Downgrade coal sector to neutral on weakening fundamentals
We are downgrading our China coal sector stance to neutral from attractive. While
the key structural drivers – small mine shutdown and long-term railway constraints –
are still in place, we believe potential further demand weakness could start putting
pressure on the cycle.
Cyclical headwinds intensifying, suggesting more downside
We see further downside for the three key demand drivers – power generation, steel, and
cement – collectively accounting for 87% of total coal demand in China as of 2007. The
relative defensive status of upstream coal could be under threat as key downstream users
are all facing further downward pressure, in our opinion.
The worsening global economic downturn will likely put further pressure on consumers, in
turn depressing China’s aggregate exports, where 55% of total is capital goods, which is
part of IP growth/power consumption. Power generation growth fell to 6% yoy in August
from a peak of 17% yoy in March this year.
Our latest channel checks indicate that China property sector (which accounts for c. 25% of
steel demand, c. 35% of cement demand) September sales (generally the strongest month)
were even weaker than in August, putting pressure on developers to cut prices further in
October to move the rising inventory. Even large developers are starting to delay/cancel
new projects more aggressively, indicating a weak demand outlook in 1H09, after the
sector saw a tangible deterioration starting in 2Q08.
Potential demand downside and further railway upgrade points to an easing of the railway
bottleneck in 2009, especially after the second derivative effect from lower shipment of
iron ore (after the steel sector slowdown we expect into 2009), leaving more room for coal
transport.
Limited upside for domestic coal prices
As the impact of July/August government price cap suggests, if coal prices rise again due
to continued intensified small mine shutdown, we believe further government intervention
could be triggered, such as a resource tax levy. The probability of this is increasing, in our
view, given lower ability of coal producers to pass on addition tax burden to downstream
users in a weakening demand environment.
In the context of the energy complex, the recent pullback in oil prices will likely also limit
coal price upside. On a heat-equivalent basis, coal is trading at 29% of oil, vs. historical
average of 26%, a peak of 35% and trough of 15%.

Despite an 8% pullback from the historical high of Rmb1,010/t in mid-08, the domestic spot
coal price at Rmb930/t (using Qinhuangdao port benchmark) is up 95% yoy due to
government’s intensified small mine shutdown leading up to and during the Olympics.
We forecast the domestic spot coal price (Qinhuangdao benchmark) to go down 10% yoy
(vs. our previous estimate of a 10% rise) to Rmb720/t in 2009 (US$114/t), putting coal on a
15% heat-equivalent basis vs. oil price of US$110/bbl (GS forecast).
The large gap between contract and spot, as shown in Exhibit 1, points to further upside
(10% per our forecast) for ’09 contract prices.
We believe the domestic coking coal price could drop by 30-40% in 2009E to US$158-184/t
level, if the steel industry experiences a severe downturn as we expect. Buffers are quickly
being reduced, as the coke industry is already entering into loss territory. Our ’09 coking
coal target would put the coking coal premium (vs. thermal coal) at the historical average
of US$80/t in China.

Table of contents
Downgrade coal sector to neutral on weakening fundamentals 2
Valuation: Shares down a lot ytd, but downside still not fully priced in 5
Majority of the thermal coal fundamental anchors weakening 12
Met coal facing sharp demand headwinds 18
Risks 19
Disclosures 31
Source: Company data, Goldman Sachs Research estimates.
The prices in the body of this report are based on the market close of September 25, 2008