U.S. Coal and Steel Companies: Be Careful What You Wish For

It can be hard to comprehend the impact that four days can have on global markets. When that four day stretch involves China's Third Plenary Session, though, all bets are thrown out the window. The Third Plenary Session of China's Central Committee in 1978 was the defining moment when the country plotted a course toward a more market driven economy, and it cemented China's rapid growth to become the world's second largest economy in less than 40 years.

This year, China's Central Committee has laid out its new vision for the country, including one detail that U.S. steel and coal manufacturers Nucor (NYSE: NUE  ) and Peabody Energy (NYSE: BTU  ) have been hoping for: a plan to scale back the Chinese production capacity flooding the market with uneconomical products. Let's take a look at what the new Chinese government has in store and how it could impact steel and coal companies. 

Chinese Politics 101

For many Americans, the idea of the Third Plenary session is a bit foreign. This meeting is a four day retreat of the 200 or so most senior members of the Communist Party at the beginning of each new President's term to lay out policy for the next several years. Many people who follow China closely were very excited by this plenary session for two major reasons:

  • In 2012, the Chinese economy saw its slowest growth rate in almost a quarter century, with GDP growth of about 7.8%. Even though we would probably all jump for joy if we saw 7.8% growth in a year in the U.S., China has only seen GDP growth below 8% twice since 1991.
  • Many analysts believe that the new president of China, Xi Jinping, has the ability to enact meaningful reforms, as Deng Xiaoping did in 1978.

One of the largest challenges for China is how to deal with the major state-owned enterprises. Combined, these entities have assets totaling $7.35 trillion. While much of the growth in China can be attributed to these industry giants, they have slowly become less efficient, and many believe they hold massive amounts of overcapacity in various industries.

Two industries that have suffered greatly from the oversupply from state-owned enterprises are coal and steel. During a recent conference call, Arch Coal (NYSE: ACI  ) CEO John Eaves stated that the global coal market is oversupplied by about 15 million tons per year, and a majority of that is from inefficient Chinese coal mines. Peabody Energy CEO Greg Boyce has also gone on record saying the same things. He recently stated that 40% of the metallurgical coal produced in Shanxi province -- the major coal region of China -- is out of the money, but still producing. 

In other industries, such as steel, some companies are even making the case that these Chinese state-owned enterprises are illegally dumping excess capacity on the market. Nucor, a low-cost steel manufacturer here in the U.S., estimates Chinese steel has over 300 million tons of excess production capacity, and has been lobbying hard to see some reforms to address the issue with dumping. 

Be careful what you wish for

One of the major reforms linked to the recent Third Plenary Session is a new allowance for private ownership of state-owned enterprises. According to China's director of enterprise reform, the government is looking to open up 10%-15% of these companies' equity to private investment, through either investment firms or the establishment of a holding company that would be traded on the open market

For companies like Arch, Peabody, and Nucor, the recent decision to increase private ownership of state-owned enterprises may seem like a blessing, but at the same time it could actually make life much harder for them further down the road. The addition of private ownership in these state-owned enterprises would put a much greater focus on efficient operation, which could potentially lead to the shuttering of some of these inefficient coal mines and steel plants. At the same time, striving for even more efficient operations could also drive down operational costs, which would make them more competitive with U.S. coal and steel manufacturers. Since China still has some major cost advantages, including cheap labor and access to cheap financing through the government, this could be a major long term threat to manufacturers outside China. 

What a Fool believes

This Third Plenary Session could have the potential to reshape China, as some of the previous ones have over the years. The notes from this recent session were rather vauge, which leaves lots of room for interpretation over the next few years as the government enacts new policy. If China were to enact some major reform to its state-owned enterprises, it could mean some temporary relief for many industries that have suffered from China oversupplying the market. Based on the meteoric rise of China over the past few decades, though, don't be surprised if these companies emerge stronger afterwards. 

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