudent that we test our forecasts. That is why when we see projections from Chinese industry organizations for 2012 that are more bearish than ours, we think it's worth pointing out. We take recent estimates from separate Chinese industry and government organizations (CCTD, MIIT and the China Coking Industry Association) and use those estimates (rather than our own) to project 2012 Chinese coal demand growth. The implication is a 20% reduction on our already weak incremental coal consumption estimate."

"These organizations have no incentive to low-ball their respective estimates. The China Coal Transport & Distribution Association was previously the Department of Allocation and Transportation of the Ministry of Coal Industry. It is an industry body for coal producers and distributors. The CCTD has over 200 corporate members who are mainly state-owned large-sized coal producers and distributors and include China National Coal Group Corporation (parent of China Coal Energy), Shenhua Coal Transport and Sales Group and Yanzhou Coal Mining Company."

"MIIT was created by the State Council in March 2008 to incorporate the functions of several ministries and offices, including the Ministry of Information Industry, the ministry-level Commission of Science, Technology and all of the industry project approval functions previously held by the NDRC. The ministry plays a role in regulating major industries and in examining and approving new industrial investments and projects."

"The China Coking Industry Association was established in 1994 and is managed by SASAC, as well as being supervised by the Ministry of Civil Affairs and the China Iron and Steel Industry Association. The CCIA's principal goal is to serve as the bridge between the coking industry and the government."

"Seasonality: There are seasonality arguments for why coal prices are about to go up… in every month of the year. At the start of winter, greater energy demand and havoc for transportation lines creates pricing pressure. By mid-January, the expectation of Chinese New Year means coal fired power stations will build inventories, pushing prices up. Queensland's rainy season can also put pressure on coal import prices, creating a floor for prices even as winter demand starts to reduce."

"The Daqin line has twice-yearly scheduled maintenance in April and October, meaning inventories get pushed up in preparation - together with prices - in March and September. In April and May, the prospect of a delay in the summer monsoon and a shortfall in hydro generation creates pricing pressure on coal. The air-conditioning season begins in June and lasts through August. August itself in China is notorious for power shortages. Inventory builds for Daqin maintenance in October start in September together with preparations for Golden Week in the first week of October which (per the bull case) means more coal demand. And then winter begins to set in."

"These are the arguments for higher coal prices that we have been listening to for the last year or more, except that for the last four months, coal prices have been falling. Each of the usual seasonality explanations for when coal prices would pick up again have proved incorrect. We are not suggesting that coal prices will continue their current monotonic decline permanently. Seasonality will play a part in demand fluctuations. We are simply suggesting that there is more going on here than simply seasonality."

"We believe the seasonality argument has flaws and that the cyclical argument is not much better. Yes, the Chinese economy is slowing, but GDP growth was still 8.9% in the fourth quarter and inflation is 4.5%. In short, it is hardly 2008 all over again. The argument that the Chinese government is about to stimulate the economy back to RMB 1,000/ton coal prices is more and more difficult to make, not least because of remarks on Monday from Chinese Premier Wen Jiabao at the National People's Congress that the GDP growth target for the year is 7.5% and the inflation target is 4%."

"There is no interpretation, in our view, that includes a fiscal stimulus package in 2012 from here without a large drop in economic activity, and a consequential fall in energy consumption growth and coal demand first. In short, coal prices have to come down before they can go up if a fiscal stimulus is going to be the "bull case" driver. We are now entering the period where the prospects of maintenance on the Daqin railway line between Datong and Qinhuangdao is generally credited with driving up coal prices. This year, the suggestion is that this maintenance will occur in March rather than April (perhaps for the good reason that Qinhuangdao inventories are currently high)."

"The total impact of the withdrawal of the line from service for four hours a day for two weeks (as occurred last September) is minimal - roughly 3M tons of coal over the period. In a soft market, power plant managers can take comfort from the fact that the line will be back to full utilization in two weeks and may dip into power station inventories in the mean time. In a tight market with low power station inventories, power plant managers do not have that luxury and coal prices get pushed up."

"Based on inventory levels at both Qinhuangdao and at power stations, there is little to suggest that the maintenance period will spike prices.
Accordingly, we expect that - like Chinese New Year and the Queensland flood season - the Daqin rail maintenance will have minimal effect on coal prices this year. Coal prices will edge up again over summer; but the race to replenish inventories by the coal-fired power fleet is off to a very slow start and there is little on the calendar to drag the push forward from the start of summer."