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Unprecedented tightness in China's coal system will ensure strong demand and limited supply

Hong Kong | | Media Releases APAC

After three years of surging fixed asset investment, China's coal supply system continues to struggle to generate growth and faces a number of challenges that have the potential to undermine attempts to boost output. As a result, UBS remains positive on coal prices in China and dispels three popular misconceptions that suggest coal prices will fall.

Contrary, to the consensus view, strong growth in coal industry fixed asset investment (FAI) will not translate into output growth and so depress prices, believes Ghee PEH, Head of Asia Metals & Mining. "The correlation between FAI growth and output growth is not as strong as some observers believe. We have found that only 55% of FAI between 2004 and 2005 translated into new capacity in 2005. The correlation is likely to be weakened further by new policies on coal mining licences which increase production costs and discourage short-term output growth; the logistical challenges that are, typically, associated with China's mines, 95% of which are underground; and the continuing closure of small mines which will further limit the growth of supply," he said.

The second misconception suggests that increasing coal rail capacity will contribute to a decline in prices. "We do not believe this will be the case for two reasons: first, the China rail sector has been underinvested since 1990 and the coal transport market remains tight. For the first 11 months of last year, coal transported on railways stood at 1.02 billion tonnes, an increase of just 4.4% on the previous year while, over the same period, coal inventories at mines grew from 140 million tonnes (21% of total China coal inventory) to 150 million tonnes (29% of total), Second, our forecast is for an increase of 122 million tonnes in eastbound rail capacity which translates to 6% of total 2006E coal supply which we do not believe is large enough to trigger a large correction in prices," he said.

Third, Peh believes an exciting new trend is China emerging as a large new coal importer in North Asia. At the same time, a number of factors are likely to underpin strong prices in the short to medium-term.

"Coal production in China faces growth and geological issues. We expect only single digit growth for 2007-2008E and only 45% of reserves comprises higher energy coal. Demand is set to remain strong and third, recent cuts in export rebates and import tariffs signal that China is set to reduce exports and increase imports. All three suggest a robust China market in 2007-2008. We expect spot prices to increase by 5% this year and to remain firm in 2008," said Peh.

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