Overcapacity in China's coal sector has reached unmanageable levels. At nearly 1 billion tonnes per annum, overcapacity is a threat to both the domestic market and seaborne coal trade.
Although the government has announced a series of measures to tackle overcapacity, we expect it is unlikely to be eliminated in the near-term due to significant risks. We look at the causes, the action the government has taken and the risks associated with the solutions.
What led to the overcapacity in the coal sector?
Rapid economic growth, dislocated markets and infrastructure bottlenecks increased domestic coal prices sharply in China. Local government focus on investment-driven GDP growth, massive fiscal stimulus in 2008 and low-cost credit saw mass construction of new coal mines. As a result, power demand growth began to fall.
We believe the industry is hugely fragmented and the implementation of mining regulations and best practices have been difficult and often overlooked. Our database of 7,300+ mines and projects suggests it is common to produce over and above the approved production capacity in China; quite often the output is double the approved capacity in several provinces. There are four likely outcomes from overcapacity, against which the government will be taking action.
1. Mine closures
The rapid elimination of excess capacity could result in large lay-offs. This means nearly 2 million workers are at risk of losing their job and would need to be provided either with alternative employment or a severance package. The government has already created a US$15 billion fund to compensate workers made redundant by mine closures. However, there is little clarity on who would bear mine closure costs and as such there could be delays in closing down a mine or other environmental risks.
2. Industry restructuring
We expect to see larger companies acquiring smaller companies in accelerated consolidation. The government has been pushing for consolidation for many years, but progress has been gradual. It is likely the government is concerned a monopolistic situation might develop in the market in the absence of a regulatory body overseeing M&A activity. But there is ample scope for consolidation and increased productivity; as Australian operations have proven over the past few years, this can lead to significant cost savings.
3. Backward integration
The government could encourage large consumers in the power, steel and chemicals space to acquire coal mines to secure long-term supplies. Nearly 80% of Chinese domestic coal production is sold by merchant miners and the rest contributes to captive end-use plants in the power and steel sectors. Big gencos have bought equity stakes in domestic coal mines in the past few years but their dependence on outside purchases is still high. We believe this is an area which can see huge activity, and coal consumers in the power, steel and chemicals space can quickly acquire domestic coal mines to ensure long-term supply security.
4. Domestic protectionism
We could see an export duty removal and VAT rebate allowance to increase exports. We believe this is an area which can benefit miners capable of producing low cost and good quality coals. The government reduced export duty from 10% to 3% in January 2015, but Chinese miners have struggled to increase exports due to oversupply and weak pricing in the seaborne market. Our analysis suggests that low cost and high energy Chinese thermal coal can effectively compete with Australian supply into Japan if the export duty is completely removed and VAT rebate allowed.
Follow China Week for more insight
China is integral to every global energy, metals, mining and resource discussion. As part of our China Week series we will be publishing regular insight on our website and social channels. Our team of expert analysts will be discussing fundamental questions about the current state of key sectors.