More tariffs: the only shortage solution

Shortage: strong demand and restricted supply

We believe the coal shortage is primarily attributed to strong demand

growth over the past five years. The coal demand from power, steel and

cement grew at a CAGR of 13-22% in 2002-07, while coal supply only

increased at a CAGR of 11.6% in the same period. Coal production is

restricted, however, by small mines closures and resource depletion in

East China.

Policy must switch to power tariff increases

We believe current energy price controls on coal and power will only

increase demand and intensify coal shortages. Coal price controls are

meant to be short-term and are not sustainable. They were devised to

ensure the power supply in the summer peak season. A coal tax hike will

increase energy price-hike pressures. The only viable measure to slow

coal demand is by increasing power tariffs.

Coal no longer offers cheap energy in China

Increasing costs in coal mining is another major factor behind the coal

and power price increases. Coal production and transportation costs

have consistently risen over the past five years, while increases in safety

investments, labour costs and transportation distances are rigid, without

any downside possibility in the foreseeable future. We believe contract

coal prices will continue to climb relative to cost hikes, while spot prices

may weaken with possible demand slowdown.

BUY reserve in the long term

We like the contract coal suppliers with abundant reserves because

existing coal reserves will appreciate with more supply coming from

West China. Also, the production cost increases will support contract

prices in the long-term. Shenhua and China Coal trade at 33% and 22%

discount to DCF. And both EV/tonne of USD5.20-7.80/tonne (based on

reserve) is cheaper than regional peers’ average of USD9.20/tonne. We

stay NEUTRAL on China’s coal sector. Shenhua is our top BUY for its

strong reserves, integrated railway assets and cheap valuation.