RAW ENERGY
Tracking coal from China’s mines to its coast becomes a journey of economics, politics, and brute competition.
By Tom Leander and Yang Jian

South of Baotou, Inner Mongolia. The rolling desert grassland has a hypnotic effect on motorists, which can be dangerous because highways sometimes end without warning. Going 60 miles per hour, the sedan driver jams the brakes as the southbound lane becomes an unpaved byway. Unfazed, Ling Wen, CFO of China Shenhua Energy, hops out and begins lifting metal struts off the road, but the driver suggests taking their chances on the completed northbound lane instead.

Soon the long, thin defile of the Wulanmulun River, as it winds down from Mongolia into Shaanxi province, comes into view. In this quiet, dusty valley are 12 mines that make up the Shendong mining group, Shenhua’s most productive coal mines out of its coterie of 21. Shendong is the heart of the company’s operations, and the point from which Shenhua’s trains – on the company’s own rail line – rumble out of the valley toward power facilities along China’s coast and to ports for export. “It’s our home,” Ling says.

It’s also the start of his journey from the source of the coal to the coast, a kind of hands-on inspection that he does several times a year. These trips have taken on a new significance as Ling, 42, becomes the eyes and ears of shareholders, not just of management and the state. Ling was hired from a senior post at the Industrial and Commercial Bank of China (Asia) to take the best assets of state-owned Shenhua Group, born in 1995, and organize them into a public-company operation. Shenhua Energy successfully completed a US$2.95 bn IPO in Hong Kong in June, the largest Chinese listing this year after China Construction Bank, and the fourth-largest mainland IPO ever.

With revenues last year of 39 bn renminbi, Shenhua is expected to grow turnover to 47 bn renminbi this year. Deutsche Bank projects that revenues will reach 66 bn renminbi in 2007. “As the largest coal miner in China with a fast growing power business,” writes Christine Pu, analyst for Deutsche Bank in Shanghai, “we expect Shenhua to be a direct beneficiary of China’s sustained economic growth.”

Can Ling deliver? Like PetroChina in oil, Shenhua Energy was given a mandate and a lot of government help on the understanding that it would be a showcase in an industry essential to China’s future. But government favor has not erased the liabilities that face it. And Shenhua has bet its future on a costly model of integrated operations, owning rails, ports, and power stations. It is cash rich, with 7.2 bn renminbi of liquid assets at year-end 2004. That hoard is expected to grow to 9.8 bn renminbi this year. Yet the company also has a debt-to-capitalization ratio of 51% because of its asset heavy base, against an industry average of 35%.

Given long-term expectations of softening coal prices, Shenhua will have to match world benchmark levels of productivity to meet its growth targets. It will also have to reinvest using higher cost capital given rising interest rates. More crucial, it must win battles at home to achieve its goals. Foreign companies have made inroads and will increase their presence. But the real competitors are the national railway and local governments, constituencies whose leaders are trying to shape their own futures as the central government loosens its control over the economy.

No wonder Ling spends a lot of time at the mines. “Our model, unique in China, demands that we achieve and maintain a world-class level of productivity from all our assets,” he says, adding: “The best way to know that we’re as competitive as we’d like to be is to see it for myself.”

The Black Stuff

China has the world’s largest reserves of coal. To a lucky enterprise – perhaps Shenhua, perhaps a competitor, and perhaps a foreign buyer – these reserves will provide the key to becoming the planet’s largest coal company. “That’s my ambition,” says Ling, simply. Yet China’s coal industry is in the middle of a political maelstrom, as the central government struggles to shut down 7,000 of the country’s estimated 24,000 coal mines because of appalling conditions that led to 6,027 deaths in 2004 from methane explosions and other mishaps. New, private mines had proliferated due to the tremendous demand for coal to burn to satisfy China’s enormous power demands.

Shenhua Energy’s IPO was priced at HK$7.50 (US$0.96) per share, near the bottom of its proposed range of HK$7.25 to HK$9.25. Analysts attributed the tepid response to investor fears that coal prices had peaked in the PRC for the near future. This prospect could take the momentum out of Shenhua’s ambitious growth plans. Deutsche Bank – one of the lead managers on the IPO – downgraded the stock to a ‘hold’ from a ‘buy’ in August, based on the softening of coal prices. But opinions on this have been mixed. JPMorgan analysts held its ‘overweight’ classification on the stock based on a visit to the mines in early September.

No one has criticized the operational efficiency or financial soundness of the company. “They have the benefit of having access to all these technologies and different resources,” says JPMorgan’s power analyst, Edmond Lee. “It is true in terms of hardware, labor, and productivity, they are way ahead of domestic competitors, even internationally as well.” Shenhua also enjoys the backing of Beijing. “Without the central government’s support, Shenhua would not have been able to consolidate coal mining assets across provinces,” says Shen Shi, a coal analyst at Guotai J&A Securities, a leading securities firm in China.

Ling’s presence at the tiller gives investors a measure of reassurance. At his previous post at ICBC, he was given the mandate of reorganizing the credit control system. Since bad lending practices have been the bane of China’s banking system, the job was a high profile one. His reorganization was tantamount to a restructuring of power within the banks, introducing a greater degree of centralization of decision-making, and direct accountability. For his efforts, Ling won a National Labor Hero award in 2000. This accolade drew the attention of the State Council committee formed to hire key personnel to prepare for the Shenhua listing. (Among the committee members was Anthony Neoh, the former Chairman of Hong Kong’s Securities and Futures Commission). Ling made the cut out of 127 applicants.

He plunged into the assignment, colleagues say, with genuine zeal, despite not knowing the world of coal first hand. The financial reorganization took two years and countless visits to the mines. At the time, Ling recalls, the level of financial knowledge in the company was uneven at best. His solution was essentially to throw the doors open to everyone on the basis of merit. Even now, he’s planning to institutionalize this process by requiring all finance staff to take exams in accounting and finance overseen independently by KPMG, the accounting firm. Qualifiers have a strong chance to get promoted to higher positions in finance. “This promotes meritocracy,” he says, “and this is quite unusual in state-owned companies. Workers will feel confident to have a career if they are capable, instead of depending on relationships with their bosses.”

The methods, reorganization, and productivity won admirers from far outside China. Jeffrey R Immelt, the CEO of General Electric, the US industrial giant, met with Ling during a recent visit to China for informal talks about coal and the nation’s economy. John Thain, CEO of the New York Stock Exchange, on a visit to China to seek PRC listings on New York’s big board, pursued meetings with Shenhua Energy. Ling stayed off the NYSE because of the cost in time and money for compliance with US regulatory rules.

“His background is not in coal or state-owned companies,” says Zhang Qing, a senior manager at PricewaterhouseCoopers in Beijing. “But they hired him to fully understand what the company is going to be, not a state-owned enterprise but a player in the international capital markets as a shareholding enterprise.” Qing, who was in charge of recommending new accounting systems for the company as it got ready for a listing, adds: “Therefore, he was breaking new ground. But that was okay – he’s a smart guy and an enthusiast about coal.”

Down the Mine

To see Ling in action is to understand that a CFO of a major coal company in China must combine the aplomb of a global banker with the bonhomie of a cadre leader. Ling has close-cropped gray hair, a broad smile, and a distance runner’s leanness. He easily tosses off his wingtips for miner’s boots. Donning a blue miner’s suit and orange helmet and lamp at the Shendong dressing station, Ling greets the director of the mines, Wang An, a short, robust man with broad shoulders. Wang leads the way to an SUV, specially fitted out, he explains, so that sparks will not fly and ignite gases in the mine.

Generations of movies have shown ramshackle elevators descending into mines, but Wang explains that all the mines drilled into the soft hillsides along the Wulanmulun are drive-ins. The tunnels seem to go on forever in the murk, winding downward. After 20 minutes, Ling and Wang park near a tunnel intersection where a conveyor whisks chunks of coal at 30 miles per hour into an adjoining shaft, delivering it to daylight and the beginning of its journey to the coast. Further down the tunnel, the men turn a corner to approach the long wall, where a science-fiction environment emerges from the dark.

Giant struts, like broad metal fingers, support a ceiling. A long continuous exposed seam of coal extends into the distance, more than 300 meters. A big, preposterous looking machine with rotating blades literally chews the coal off the coalface, coal shards flying onto the conveyer. The miners break into broad smiles when Ling surprises them and shouts questions over the din.

At any given time, only seven people are in the roar and the dark (with a total of 270 workers to support this particular mine complex). This is a sign of progress, not privation. Shenhua’s productivity levels resemble those of the world’s top mining companies. “Production of metric tonnage for every mine site employee per year was 28,000,” Wang says, with the zeal of someone recounting an Olympic victory. “In the United States, it’s only 10,000. So it’s more than double the US.”

In a nation famous for cheap labor, the spare employee levels seem anomalous. In fact, the productivity is due to a blessing of geology – conditions for long-wall mining are relatively rare, but, when found, are often the most efficient because they allow highly mechanized continuous cutting of the rock over a long distance.

The Shendong area is also blessed with higher quality coal than at many other mines in China. The coal from Shendong, and many of Shenhua’s other mines, has a relatively high calorific value, and is lower in sulfur and ash content than other types of coal. Power plants in China cannot get enough of Shenhua’s coal ever since the government slapped discharge fees on their pollution-causing emissions. Shenhua’s higher grade coal is also desired by energy-hungry economies such as Japan, Taiwan, and India.

Safety First

Back at the changing station near the mine entrance, a digital sign scrolled in bright red shows production targets set out for each of the miners in the operation, as well as other metrics, including a record of fatalities for the year (so far zero).

Ling has challenged the Shenhua miners to zero fatalities in the calendar year – and everyone is keeping their fingers crossed. It would be a first in this nation that holds the world’s records in this grim category. For every million metric tonne of coal produced in China, according to government statistics, the national average is three fatalities. For the first half of the year, Shenhua has produced 60 million metric tonnes without a death.

Safety standards in private mines in China have been shocking in recent years. Those 6,027 China mining deaths last year compare to only 28 in the US. Coal mining deaths in China have been running about level this year, with several catastrophic accidents grabbing headlines, such as an explosion that killed 203 people in Sunjiawan mine in Liaoning province in February. The magnitude of these accidents caused the China State Council, the body that ultimately regulates mining safety, to announce a broad crackdown in July. The generally accepted cause of the appalling conditions in China’s mining industry is that local officials own illegal shares in the enterprises – usually handed over as bribes to allow the mines to operate in the first place, and out of sight of inspection.

“The government now has a standard in terms of the safety,” explains Ling, “and the standard includes environmental issues as well as recovery rate. If a coal mine cannot meet the requirements, then it must be closed down.” He adds: “This will restrict the coal supply, because currently, smaller mines represent more than 30% of the whole coal production volume.”

The government crackdown will save lives; it will also stabilize the coal supply. According to JPMorgan analyst Feng Zhang, a likely result is reduced growth in coal output. In August, since the crackdown began, the growth rate of raw coal production hovered at 5.7%, down from the 8.8% monthly average for the first half of the year. With less coal available for the spot market, analysts see the price of spot coal rising and increasing the demand for contract coal, particularly on the east coast, where coal prices are typically higher. This trend may well redress investor skittishness about soft coal prices since the launch of the IPO. Shenhua Energy’s stock was HK$8.95 at presstime, down from its peak of HK$9.20 in early August.

All Aboard

As with other essential commodities, coal is about so many things more than coal. The brutal economics of getting the stuff to market defines a company’s success. The greatest advantage that the State Council conferred on Shenhua at its birth was the right to build its own railway. Today it covers 1,300 kilometers, running from Baotou to Huanghua Port in Hebei Province. With other coal mines queuing up for their opportunity to use the national railway system, the only transportation option for them, Shenhua has an easy way out, that is, to transport all its coal output to its power plants and port by its own railway line. It also sets Shenhua Energy up for a future advantage in any acquisition battle. With its own rail system it will be a natural choice for government grants of new reserves – and for foreign partnerships.

Waiting at the rail depot is the head of railway system, Zhang Jian, a supervisor who eschews his desk job once a month to ride the locomotive to the coast. Shenhua’s trains pull a maximum of 66 cars holding 4,000 metric tonnes each, to a rail depot at Shenchinan, and onward to the company’s new port facility south of Beijing. Zhang wants to be sure that sections of track and schedules are maintained. He and Ling scramble up the ladder of the locomotive and take a seat on a metal bench behind its conductors. The whistle blows and the train lurches forward. The first leg of the trip – a four-hour journey of about 270 kilometers – is uphill on a slight grade, which slows the train to 50 kilometers per hour. The landscape turns barren, with little grass, high cliffs, and yawning gullies. Truck-loading docks for private coal mines can be seen everywhere. Private coal mining makes up a large part of the income of Shaanxi province, where there is little arable land. Empty trains whisk past in tunnels, with coal dust blown from their surfaces, making the tunnels look as if they’re exhaling smoke.

Without the need to apply to the national railways for car space and track time, Shenhua Energy can run coal trains to the coast on a continuous basis for 24 hours. This advantage has pitted the company against the national railway system more than once. The national system runs far less efficient coal trains. “At Shenhua, our cost for transportation of every metric tonne for every kilometer is only 0.05 renminbi,” says Ling. Figures for the national railway are about twice as high. Yet the national railway keeps more people employed, albeit in less efficient operations, a powerful argument when approaching the government for the rights to lay track on new transportation routes. Why allow Shenhua Energy to monopolize the industry, given that it is partly funded by investors outside China? But Ling has reversed this argument successfully, he says. State-owned companies must show concern for minority investor rights to gain credibility.

By the time the train crosses the Yellow River, the mud houses of the hillsides give way to small, smoky towns. At the rail switch point at Shenchinan, Ling and Zhang tour a highly computerized central rail control station. They are met with great pomp by saluting police officers – like Shendong, this is a company town. The party leaves the coal train and climbs onto a sleeper car drawn by a locomotive, and the journey continues into Hebei province.

Close to midnight, the train stops at Dingzhou to visit Guohua-Dingzhou power station, owned 40.5% by Shenhua Energy, with another 40.5% owned by the provincial government of Hebei. Over merely six years, Shenhua has built a sizeable presence in the power generation sector. It currently controls and operates eight coal-fired power plants with a total installed capacity of 5,960 MW. Two more coal-fired plants and one gas-fueled facility are under construction.

Two factors prompted Shenhua to step into the power sector, says Ling. One is the attraction of profitability. Thanks to shortages, the power sector is one of the least deregulated industries in China’s economy and has been enjoying high profit margins for decades. The other is rather simple: Shenhua had no other choice.

In the late 1990s, there was an oversupply of coal on the domestic market. “It was difficult to sell coal at that time,” he says. Eventually, the company decided to sell coal to itself, that is, to build its own coal-fired power plants.

That decision turned out to be a wise one. When coal supply tightened in 2003, most power plants faced sourcing difficulties. Not Shenhua’s eight plants. “Now our coal has a stable market and our power plants have a stable coal supply,” Ling notes.

Ling believes that Shenhua has already outperformed China’s five independent power producers (IPPs) in terms of efficiency. However, Edmond Lee of JPMorgan begs to differ slightly. “Compared with the coal sector, the discrepancy between Shenhua’s power plants and its domestic competitors is narrower,” he notes, “but some of the listed power plants of the IPPs are also highly efficient and profitable.”

In the morning, the trains have reached the sea. Shenhua’s port in Huanghua is built on a long causeway of landfill, extending out into the bay. After rumbling all night, the train is silent and still. Ling and Zhang are met at the terminus by Hao Zhong, the manager of Huanghua port. It’s another round of visits to the final loading area for Shenhua’s coal for export. They drive past giant machines on rail tracks that scoop and mix the coal to specifications for certain types of burning. Coal lies in small hills everywhere. Beyond is a long berth where a coal ship is being loaded by ubiquitous conveyor.

Shenhua’s export business is expected to grow from 3.5% this year, level with last year due to tight government control of exports in this sector. But access to a deepwater port has been a nettling problem to Ling. Huanghua, the company’s sole port, can accommodate only medium draw ships. The company had been refused better options along the coast by the Hebei provincial government, which favored the site because it is pushing to develop the economy of Huanghua. The site is far from ideal. Shenhua is constantly dredging, and had to build a long sea wall to ensure that the channel would remain open.

Due to be finished by 2007 is a three-berth loading facility in Tianjin, southeast of Beijing, a full deepwater port, with an export capacity of 35m metric tonnes a year. Shenhua Energy plans to build a rail link covering the 67 kilometers between Huanghua and Tianjin. Still negotiating for land rights to lay the track, Ling says he’s confident that he will be able to overcome local concerns.

Obviously, being a showcase company doesn’t mean a silver spoon. But if the cost base stays low enough, Shenhua will start to acquire outside of China much in the way CNOOC is attempting in the oil business. Ling says that he is actively looking overseas at several acquisition prospects, but would not comment further.

And there’s a lot to do in China where things are changing rapidly. “You’ll notice,” says Ling, “that the journey we’ve taken is from west to east. Most coal traffic now travels in this direction. That’s because in China most development is in the east. But it won’t be like that forever. Someday soon, we’ll be loading minerals and supplies on our trains instead of sending them back empty. We’ll be serving new markets there.” He adds: “There’s plenty of growth to look forward to in China.”