THIS YEAR’S CHINESE TAKEAWAY

24 March, 2017

In 2016 Australian coal and iron ore miners enjoyed a jump in commodity prices thanks to capacity closures mandated by the Chinese government. Prices have since pulled back from their peaks, and companies such as BHP and Fortescue have warned that the current level of prices cannot be sustained. We provide an overview of why the Chinese government has been shutting down coal-fired power stations, and explain why commodity prices will fall back again.

Ever since the Communist Party took over in 1949, China’s economic planners have favoured the growth of heavy industries. Nowhere is this trend more obvious than in China’s enthusiastic construction of coal-fired power stations. As the chart below shows, by end-2015 China had more generating capacity than the USA, even though the USA’s GDP is 50% larger than China’s.

Not surprisingly, China has far more generating capacity than it can use in the near future, especially as growth rates in GDP and electricity demand have been slowing down. As a consequence, capacity utilization rates have been falling in recent years, and some generating capacity has been voluntarily shut down. In 2016 the utilization rate fell to 47.5%, its lowest level since 1964.

The particular problem with coal-fired power stations – unlike generators which use natural gas – is that they contribute to air pollution, which is an increasingly hot topic for the Chinese public. Coal accounts for two-thirds of China’s total energy consumption, whereas it makes up only 20% or so in developed countries such as the USA  and Germany. Therefore the Chinese government has been trying to selectively shut down coal-fired power stations, at the same time as it keeps on building gas-fired, hydro, solar, wind and nuclear power stations. By 2020 it is forecast that coal will account for only 55% of the country’s total energy consumption.

The government is also eager to upgrade existing coal-fired power stations so that they are more efficient and less polluting. By 2020 (the end of the current Five Year Plan), the electricity grid will include spot electricity markets to encourage competition between generators.

It is clear that the Chinese government wants to bring about a net reduction in the country’s use of thermal coal in the long run. This is obviously bad news for Australian coal exports.

The over-capacity in China’s power generation industry is symptomatic of the over-capacity in most of China’s heavy industries. The planners’ longstanding bias in favour of heavy industries was reinforced by a decade of rapid growth from 2001, followed by the effects of the RMB 4 trillion stimulus package of November 2008. By 2012 China was producing 46% of the world’s steel, 45% of its aluminium, and nearly 60% of its cement.

When the economy was growing at 10% pa or more, it seemed self-evident that China would eventually use all the industrial capacity that it could build. Rapid construction also fitted the political imperatives in the Chinese system. Building a steel mill or an aluminium smelter or a cement plant helped the local government meet its GDP growth targets. From the local authorities’ point of view, once these projects were operating, they also functioned as sources of jobs, taxes, and bribes.

After 2012, when GDP growth rates slowed and commodity prices fell, however, these heavy industry projects turned into problems. They began to lose money, so that instead of paying taxes, they needed subsidies to keep them operating. Most projects had been funded by debt, so they began to default on their loans. The coal and steel industries have caused the majority of China’s loan defaults in the last two years.

Faced with gross over-capacity, mounting losses, and a pile of bad loans, the central government took action. The 13th Five Year Plan (covering the years 2016 to 2020) set targets for capacity reduction in each over-supplied sector. Because the government also wanted to reduce air pollution and improve workers’ safety, it selectively shut down hundreds of smaller, dirtier producers in each sector. As a result, in 2016 steel capacity fell by 65 million tonnes per annum (mtpa) and coal capacity fell by 290 mtpa, according to official figures. The intention was that any excess demand that appeared would be taken up by the larger, more efficient – and State owned – producers in each sector.

The unintended consequence was that shortages appeared in coal and steel, driving up the prices of inputs as well as outputs. Coal-fired power generators saw their profits collapse in 2016, and most of them are facing losses in 2017. Low inventories and long production lags in China meant that shortages of thermal coal, coking coal and iron ore were filled by imports, to the benefit of producers such as BHP, Rio and Fortescue.

In response, the Chinese government has halved its 2017 target for coal closures to 150 mtpa, and it has left the timing and size of closures in the hands of local governments. In view of the benefits which coal mines can provide to local governments, this is tantamount to putting the fox in charge of the henhouse. Not surprisingly, domestic coal production has begun to rise again – more bad news for Australian coal producers.

Investors need to understand that capacity closures are a tap that can be turned on or off at the whim of the Chinese government. In short, last year’s commodity price rises were caused by artificial restrictions on supply, not by economic forces such as excess demand.

Current prices for coal and iron ore are the result of a miscalculation by China’s planners, whose objective is to close down unsafe and polluting producers and transfer their production to larger, more efficient state-owned companies. The planners still intend to close 50mtpa of steel-making capacity in 2017, and probably the same next year. Making Australian exporters more profitable is not among the planners’ objectives.

The main Australian producers have warned their shareholders that current levels of commodity prices are not sustainable in long term. We agree – which is why we suggest that investors treat resource companies very carefully, because current levels of profitability are unlikely to persist for long.

Q.E.D.

 

Sources: The Wall Street Journal