Broker's View

Coal price spike will be fleeting, analysts say

In the absence of any substantial supply-side reform of the industry, Chinese price rise is only temporary as declining demand inevitable

PUBLISHED : Tuesday, 05 July, 2016, 6:44pm
UPDATED : Tuesday, 05 July, 2016, 10:05pm

The recent spike in Chinese coal prices will be temporary, and more effective supply-side reforms are urgently needed right across the sector, according to analysts.

The domestic price of coal climbed 4 per cent in June, following the government’s move in May to lower annual operating days at mines from 330 to 276 days, resulting in a cut in inventories.

“We believe this is not supply-side reform,” analysts at global investment bank Jefferies said in a report.

“The policy indiscriminately handicaps all producers, to provide life support for zombie mines.”

They added that real supply-side reform for the sector should see uneconomic mines starved of cash, forcing their closure.

Another report from Deutsche Bank analyst James Kan, suggests that stricter control measures by the authorities in the country’s three major coal-producing provinces — Shanxi, Inner Mongolia autonomous region, and Shaanxi, which hold a combined 60 per cent market share — had cut production by more than 20 per cent.

Kan said the normal summer demand for coal had started to pick up, just at a time when production remains constrained and supply levels are around a fifth lower.

The policy indiscriminately handicaps all producers, to provide life support for zombie mines
Analysts at global investment bank Jefferies

He now expects the price of Qinhuangdao (QHD) 5,500 kcal coal to reach 450 yuan per tonne over the summer, six months earlier than his original expectation of hitting that level.

He predicts the price of QHD 5,500 could even surge to 480 to 500 yuan per tonne in the last quarter of the year, the peak season for such thermal coal.

In view of the short-term price surge, Deutsche Bank upgraded shares in China Shenhua Energy Company from “hold” to “buy” late last month, expecting its price to rise to HK$15.9.

It also upgraded China Coal from “sell” to “hold”, with a target price of HK$4.3, on the assumption QHD’s price could hit 500 yuan per tonne.

Shenhua shares closed at HK$14.06 on Tuesday after rising 25 per cent since mid May, and China Coal Energy Company shares closed at HK$4.05, up 38 per cent in the past month and a half.

Kan said the 276-day policy, however, may only shift the balance between supply and demand short term in the absence of any meaningful supply-side reform, creating effectively a fleeting coal price spike.

“In the coming two quarters, government officials might be encouraged by the near-term upward trend in the coal price, and stick to their strict policy execution,” he said.

“We believe once the coal price gets close to 500 yuan per tonne, the incentive for coal producers to influence, and the potential for the government to loosen, the policy will be much higher,” Kan said, adding he expects coal to fall back in price to 380 yuan per tonne if policy measures are loosened.

Jefferies also believes that coal shares will rally short term as prices inch up, but added in its note that the market will figure out the production restrictions are temporary, and that declining demand is inevitable.

It said permanently restricting production was entirely the opposite of lasting supply-side reform as it eternally subsidises high cost producers.

Coal producers will not meaningfully benefit, it said, from incremental increases in prices as they substantially cut production.

It called the 276-day policy, a managed unwinding being made to reduce systemic financial risks from long-standing liabilities.

According to recent mainland reports, Shanxi province has now requested debt relief from banks for its seven largest coal producers, with debt levels nearly matching the province’s total gross domestic product.

“Price support from production restrictions is only justified if it is temporary,” said Jefferies in the note, “and they need to be lifted after bad debts are restructured, written off or unwound.”