China, Commodities

Mirae Asset Global Research
Chinas commodities in a soft-landing scenario
Henry Liu
Regional Head of Commodities Research
henry.liu@miraeasset.hk +852 3653 8606
July 2012
See the last page of this report for important disclosures
Chinas commodities in a soft-landing scenario

Watch out for long-term weak commodity prices
Liquidity-driven FAI growth will become increasingly unsustainable in 2012 and beyond. We see a long-term price downtrend for commodities: Thermal coal, coking coal, iron ore and steel. Be picky in trading opportunities and pick the strategic winner.
The real cost of thermal coal: An inconvenient truth

We forecast Chinas QHD thermal coal price will go down to Rmb630/t by 2015. Demand growth will slow with contracting credit and FAI growth, while supply from domestic miners and imports is growing at double digits. The transportation bottleneck is not as rigid as the market assumes; there is cost flexibility. We initiated coverage on Shenhua with a BUY rating; Yanzhou Coal with a REDUCE rating; and China Coal with a HOLD rating.
China steel value chain: Coking coal preferable to steel mills

We maintain our UNDERWEIGHT view on the Chinese steel sector in 2012, as massive capacity expansion will continue to destroy value. We believe upstream coking coal miners are a good hedge to SOE steel mills. We are initiating coverage on Shougang Fushan Resources with BUY and on Hidili with HOLD.
Copper: Range-bound between US$7,500/t and US$8,500/t

We think copper prices above US$8,500/t are not sustainable, judging by sluggish real demand in China. Financing activities and fund speculation are increasingly becoming the driving forces in the copper market.
2012 Bulk Commodities
Stock coverage of Mirae Commodities Research
Mirae Commodities stock coverage
Source: Mirae Asset Research Prices as of 17 June 2012
The real cost of thermal coal: An inconvenient truth Slowing FAI does not bode well for coal demand
Sluggish lending activity during 1Q12 indicates that new loans in FY12 may not even reach the comfortable credit zone of Rmb10.5tn. This does not bode well for the FAI outlook in 2012. Our base-case China coal demand CAGR is 5.7% over 2012-2015E.
Transportation bottleneck? Think again!
We see flexibility in Chinas typical marginal coal miners cost. Increasing coal railway transportation capacity and potential railway system reforms will reduce the pressure on long-haul trucking costs from 2013.
Supply glut in 2013-2015
The top-17 coal mining firms in China will increase their capacity to 2.9bn tonnes by 2015, up 90% from 2010.
Long-term downtrend in thermal coal prices

We forecast QHD 5,500 thermal coal price will fall to Rmb630/t in 2015, from the current Rmb770/t. We have a BUY rating on Shenhua; REDUCE on Yanzhou Coal; and HOLD on China Coal.
Slowing FAI does not bode well for coal demand

We observe a strong correlation between FAI new construction and apparent consumption of thermal coal. However, the sluggish lending activity during 1Q12 indicates that new loans in FY12 may not even reach the comfortable credit zone of Rmb10.5tn. This does not bode well for the FAI outlook in 2012. More importantly, huge FAI investments - with declining investment efficiency - since 2009 have led to an investment frenzy for commodity capacity expansion (not just in the coal sector).
Strong correlation between Chinas FAI (new construction) and coal consumption growth
60% 50% 40% 30% 20% 10% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 10% 5% 0% 25% 20% 15%
FAI new construction (LHS, YoY %)
China raw coal app. Consumption (RHS, YoY %)
Source: CEIC, SXcoal, Mirae Asset Research
Slowing FAI does not bode well for coal demand

A breakdown of Chinas power consumption clearly indicates that FAI-related industries accounted for the lions share of Chinese power demand and hence thermal coal demand.
Chinas power consumption breakdown
Others (individual<2%), 18%
Mining, 5% Chemicals, 7% Cement, 6%
Residential, 12%
Steel, 11%
Non-ferrous, 7%
Other Industrial Usage, 34%
Source: CEIC, Mirae Asset Research
Our base-case: 5.7% CAGR in China coal consumption

On the coal demand side, our base-case projection is 4.6bn tonnes of raw coal production by 2015, based on assumptions of: a) 7% GDP growth over 2011-2015; b) a decline in the correlation between coal consumption growth and GDP growth to 0.8x (from 1.07x in past decade).
Our base-case scenario: 5.7% CAGR in apparent coal consumption
China's raw coal production (m tonne) 2008 2009 2010 2011 Our base case scenario 2012E 2015E R from 2011 to 2015 2,716 3,050 3,413 3,710 China's net imports (m tonne) -5 103 146 169 China's apparent raw coal consumption (m tonne) 2,711 3,153 3,559 3,879 Averaga Annual thermal coal price (QHD 5500kcal, Rmb/t) 738.0 606.8 750.8 824.0
YoY 12% 12% 9%
YoY 16% 13% 9%
YoY -18% 24% 10%
3,951 4,600
6.5% 5.5%
185 250
4,136 4,850 5.7%
6.6% 5.7%
820.0 626.5
-0.5% -6.6%
Our base-case scenario: 5.7% CAGR for coal consumption during 2012-15
2.5 2.0 1.5 1.0 0.5 0.0
Coal consumption growth of 0.8% will be able to support 1% GDP growth: It happened in 2005-2008.
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
App. Coal consumption growth/GDP growth ratio
10-year average at 1.07
Source: CEIC, SXCoal, Mirae Asset Research
2011
Chinas coastal provinces: Demand is slowing down

Out of the six coastal provinces, which account for 35% of Chinas thermal coal consumption, only two recorded more than 15% industrial-value added growth in 2011; the rest saw growth of less than 10%.
Central/western China outpaces coastal regions, in terms of industrial value-added
Industrial value added > 20% Industrial value added between 15-20% Industrial value added < 15%
Huge investments in coal mining leading to a supply glut

Chinese coal mining has been providing a decent return over the past few years, encouraging strong investment. The combined mining capacity of Shenhua, China Coal and Yanzhou (including the Australian unit) will reach 870m tonnes by 2015, up 86% from 2011's 467m tonnes. The top-17 coal mining firms in China will increase their capacity to 2.9bn tonnes by 2015, up nearly 90% from 2010, according to China Coal Industry Association.
Chinas coal mining offers decent return, encouraging expansion
Gross profit (%)
Three Chinese coal miners have aggressive expansion plans (mt)
50 40 30 20 10 0
900 800 700 600 500 400 300
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
200 100 0 2010 2011 2012E 2013E 2014E 2015E
-10
Steel making Iron ore mining
Copper mining Thermal power
Coal mining
Shenhua Energy
China Coal
Yanzhou Coal
Source: Wind, Mirae Asset Research
Source: Company data, Mirae Asset Research

Increasing coal railway transportation capacity and potential railway system reforms will reduce the pressure on long-haul trucking costs from 2013. The capacity potential is locked due to:
The imbalance in allocation of transportation capacity between contract shipments and spot coal shipments. Inefficient coordination between regional railway administrative powers.
Railway bottleneck to be alleviated to some extent, but not resolved completely
5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0
million tonnes
66% 64% 62% 60% 58% 56% 54% 52% 50%
2012E
Raw coal production (LHS)
coal transported by rail as % of total coal output (RHS)
Source: NBS, SXCoal, Mirae Asset Research
2015E
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
10

Due to limited funding sources, railway coal transportation has now become the cash cow for local railway bureaus to subsidize other operations. With cooling downstream demand, it will be increasingly difficult for local governments and other administrative powers to milk the thermal coal supply chain in the coming years.
Compliance cost = Fee & taxes + difference between truck and railway price
How much does it cost to transport coal via railway?
350 300 250 200 150 100
Rmb/t 25 140 265
325
Profit made by coal miners & coal traders 19%
Production 9%
Railw ay charge (Ordos to Tianjin Port) 19% Fee and Taxes 18%
65 20
50 0
15
Storage fee
Loading fee
Access fee to railway
Railway charge Discharging fee (Ordos to Tianjin Port)
Total railway Truck cost (Ordos transportation to Tianjin Port) cost
Differ betw een truck and railw ay 35%
Source: Mirae Asset Research
11
Chinas marginal coal miners: How flexible are their costs?

The two charts compare the cost difference between the high and low demand seasons for a private open pit coal mine in Inner Mongolia. This illustrates the cost flexibility at each node of the coal supply chain, in response to coal demand. In reality, low demand seasons will reduce the traffic jam and drivers will prefer to travel along the low-grade r outes, rather than the high-grade highways, to avoid toll fees and fines.
A marginal cost supplier - slack time
A marginal cost supplier peak time

800
28 320 35 610
700 600 500 400 300 200 100 0
Rmb/t
Rmb/t 400
28
35
744
700 600 500 400 41 280
75 60 50 10
33
228
300 200 100 0

Coal Coupon
FOB at Tianjin Port
110 60 60 10
Coal Coupon
Coal trader's income
Source: Mirae Asset Research Note: The price here is for 4700kcal thermal coal
FOB at Tianjin Port
mining costs
mine mouth price, incl. VAT
mining costs
mine mouth price, incl. VAT
Loading and storage at Port
Trucked to Tianjin Port
Coal trader's income
Cash Profit
Loading and storage at Port
Trucked to Tianjin Port
Cash Profit
SG&A
SG&A
VAT
VAT
12
Thermal coal imports will depress coastal thermal prices, but we do not expect a flood of imports
The supply competition in eastern coastal provinces will intensify in the coming years, with increased imports, which - coupled with the slowdown in demand growth in coastal regions - will effectively depress spot prices. We do not expect the Chinese coal market to be inundated with coal imports, as there will be enough low-cost coal supply to compete in inland China.
China's thermal coal imports by sourcing nation Cost curve of Australian thermal coal exports (A$/t, FOB)
140,000 120,000 100,000 80,000 60,000 40,000 20,000 0
million ton
120
53,285 45,893
100 80
A$/t
41,617 53,477 28,646 20,935 10,851 2,190 2008 Australia 21,881 2009 Indonesia 19,576 2010 22,228 2011 62,928
60 40 20 0 30 60 2011 90 2012 120 150 180 Million tonnes
Others (Russia, Vietnam, South Africa, etc)
Source: SXCoal, Mirae Asset Research
Source: Wood Mackenzie, Mirae Asset Research Note: Pre-royalty cash cost 13
Thermal coal Major seaborne trade flows: Exports 767mt (2011)
Russia 88mt Europe 199mt USA 35mt India 93mt
China 130mt
Japan, Korea, Taiwan 345mt
Colombia 76mt
Major exporter Major importer
S Africa 71mt
Indonesia 320mt Australia 145mt
Source: GITIS, Mirae Asset Research
14
Our framework for the seaborne thermal coal market

could arbitrage between the domestic and seaborne markets.
Chinas domestic coal prices provide a floor for the seaborne market. The IPPs in Chinas southeast coastal regions
Japan and Korea provide a cap price. Since Japan and Korea do not have domestic coal reserves, they are price-takers in
the seaborne market.
Chinas domestic coal price provides a floor for the seaborne market
190 170
$/t, incl VAT
150 130 110 90 70 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12
Newcastle thermal coal price incl. VAT, delivered to GZ port Shanxi Premier Blended thermal coal price, delivered to GZ port
15
Stock pick: Shenhua Energy (1088 HK, BUY, TP HK$42)

Shenhua Energy is our top pick among Chinese thermal coal miners. We believe Shenhua is well positioned in a weak thermal coal demand environment, given its integrated coal s upply chain across coal mines, transportation (railway) and IPPs. The companys extensive railway network enables it to stay at the lowest-end of the cost curve, while exposure to IPPs provides an earnings hedge against coal price volatility.
Shenhuas coal cost is the lowest among peers (2011, Rmb/t)
600 500 400 300 200 100 0 Shenhua Energy Yanzhou Coal China Coal Energy Marginal cost player - Inner Mongolia private mines trucking coal to east ports
Mine mouth cash cost
Depreciation
Transportation
Shenhua has least spot price exposure among the three companies
2011 Actual Volume in 2011 Contract Vol (mt) (mt) 282 172 100 52 51 9 Spot Vol (mt) 110 49 42 Spot volume as % of total 39% 49% 82% 2015 Mirae Estimate Volume in Contract 2015 (mt) Vol (mt) 500 172 180 52 150 9 Spot Vol (mt) 328 128 141 Spot volume as % of total 66% 71% 94%
Shenhua Energy (1088 HK) China Coal Energy (1898 HK) Yanzhou Coal (1171 HK)
16
Yanzhou Coal (1171 HK, REDUCE, TP: HK$13.00)

Cost is crucial to compete in the seaborne market, but Yanzhou is moving to the high end of the cost curve. We believe the companys rapid growth stage will be 2013-15. However, we see too much uncertainty in the coal market after 2012.
Yancoal Australia is moving to the high end of the cost curve
110 100 90 80 70 60 50 40 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 Million tonnes
Abel A$103/t Moolarben A$44/t Minerva A$58/t
Moonlarben and Minerva belong to Felix, which Yancoal Australia acquired in October 2009. Stratford and Duralie belong to Gloucester Basin, Tasman and Abel belong to Donaldson, both of which are mining locations in Gloucester. Yancoal Australia announced the acquisition of Gloucester in December 2011.
A$/t
Stratford A$68/t
Duralie A$77/t
Tasman A$85/t
Australia export thermal cash costs (2012, A$/t FOB)
Yanzhous coal output plan

2011 2012E 2012 YoY Shandong Province Ordos+ Shanxi Province Australia Self-produced coal External purchased coal Total coal sales (mt) 35.3 5.6 10.1 50.9 13.3 64.2 (mt) 35.4 8.2 12.4 55.9 20.0 75.9 (%) 2015E CAGR 2013-15 Note (mt) 40.0 50.0 50.0 140.0 (%) 4.2% Growth from Heze Nenghua 83.1% Rapid growth in 2013-2015 59.4% Rapid growth in 2013-2015 35.8%
9.7% 18.2%
Source: Wood Mackenzie, Mirae Asset Research
17
China Coal Energy (1898 HK, HOLD, TP: HK$8.50)

Mining accidents have a profound impact. China Coal will need to spend more on operational expenses than peers, due to spending on safety checks and infrastructure, increasing safety procedures, etc. The company lacks a long-term strategy to deal with the weak coal market.
China Coals material cost is the highest (Rmb/t)
300 250 200 150 100 50 0 Shenhua Energy Materials, fuel and power
Yanzhou Coal Personnel expenses
China Coal Energy Other costs
Repairs and maintenance
18
China steel mills: With ebbing demand growth, it is all about competition Massive capacity expansion destroying value
How will China consume more than 900m tonnes of steel-making capacity in 2012, once steel demand is detoxified from liquidity stimulation and the investment frenzy of the local governments?
Structural and cyclical steel demand facing headwinds

Two drivers of Chinese steel demand are: 1. Urbanization (a structural driver): Short-term pressure from a weak property market 2. Credit growth (a cyclical driver): Losing momentum in 2012.
Large SOE mills are losing out to hybrid competitors

We believe hybrid steel mills will be the future leaders in the Chinese steel sector. They enjoy local government support and have the aggressive management style of private entrepreneurs. HK-listed Chinese steel names are all SOEs: We have REDUCE on Angang Steel (347 HK, REDUCE, TP: HK$2.80) and Maanshan Iron & Steel (323 HK, REDUCE, TP: HK$1.70).
Raw material cost savings Steel profit margins

The entry barriers in building new steel-making capacity are negligible in China. Capital expenses of the integrated long and hot rolled coil steel mills have dropped to Rmb1,000/t (US$160/t) and Rmb2,000 (US$317/t), respectively.
19
Massive capacity expansion destroying value

We estimate Chinas crude steel-making capacity reached 860mtpa by the end of 2011. It will exceed 920mtpa by 2012. One consequence of capacity expansion is a deteriorating utilization rate. We expect further decline in utilization in 2012, as demand growth faces the double-whammy of shrinking liquidity and a weak property market.
Utilization rate of steel mills is going down
Chinese crude steel capacity expanded again since 2009
2011E
2012F
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Crude steel capacity at year end, LHS
Annual crude steel output, LHS
Crude steel capacity at year end, LHS
Incremental capacity per year, RHS
Utilization rate, RHS

Source: NBS, CISA, Mirae Asset Research
Source: CISA, Mirae Asset Research
2011E
2012F
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1000 900 800 700 600 500 400 300 200 100 0
140
mn tonne per annum
mn tonne per annum
mn tonne per annum
120 100 80 60 40 20 0
1000 900 800 700 600 500 400 300 200 100 0
100% 95% 90% 85% 80% 75% 70%
20
steel sector suffering from a chronic margin squeeze
A chronic net margin squeeze since 2003
Margins have deteriorated further since 3Q11
400
8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2%
Dec-99 Jul-99 Nov-00 Feb-99 Jun-00 May-01 Apr-02 Aug-03 Dec-04 Oct-01 Sep-02 Mar-03 Jul-04 Jun-05 Nov-05 May-06 Oct-06 Aug-07 Nov-08 Feb-04 Feb-10 Mar-11 Aug-11
300 200 100 0 -100 -200 Feb-11 Apr-11 Nov-11 Feb-12 Apr-12 Jan-11 Jan-12 Jun-11 Aug-11 Dec-11 Sep-11 Mar-12 May-11 May-12 Mar-11 Jun-12 21 Jul-11 Oct-11
Cash profit Rmb/t
Source: Mysteel, Mirae Asset Research
Structural steel demand facing headwinds

The structural steel demand driver urbanization remains a valid long-term call, but it may be interrupted in 2012, due to the central governments crackdown policies on house prices.
Long steel outpaced flat steel prices in 2011, a typical FAI-driven growth model
1500 1200 900 600 300 0 -300 Sep-07 Sep-08 Sep-06 Sep-09 Jan-06 Mar-06 Jan-07 Mar-07 Jan-08 Mar-08 Sep-10 Jan-09 Mar-09 Jan-10 Mar-10 May-07 May-06 May-08 May-09 May-10 Jan-11 Mar-11 Sep-11 May-11 Nov-07 Nov-08 Nov-09 Jan-12 Mar-12 May-12 Nov-06 Nov-10 Jul-07 Jul-08 Nov-11 Jul-06 Jul-09 Jul-10 Jul-11
Since 2011, Chinese steel demand has been driven by long steel products, which is a typical feature of the fixed asset driven growth model.
HRC and Rebar price difference (Rmb/t, incl. VAT)

22
mainly due to a weak property market in 2012

In 2012, we believe the key driver of Chinese steel demand the property market will feel the pinch of the governments crackdown on property prices on all fronts. We are already seeing some early signs of the negative impact, as indicated in the chart below.
A cooling property market does not bode well for steel consumption
60% 50% 40% 30%
y-y
20% 10% 0% -10% -20%
Mar-06 Jun-06 Sep-06 Dec-06
Mar-07 Jun-07 Sep-07 Dec-07 Mar-08
Jun-08 Sep-08 Dec-08 Mar-09
Jun-09 Sep-09 Dec-09 Mar-10 Jun-10
Sep-10 Dec-10 Mar-11 Jun-11 Sep-11
crude steel apparent consumption growth, 3mm under construction area growth, 3mm
Source: NBS, Mirae Asset Research
Dec-11 Mar-12
23
Credit growth is also questionable

From a long-term perspective, we can see that Chinas credit growth has a correlation to its steel and cement c onsumption. In 2012, as inflation remains a concern for the central government, we do not think credit growth will continue to drive steel demand.
Credit growth pattern is in line with steel consumption as well as cement consumption
35% 30% 25% 20% 15% 10% 5% 0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011E
30% 25% 20%
35% 30% 25% 20% 15% 10% 5% 0%
10% 5% 0%
y-y
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
crude steel app. Consumption growth (RHS, %) Credit growth (LHS, %)

Cement production growth (RHS, %) Credit growth (LHS, %)

2011E
y-y
24
15%
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0%
y-y
y-y
local government spending is simply not sustainable

Since 2009, spending by local governments has been the key driver of fixed asset investment in China. It has n ow reached a turning point. They now face an inevitable question: How to repay mounting debt with ever-decreasing investment returns on pet projects?
Local government the key spender for FAI projects Total local govt debt exceeded national fiscal revenue in 2011
30,000 25,000 20,000
12,000 10,000 8,000

Rmb bn
Rmb bn
15,000 10,000 5,000 0
6,000 4,000 2,000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
0 Central government fiscal revenue Local government fiscal revenue National fiscal revenue Total balance of local government debt
Central govt projects
Local govt projects
25
Chinas steel consumption to slow to 3% in 2012

We expect Chinas steel consumption will slow down further, from 8% in 2011 to 3% in 2012.
Crude steel balance in 2012
Million tonnes Crude steel capacity Crude steel output Output Changes % Utilization rate Net steel exports (crude basis) Apparent steel consumption (crude basis) Apparent consumption changes% Steel inventory change Real consumption Real consumption changes % Rebar avg. price incl Vat RMB/t HRC avg.price incl Vat RMB/t Rebar avg. ex vat US$/t HRC avg. ex vat US$/t
Source: NBS, CISA, Mysteel, Mirae Asset Research
2006 510 425 20% 83% 34 391 10% -10 401 13% 2992 3916 321 421
2007 550 495 16% 90% 54 441 13% -5 446 11% 3619 4283 407 481
2008 620 500 1% 81% 47 453 3% 2 451 1% 4691 5100 577 627
2009 680 568 14% 84% 3 565 25% 30 535 19% 3606 3712 451 464
2010 780 640 13% 82% 27 613 8% 10 603 13% 4065 4286 515 544
2011E 860 690 8% 80% 34 656 7% 5 651 8% 4650 4680 615 620
2012F 920 720 4% 78% 40 680 4% 8 672 3% 4400 4300 597 583
26
Large SOE mills are losing out to hybrid competitors

We see an emerging league of future winners. We call them hybrid players; they enjoy strong support of the local governments and have the aggressive management style of private entrepreneurs. On average, they saved Rmb234/t in cost in 2011 (compared with SOEs) by using low Fe content in iron ore.
Private steel mills reduce costs by bringing down Fe content in iron ore to 55% (2011 average)
Item Iron ore Coke Private steel mill's iron ore and coke cost per ton Iron ore Coke SOE steel mill's iron ore and coke cost per ton Difference
Note 55% Indian ore 550kg/t input due to low Fe content iron ore 62% iron ore 400kg/t input
Price (Rmb/t) Cost per ton (Rmb/t) 854 1,580 1,932 1,315 1,932 1,063 2,643 2,104 773 2,877 -234
27
Hybrid steel mills have consistently been more profitable than SOEs
There are two listed hybrid steel mills in Chinas A-share market: Jiangsu Shagang (002075 CH, NR) and Nanjing Iron & Steel (600282 CH, NR). Both exhibited excellent profitability in 2010 and 2011, compared with SOEs such as Baosteel, Angang Steel and Maanshan Iron & Steel.
Hybrid steel mills have consistently been more profitable than SOEs
Name
Ticker
M.Cap 2010 PB (US$M) (x)
Jiangsu Shagang
002075 CH
1,013
2.9
Nanjing Iron & Steel Baoshan Iron & Steel Angang Steel Maanshan Iron & Steel
600282 CH 600019 CH 000898 CH 600808 CH
1,709 13,470 5,219 2,903
1.1 0.8 0.6 0.7
Gross margin 2010 1H2011 3Q2011 Ownership % % % Hybrid of private and SOE. Shen Wenrong controls 38.8% of Shagang Group, which owns 74.88% of listco. SASAC controls 11.0% 9.1% 10.0% another 7.5% of listco Hybrid of private and SOE. Parentco Nanjing Iron and Steel United Co. (holds 83.78% of listco) is 60% held by Foson Int'l, and 40% by 8.8% 7.9% 6.2% Nanjing Iron and Steel Group (SOE) 11.9% 9.4% 5.3% SOE 7.1% 4.6% 5.8% SOE 5.3% 3.5% 3.0% SOE
28
SOE Steel mills: Nominal P/B deflated by high historic book value
Our channel checks indicate that the replacement cost of steel mills is currently only Rmb1,000/t for long steel and Rmb2,000/t for flat steel (for the full-process, from blast furnace to rolling). Angang Steels capacity is 21mt flat steel, implying a replacement cost of Rmb42bn, while its 2011YE fixed asset balance was Rmb53.5bn, which indicates a potential impairment loss of Rmb11.5bn. Maanshan Steels capacity is 15mt (8mt in flat steel, 7mt in long steel), implying replacement cost of Rmb23bn, while its 2011YE fixed asset balance was Rmb32.4bn, which indicates a Rmb9bn potential impairment loss.
SOE steel mills fixed assets are overstated, versus the leading private steel mill
Ticker
Capacity (mt) 2010 2011 3.0 15.0 25.0
Fixed asset per ton (Rmb/t) 2010 1,518 2,294 2,291 2011 1,443 2,110 2,013
Book value per ton (Rmb/t) 2010 1,278 1,867 2,214 2011
Flat/long steel
Ownership
Jiangsu Shagang Angang Steel
002075 CH 347 HK
3.0 15.0 25.0
Mixture of long steel, flat steel Hybrid of private and SOE. Shen Wenrong controls 38.8% 1,385 and special steel of Shagang Group, which owns 74.88% of listco. 1,884 Mixture of long and flat steel 2,091 Mixture of flat steel SOE. 65% owned by Maanshan Iron and Steel Group SOE. 67% owned by Anshan Iron and Steel Group
Maanshan Iron and Steel 323 HK
29
Iron ore is a step closer to being a buyers market

However, it is still too early to see a market turnaround in favor of the Chinese buyers in 2012, due to: 1. A decline in Indian iron ore exports, reducing marginal supply of iron ore to the Chinese market 2. Massive expansion in Chinas steel-making capacity 3. Easy exit from domestic iron ore production, making the marginal iron ore supply cost support rigid
Iron ore prices declined since 3Q11
Indian iron ore imports to China are declining
210 190
25% 20% 15% 10% 5% 0%

Sep-10 Sep-09 Mar-11 Sep-11 Mar-09 Mar-10 Mar-12 May-09 May-10 May-12 May-11 Nov-10 Jan-11 Nov-11 Jan-09 Nov-09 Jan-10 Jan-12 Jul-10 Jul-09 Jul-11
$/t, CFR, excl.VAT
170 150 130 110 90 70 50
2008
2009
2010
2011
Indian ore 63.5%
India iron ore imports to China as % of total China iron ore imports (%)
Source: China Customs, Mirae Asset Research 30
Iron ore spot prices are dominant in the Chinese market

After several years of painful negotiations, the global iron ore pricing system has finally moved from annual contracts to spot-based pricing. For 2H11, the average spot price was lower than the contract price; a significant game-changing sign. SOE steel mills, which used to enjoy large discounted contract prices, are losing their input advantages.
2H11s average spot price was lower than the contract price
200 180 160
$/t, FOB
140 120 100 80 60 40
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12
PB Fines spot price PB Fine contract price
31
Coking coal: Survival by being flexible Face the reality that luck is running out
Coking coal miners have to face a tough reality: A slowdown in steel production since 2H11. We predict a gradual single-digit annual price decline over 2012-13, rather than a collapse in the domestic market.
Coking coal market is under pressure of increasing supply

New supply is coming on stream from China (Shanxi), Australia and Mongolia. Integration of the domestic and Asia-Pacific seaborne markets has intensified since 2009.
Be flexible to survive the demand slowdown

The competition between local and overseas resources allows for some flexibility to be built into the cost curve, to moderately rebalance the market. We are initiating coverage on Shougang Fushan Resources with BUY and on Hidili with HOLD.
32
Metallurgical coal Major seaborne trade flows: Trade 237mt (2011)
Mongolia 16mt Canada 25mt W Europe 45mt USA 59mt India 31mt Brazil 14mt E Europe 6mt China 41mt
Russia 9mt
Japan, Korea, Taiwan 83mt
Australia 113mt
Major exporter Major importer

Source: Clarksons, Mirae Asset Research
33
2011 Chinese coking coal balance by source

(C&F prices USD/t)
Canada & USA 7.5mt Canada: 233$/t US: 180$/t China 591mt
Mongolia 16mt, 79$/t

Shanxi 240mt
Domestic supply 550mt

Rest of the country 310mt
delivered to Northern China Ports, excl. VAT)
Cash cost from main sources (C&F, Mongolia: $125/t Australia: $130/t China: $130/t
Other seaborne sources 7mt
Australia 10mt 220$/t

Coking coal main supplier Coking coal demand
34
China provides a floor for seaborne coking coal prices

- Chinese coke producers and steel mills have been flexible in adopting the best economics of raw material inputs. - We believe the competition between local and overseas resources allows for some flexibility to be built into the cost curve, to moderately rebalance the market.
Chinas domestic prices provide a floor for seaborne prices
450 400
Chinese steel mills are flexible between domestic supply and imports
40 20 0 (20) (40) (60) (80) (100) (120) (140)
Mar-09 Mar-10 Mar-11
3500 3000 2500 2000 1500 1000 500 0

Mar-12 Dec-08 Dec-09 Dec-10 Dec-11 Sep-08 Sep-09 Sep-10 Sep-11 Jun-08 Jun-09 Jun-10 Jun-11
$/t, excl. VAT
350 300 250 200 150 100
Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12
Liulin #4, spot price
Australian prime coking coal, FOB (US$/t, LHS)
Domestic coking coal price prem/(disc.) to Australia imports (LHS, US$/t) Import from Australia to China (kt, RHS)
35
Mongolian and Australian imports are growing

Increasing imports from Australia and Mongolia pressures domestic coking coal prices. Over January-April 2012, coking coal imports were up 26.7%, with incremental supply from both Australia and Mongolia.
China's coking coal import voume has increase 26.7% YTD
50 45 40 35 30 25 20 15 10 5 0 1.8 3.6 1.4 2008 2009 2010 Australia Mongolia 22.7 17.4 10.3 2011 Others 5.1 5.0 3.6 Jan-Apr 2011 7.8 4.0 15.0 20.0 6.8 5.5 5.0 Jan-Apr 2012 14.8 14.3
26.7% YoY growth
Source: NBS, Mirae Asset Research
36
Double-digit growth in Chinas domestic coking coal supply

Raw coal output from the four major coking coal producing regions in Shanxi was up 38% YoY in 2011 and 28% YoY over January-April 2012. This growth has largely outpaced Chinas crude steel output growth of 1% YTD.
Raw coal output of four major coking coal producing areas in Shanxi province
37
Stock pick: Shougang Fushan (639 HK, BUY, TP HK$ 3.0)

Fushan is our top pick among Chinas coking coal miners. We like the company for its premium coking coal quality and prime location. Its clients are concentrated in Hebei Province; the heartland of Chinas steel industry.
Fushan is located in Shanxi province with clients mainly concentrated in Hebei province
Benxi Steel, 2% Baogang Group, 3%
Others, 12%
Hebei Iron&Steel Group, 52% Shougang Group (parentco), 31%
38
Stock pick: Shougang Fushan (639 HK, BUY, TP HK$ 3.0)

Fushans margins are less volatile, due to its resilient ASP. We think Fushan is a heads you win, tails you dont lose hedge to our UNDERWEIGHT call on steel; with good steel demand, the coking coal price has more upside than the steel price; with weak demand, the coal price suffers less downside than the steel price.
Fushans ASP was resilient in 2009 and 1Q12
2012 1Q 2012 1Q YoY QoQ -1.4% -0.7% -31.7% -0.1% -3.1% -11.7%
Fushan outperforms Angang in a bull market, but seldom underperforms it in a bear market
2011 1Q Fushan ASP of washed coal Liulin #4 coking coal Australian prime hard coking coal 1,802 1,654 2,017
2011 4Q 1,778 1,695 1,561
2012 1Q 1,776 1,643 1,378
450% 350% 250% 150%
US$/t Fushan ASP YoY % Average of Liulin #4 YoY % Average of Australian prime hard coking coal YoY %
2008 198 208 300
2009 180 -9% 159 -24% 145 -52%
2010 219 22% 187 18% 221 52%
2011 233 6% 222 19% 294 33%
50% -50% -150% 2007 2008 2009 2010 2011 2012 YTD
Fushan Energy share performance Angang share performance

Source: Company data, Mirae Asset Research Source: Company data, Mirae Asset Research
39
Hidili Industry (1393 HK, Reduce, TP HK$ 2.00)

Hidilis ASP is more volatile than that of Fushan, due to location disadvantage and coal quality. Management has guided that raw coal production will increase from 4.1mt in 2011 to 10mt in 2015. We think the target is likely to be revised downwards, due to: 1) tight cash flow in 2012-13E with repayment of debt; and 2) weak coking demand during 2013-2015.
Hidilis ASP is lower than Fushans due to location disadvantage
Rmb/t Hidili ASP YoY % Fushan ASP YoY % Average of Liulin #4 YoY % 2008 1,312 1,367 1,436 2009 870 -34% 1,234 -9% 1,088 -24% 2010 1,132 30% 1,477 20% 1,483 36% 2011 1,302 15% 1,568 6% 1,675 13%
Volume increase in 2014-15 will coincide with weak prices
10 9 8 7 6
(mt)
10.0
8.0
6.0 5.0 4.1
Rmb/t (incl. VAT) Guizhou Yunnan Sichuan Average price of Guizhou, Yunnan and Sichuan Liulin #4 in Shanxi Discount %
2009 956 951 1,016 974 1,088 -10%
2010 1,237 1,132 1,333 1,234 1,483 -17%
2011 1,560 1,460 1,512 1,511 1,675 -10%
5 4 3
2011
2012E
2013E Raw coal production
2014E
2015E
Source: Company data, Mirae Asset Research Source: Company data, Mirae Asset Research
40
Hidili Industry (1393 HK, Reduce, TP HK$ 2.00)

Hidilis interest burden has been increasing rapidly over the past three years. Moreover, the companys Rmb1.7bn convertible bond is at risk of being redeemed in January 2013. Hidili will h ave no choice but to re-finance at higher interest rates (the convertible bonds interest rate is only 1.5%). The increasing financial cost will impact Hidilis net profit margin in 2013E.
Hidilis financial burden has increased rapidly
Additional interest expenses for re-financing of convertible note
Rmb m EBIT interest expense Interest coverage ratio Net Debt (net cash) Net debt/Equity
2008 1,097 32 34.3 (535) -9.1%
2009 514 56 9.2 2,287 35.6%
2010 1,036 214 4.8 4,227 59.2%
2011 1,240 309 4.0 5,492 70.3%

Interest rate on convertible note (%) Re-financing interest rate (%) Net increase of interest rate (%) Convertible note Payback amount (Rmb m) Increase of interest expense (Rmb m) Estimate 2013 EBIT (Rmb m) Impact on EBIT
2013E 1.50% 6.65% 5.15% 1,814 93 1200 8%
41
Copper: Range-bound between US$7,500/t and US$8,500/t

We reiterate our view from last October that the LME copper price would be rangebound between US$7,500 and US$8,500/t in a soft-landing scenario for China. We think the financial demand of copper imports provides a support level at US$7,0007,500. Meanwhile, we think copper prices above US$8,500/t are not sustainable, judging by the current sluggish real demand in China. We are seeing receding momentum for copper imports, as LME and SHFE arbitrage suggests a loss in Cu imports.
42
The recent copper price rally was not based on real demand
Chinas refined copper imports volume reached an historic high in December 2011. We believe the surge in copper imports was mainly driven by financing demand and improved liquidity, while the real economy was suffering from the aftershock of a severe credit crunch.
Refined copper imports posted a record high in Dec 2011
Chinas copper consumption breakdown by sector
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0
Tonne
400% 350% 300% 250% 200% 150% 100% 50% 0% -50% -100%
Jul-07 May-08 Mar-09
Consumer Durables 24%
Capital Goods 10% Power Infrastructure 17% Public Infrastructure 2% Transportation 5% Others* 17%
Jan-05
Apr-06
Dec-07
Oct-08
Nov-05
Sep-06
Feb-07
Aug-09
Nov-10
Apr-11
Jun-05
Jan-10
Jun-10
Sep-11
chg YoY %
Refined copper imports montly (LHS)
Source: China Customs, Mirae Asset
Feb-12
Construction products 25%
Source: China Customs, Mirae Asset
43
LME and SHFE arbitrage suggests a loss in Cu imports

The arbitrage between LME and SHFE copper price is only US$119/t, down from US$700/t when LME copper price was at US$8,454/t on 26 April. When copper is imported for financing purposes, such a loss is deemed a part of the cost of seeking arbitrage on interest rate differences. When the loss is too big to be affordable, it always ends with a decline in LME price, which narrows the loss.
Arbitrage window reopened partly explains Chinese buying
12,000 11,000 10,000 9,000
1,000 800 400 200 0 -200 -400 -600 -800 -1,000

Jul-05 Jul-06 Jul-08 Apr-05 Oct-05 Apr-06 Oct-06 Jan-07 Apr-07 Oct-07 Apr-08 Oct-08 Jan-09 Apr-09 Oct-09 Jan-10 Apr-10 Oct-10 Apr-11 Jul-11 Jul-07 Jul-09 Jul-10 Oct-11 Apr-12 Jan-05 Jan-06 Jan-08 Jan-11 Jan-12
USD/t
8,000 7,000 6,000 5,000 4,000 3,000
SHFE/LME arbitrage (RHS)
LME spot copper(LHS)
SHFE spot copper (LHS)
Source: Bloomberg, Mirae Asset
USD/t, incl. VAT
600
44
Appendix 1: Steel financing flow chart

Guarantee Parties
Deliver the cargo into a warehouse designated by the bank. Or directly transfer warehouse receipts to the warehouse.
Warehouses
Steel traders
Steel traders are usually well connected with warehouses. Some traders use the same batch of cargo to repeatedly get bank loans. Some inflate the value of their stocks to get a bigger bank loan.
Invest the cash in higher return projects
Collaterals
Banks
46
Appendix 2: Copper imports financing flow chart

Higher return projects Copper spot market 5. Sell the cargo in spot market and get cash. 1. Signing contracts
6. Invest in
higher return projects
Domestic importers
Overseas exporters
7. (6 ) Exporter asks for payment using L/C and shipping bills. Paying banks release payments (discount if earlier than 6 months).
4. Export er delivers cargo after verifying the L/C.
2. 15%-30% Apply for L/C. Deposit 15%-30% margin.
9., 6 , Repay issuing banks when L/C expires in 6 months.
Issuing banks
8. Paying banks deliver the remittance bill and shipping bills to issuing bank for payments.
Paying banks
47
14 12 10
18 16
2 0
16-Mar-07
8 6 4
(%)
19-Feb-08 2-Apr-08 22-May-08 4-Jul-08 15-Aug-08 6-Oct-08 19-Nov-08 8-Jan-09 24-Feb-09 8-Apr-09 21-May-09 3-Jul-09 14-Aug-09 25-Sep-09 12-Nov-09 24-Dec-09 5-Feb-10 29-Mar-10 12-May-10 25-Jun-10 6-Aug-10 17-Sep-10 4-Nov-10 16-Dec-10 10-Feb-11 23-Mar-11 11-May-11 30-Jun-11 7-Sep-11 9-Nov-11 30-Dec-11 27-Feb-12 12-Apr-12
Appendix 3: Chinas grassroots financing cost
Source: Wind, Mirae Asset
We use the discount rate of 6m bank acceptance bill as the benchmark interest rate
Annualized discount rate for 6m Bank Acceptance Bill
48
Analyst Profile
Henry Liu
Shirley Zhao
REGIONAL HEAD OF COMMODITIES RESEARCH +852 3653-8606/ 6628 1039 henry.liu@miraeasset.hk
ANALYST, METALS AND MINING +852 3653-8648/ 6928 6600 shirley.zhao@miraeasset.hk
Henry joined Mirae Asset Securities in November 2010 to head up the commodities sector. Henry has more than eight years of experience in the commodities sector, having previously worked at Macquarie Bank, McKinsey & Company, CICC, China Asset Management and Gerald Metals. His research notes and opinions on ferrous/non-ferrous metals receive excellent feedback from international conferences, clients, and the market. Henry obtained a Masters Degree in Business Administration and a Masters Degree in Commerce (International Business) from the University of New South Wales, and another Masters Degree in Commerce (Accounting) from the University of Western Sydney.
Shirley joined Mirae Asset Securities in August 2011 as an equity analyst in the metals and mining sector. Previously, she worked at Macquarie Securities for four years, focusing on China equity strategy for both H-shares and A-shares. Her research was well received by international and China domestic clients. Also, she has a solid financial and accounting background of more than two year experience with Deloitte and PricewaterhouseCoopers. She obtained her Bachelor in Economics at the Fudan University and she is a CFA charter holder.
49
Disclosure / Disclaimer
Hong Kong Compliance Disclosure The views expressed in this report accurately reflect the personal views of the analysts about the subject securities, issuer(s) or new listing applicant(s). Each Hong Kong analyst declares that neither he/she nor his/her associate serves as an officer or has any financial interests in relation to the issuer(s) or new listing applicant(s) reviewed by the analyst. None of the issuer(s) or the new listing applicant(s) reviewed or any third party has provided or agreed to provide any compensation or other benefits in connection with this report to any of the analysts of Mirae Asset Securities (HK) Limited (MASHK). MASHK Group and/or its employees may pa rticipate or invest in financing transactions with the issuer(s), referred to in this research report, perform services for or solicit investment banking business from such issuers, and/or have a principal investment positio n or effect transactions in the securities or other financial instruments thereon. MASHK confirms that it (i) does not own 1% or more aggregate financial interests of market capitalization in any of the issuer(s) or new l isting applicant(s) reviewed; (ii) has no investment banking relationship with the issuer(s) or new listing applicant(s) covered within the preceding 12 months; (iii) does not involve in market making activities in the sec urities of the covered issuer(s) or new listing applicant(s); or (iv) does not have any Individual employed by or associated with any member companies of MASHK Group serving as an officer of any issuer(s) or new listi ng applicant(s) reviewed. The aforesaid Individual means (i) any individual employed by MASHK in accordance with whose directions or instructions the analyst is accustomed or obliged to act; (ii) employed by MASH K who has influence on the subject matter or content, or the timing of distribution, of research report; or (iii) who is responsible for determining the remuneration of the analyst. This disclosure statement and above terms interpretations are made and defined pursuant to paragraph 16 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. Disclaimer This report was originally prepared and issued by MASHK and/or Mirae Asset Securities Co. Ltd. (MAS) for distribution to their professional, accredited and institutional investor customers. It is not directed to, or inte nded for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contra ry to law or regulation or which would subject MASHK and its subsidiaries and affiliates in Hong Kong (collectively MASHK Group) to any registration or licensing requirement within such jurisdictions. 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Mirae Asset Global Research

Chinas commodities in a soft-landing scenario

Mirae Asset Global Research

Chinas commodities in a soft-landing scenario

The real cost of thermal coal: An inconvenient truth

China steel value chain: Coking coal preferable to steel mills

Copper: Range-bound between US$7,500/t and US$8,500/t

2012 Bulk Commodities

Mirae Asset Global Research

Stock coverage of Mirae Commodities Research

Mirae Commodities stock coverage

Source: Mirae Asset Research Prices as of 17 June 2012

2012 Bulk Commodities

Mirae Asset Global Research

Transportation bottleneck? Think again!

Supply glut in 2013-2015

Long-term downtrend in thermal coal prices

2012 Bulk Commodities

Mirae Asset Global Research

Slowing FAI does not bode well for coal demand

FAI new construction (LHS, YoY %)

China raw coal app. Consumption (RHS, YoY %)

Source: CEIC, SXcoal, Mirae Asset Research

2012 Bulk Commodities

Mirae Asset Global Research

Slowing FAI does not bode well for coal demand

Others (individual<2%), 18%

Mining, 5% Chemicals, 7% Cement, 6%

Other Industrial Usage, 34%

Source: CEIC, Mirae Asset Research

2012 Bulk Commodities

Mirae Asset Global Research

Our base-case: 5.7% CAGR in China coal consumption

YoY 12% 12% 9%

YoY 16% 13% 9%

YoY -18% 24% 10%

4,136 4,850 5.7%

App. Coal consumption growth/GDP growth ratio

10-year average at 1.07

Source: CEIC, SXCoal, Mirae Asset Research

2012 Bulk Commodities

Mirae Asset Global Research

Chinas coastal provinces: Demand is slowing down

2012 Bulk Commodities

Mirae Asset Global Research

Huge investments in coal mining leading to a supply glut

Three Chinese coal miners have aggressive expansion plans (mt)

900 800 700 600 500 400 300

200 100 0 2010 2011 2012E 2013E 2014E 2015E

Steel making Iron ore mining

Copper mining Thermal power

Source: Wind, Mirae Asset Research

Source: Company data, Mirae Asset Research

2012 Bulk Commodities

Mirae Asset Global Research

Transportation bottleneck? Think again!

Railway bottleneck to be alleviated to some extent, but not resolved completely

66% 64% 62% 60% 58% 56% 54% 52% 50%

Raw coal production (LHS)

coal transported by rail as % of total coal output (RHS)

Source: NBS, SXCoal, Mirae Asset Research

2012 Bulk Commodities

Mirae Asset Global Research

Transportation bottleneck? Think again!