CHINESE COAL & MARKET THOUGHTS
by Yiannis G. Mostrous
Editor, Growth Engines
July 5, 2007

Bears of any kind (i.e., perma or otherwise) continue to find reasons why the markets will collapse any day now. At the same time, the global markets continue to defy all those extremely intellectual observers and have done so for the past four years.

Of course, some of these commentators feel such a thrill every time they manage to call a top--which is often--that they now live in fear that the top may come and, if they're not there to "call it," they'll miss the greatest opportunity in their professional lives.

Asia especially is on everybody's "fundamental purity" radar as the region of the world that's so out of sync with reality that a collapse is imminent.

It's understandable a lot of people are upset with Asia; their main concern in the past five to six years has been to identify reasons for its collapse. And now that the global economy--led by the US--is showing some signs of a slowdown, their voices have become even louder as they proclaim the end of the "high beta-growth proxy" Asian markets.

I profess no knowledge on the timing of a market slowdown. But absent a US recession, every prolonged market weakness should be viewed as a buying opportunity by long-term investors.

I concede that Asia-–and the emerging markets as whole--have a lot to prove regarding their ability to weather a severe economic slowdown in the US, and maybe they're not ready to do that yet. The fact of the matter is, though, that Asia in particular has been able to weather the US slowdown that's been taking place since last year.

Asia continues to grow as a whole. China and India remain the main engines, but there’s room for everyone. Asia’s growth potential, although influenced by global growth, should be viewed in the context of an economic region that’s developing while ensuring long-lasting structural change. In other words, Asia is counting more on itself now for its economic development than on the kindness of foreign investors, as it did before.

Headwinds will always be present; after all, nobody’s immune to economic cycles and disruptions to global trade. But they should be viewed as short-term slowdowns in the context of a long-term economic trend that will make Asia an equal partner and a strong contributor to the world’s economic growth.

My view remains benign when it comes to the danger of a financial disaster in Asia because of the increased portfolio inflows. Aside from the fundamental improvement in Asian economies, net portfolio inflows remain much lower today at 4.5 percent of the region’s GDP than they were 10 years ago--during the Asian Crisis--at more than 6 percent of GDP.

As changes in Asia continue to take place, I expect the market to stay stronger for longer, even trading at par to US valuations given its superior growth characteristics. If the selloff scenario materializes--in a tactical rather than a recessional context--expect the Asian markets to rebound, finishing the year 40 to 50 percent above current levels.

Coal In China

A little more than two months ago, Saudi Arabia hosted a roundtable discussion featuring Asian energy ministers. During these meetings, the Chinese representative--Deputy Commissioner of the National Development and Reform Commission Chen Deming--informed the participants that China will try to increase its use of domestic resources to meet its energy needs.

As I’ve noted here previously, the political leadership in China has made diversification of energy dependence away from oil a matter of national security. Given that China's not only a big consumer of energy but also a big producer, there’s scope for the country to achieve its objective.

Although China will have the opportunity to exploit its gas resources or continue to explore opportunities in the hydro, solar and bio energy areas, its main source of energy will remain coal for years to come. It seems that the Chinese leadership has realized that fact and has taken the necessary steps to ensure that its coal resources will be used wisely.

For starters, Chen was governor of the Shaanxi province--one of the largest coal-producing regions in China--and had experience on the subject before he was selected to essentially lead the national energy policy efforts. And the Chinese have been working on exploiting technologies to convert coal into oil, something that South Africa has been doing for a long time.

According to studies, oil prices above USD40 per barrel make such a conversion viable. Given that a good-sized conversion factory costs around USD3 billion, the Chinese are making sure that the viability of the project is satisfactory, given the big scale of such a project in China.

If that’s the strategic part of the story, there’s a more tactical consideration that should also be positive for coal: Although China is a gigantic coal producer--second only to the US--its massive domestic coal production isn't enough to keep pace with the country’s domestic demand.

There are a few reasons for China’s apparent problems in satisfying its coal needs shorter term, too, as the country’s power demand is growing by 14 percent this year.

China has seen low rainfall this year, meaning hydropower generation has been down. Thermal power plants (mostly coal fired) have been picking up the slack, taking their production growth up 18 percent and their power share to 85 percent or more at times.

Notice that China’s coal supply has been growing modestly at 8 percent per year, which, in turn, has made the country a net importer for the first quarter of 2007 and probably the rest of the year. Most recent statistics have shown that, in May, Chinese exports fell to 3.43 million tonnes from 4.46 million tonnes in April. Net imports for the year to date now stand at 3.4 million tonnes, and more tightness in the domestic coal market should be expected.

According to reports, Japan just agreed to new prices of USD68 per ton for April 2007 to March 2008 from USD52 ton, about a 30 percent year-over-year increase. China exported 20.6 million tons of coal to Japan in 2006, 19.2 million tons to Korea and 13.3 million tons to Taiwan.

Furthermore, if demand for power in China remains strong this summer--one of the most demanding seasons of the year--industry experts have warned that the country’s ports, as well as vessel inventory, will have a hard time keeping up. The problem is that, although rail capacity has been increased, ports are able to handle only two-thirds of the new capacity. It seems there aren’t enough ships to make the round trips.

Investors who think--as I do--that coal will surprise on the upside this year and that the majority of the investment community has failed to realize its strategic potential for China should invest in Yanzhou Coal Mining Co.

Incorporated in 1997, Yanzhou is one of the four largest coal producers in China. It derives two-thirds of its sales from the domestic market, while it sells mostly to Japan and South Korea in the export market.

The company is a leveraged play on Chinese coal because about 55 percent of its sales are on the spot market, which is entering a seasonally strong period, as noted above. The company also sells higher margin semi-soft coking coal, which is also up year-over-year.

The company has been expanding its operations, adding three new mines to its assets. With its strong balance and cash reserves, more long-term growth-oriented investments should be expected.

Yanzhou’s exposure to spot pricing raises the risks of investing in the company, given that its earnings will be affected more than others. On the other side, it will perform better if demand remains strong.

© 2007 Yiannis G. Mostrous
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