Chinese Coal, Global Tremors

The Shenhua-Guodian deal may spawn a global trader in the mold of Glencore or Trafigura.
Photograph: China Photos/Getty Images
At Closing, February 23rd
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It's tempting to view a merger between giant state-owned Chinese companies as a strictly internal affair. But make no mistake: The combination of the country's largest coal miner with one of its top five power generators will have ramifications around the world.

To see why, it's worth looking at how the integration with electricity producer China Guodian Corp. will change miner Shenhua Group Corp.

Shenhua's size and reach give it a crucial position in China's internal power market. It sold almost 400 million metric tons of coal last year, equivalent to about two-thirds of the amount used in power generation in the U.S.  It owns a rail network that could reach from New York to Miami, stretching from the Mongolian border, through the Shaanxi coal belt, to Huanghua port on the Yellow Sea.

Profit Generation

Shenhua is a far stronger player than Guodian, judging by its operating margin

Source: Bloomberg

It's clearly the stronger of the two companies: Net margins at listed unit China Shenhua Energy Co. dipped below 10 percent just once over the past decade, coinciding with the only occasion when Guodian's margins edged above 2 percent.

Shenhua's influence in setting China's domestic coal prices is so great that it's often been the target of ire from generators, which regard it as profiteering at their expense. Looking at the gap between what it costs Shenhua to produce coal and the amount it makes from selling the stuff, the power stations seem to have a point.

Cheap at the Price

The prices Shenhua gets for its coal are consistently below what Guodian pays

Source: Company reports, bond prospectuses

The merged company, to be called Guoneng Investment Group, could make surprisingly dramatic changes to this picture.

At present, Shenhua sells overwhelmingly to external customers. Production from its own mines comes in at around 300 million tons a year and a further 100 million tons is purchased from other companies. Of that total, some 85 million tons is then burned in Shenhua's power stations, with the balance sold on the open market.

Charity Begins at Home

Shenhua mainly sells coal to external customers. After its merger with Guodian, it will sell mainly to internal customers

Source: Company reports, bond prospectuses, Gadfly calculations

Note: mtpa = million metric tons per annum.

Add Guodian's coal demand and that changes dramatically. The 200 million tons that Guodian's power stations consume, added to the 85 million tons burned in Shenhua's own furnaces, would be sufficient to swallow up almost every ton that the combined company produces from its own pits.

Over the past decade, miners and generators have been set up to compete with each other, and Shenhua has always sought the best price for its product. That's about to change: As Guoneng, its largest customer will be its own power stations. The best way to increase group margins will be to sell to its generators at something close to cost prices, and then focus the group's entrepreneurial energies on the trading business.

Pit to Port

Higher-quality Chinese coal used to cost more inland than at coastal harbors. That's reversed

Source: Bloomberg

There's a risk to the global coal trade from such a shift. Domestic Chinese coal is generally lower in quality than what's available in the seaborne market, but not universally so. Shenhua's Shendong complex, its biggest coal asset, has a heating value of about 5,400 kilocalories per kilogram, in line with benchmark seaborne grades of 5,500 kcal/kg. A Guoneng that's diverting more lower-quality product to its own generators may look to sell the better stuff to domestic and international customers.

That risks reversing a trend that's held over most of the past decade, during which China has been a net importer of the black stuff. Major coal miners already seem to be moving to upgrade their product quality above the 5,500 kcal/kg benchmark. Glencore Plc's planned purchase of a stake in some of Yancoal Australia Ltd.'s mines north of Sydney will give it hundreds of millions of tons north of 6,500 kcal/kg, while the planned sale of its Rolleston pit would remove about 235 million tons of reserves that average 5,600 kcal/kg

Guoneng's best prospects for generating profits over and above what's permitted in the regulated utility business will involve giving its trading arm free rein to be a player on local and international energy markets. That means the interest in China creating the world's biggest electricity generator may be missing the point.

This deal doesn't just create a new Electricite de France SA. Should Shenhua's trading arm be taken off the leash, it may create a new Vitol Group, Trafigura Group Pte, or Glencore as well.

Peter Grauer, the chairman of Bloomberg LP, the parent of Bloomberg News, is a senior independent non-executive director at Glencore.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    David Fickling in Sydney at

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