China's banking sector

Benefited from China's stable economic growth in 2011, the profits of China's banks still kept strong increase, as at the end of 3Q2011, average year-on-year growth rate of all Chinese listed banks` net profits achieved to 31.8% approximately. In this report, we mainly focus on 9 domestic listed banks in HK, and according to IFRS, accumulated net profits of 9 domestic banks increased by 36.6% yoy in average, the banks` performances were better than our previous expectation.

Due to the sharp increase of loans in the last two years, the liquidity of the banks` capital has reduced obviously, the capital pressures increase and meet huge demand of financing, representing the potential deterioration of asset quality in the future.

In all, although the effects of European debt crisis are expanding, we believe the banks` profits would continue to increase stably in the next two years under the precondition of current stable growth of China's economy, the banks` capital demand would increase and the asset quality might deteriorate. However, considering the stable prospects of banks` performance in the near future, and their current valuation locate close to the bottom peak, the stock performance were better than the most of sectors, therefore we still hold an optimistic view on the performance of domestic listed banks, and upgrade the sector to Outperform.

PRC Coal Industry

Domestic Spot coal prices continues their losing streaks after the implementation of price cap. As at 10th Jan, thermal Coal with 5800 kCal/kg at QHD priced at RMB 845-855/t.

While, as at 7th Jan, the inventory at QHD was 6.92mt, which was 555kt higher than last week.

We expect the short-term domestic spot coal prices would be stabilized due to the offsetting effects of downward pressure of domestic spot prices (resulting from plenty inventory in downstream industries) and support from regional spot prices.

The elimination of excessive capacity, cooling measures of property market and the slowing down of PRC economy would result in the lower energy demand and hence thermal coal demand in mid/ long term. Thus coal prices in mid/long term remain highly uncertain without economic stimulating measures from PRC government.

The highly uncertain spot prices would result in the relatively high uncertain on the ASP of spot price oriented coal producers, like Yanzhou Coal <1171 HK>. Therefore, it is not surprising that those contract coal oriented coal producers would trade in a relatively higher valuation, in terms of PE.

We reiterate our view that China Shenhua <1088 HK> would be would top pick in this sector.

Local Banking Sector

Hong Kong banking industry is closely related to global economy, particularly the international banks such as HSBC (0005), Standard Chartered Bank (2888) which is more likely to be affected by global economic change. However, the influence of Europe debt crisis will affect the banking industry in 2012- a tough year, mainly due to the global banking systemic risk will gradually increase.

Inefficiencies of euro zone leaders consultation mechanism, the European debt crisis will be peak in this year, we expect at least have a euro-zone countries from the euro zone. It must be a negative impact to the global banking system, triggering a chain reaction, the interbank liquidity stagnation is expected, especially in Europe and the U.S. banks bear the brunt, the impact will like a replica of the U.S. subprime mortgage crisis. Continuing debt crisis in Europe, we recommend investors to invest in local financial stocks with high dividend.

First rank is BOC Hong Kong (2388) with a unique concept of RMB business , second is Hang Seng Bank (0011) with stable dividend.

Oil market

Refined oil pricing mechanism reform is highly anticipated

According to China Securities Journal, the three SOEs may be given the flexibility to adjust prices for their refined oil products under the new pricing mechanism being considered by the NDRC. The new pricing mechanism is likely to shorten the pricing adjustment cycle to 10 days from the original 22 days. Also, the SOEs can adjust the prices if the international oil prices are within certain ranges, given that the NDRC may not issue further notices for price adjustment. According to the proposal, the three SOEs must lower the prices if premises are met; on the other hand, the SOEs may adjust prices upwards within or beyond the upper limit allowed by the NDRC when raising premises are met.

The transfer of pricing power from NDRC to the refiners will reward all three SOEs with a small refining margin. While we believe that most refiners will be able to turn around and earn a reasonable return going into 2012, Sinopec is expected to benefit the most from this policy change.

It's all about the growth: gasoline, ethylene, and diesel

China has surpassed the US to become the largest energy products consumer in the world. While the Chinese per capita energy demand jumped 50% in the past 10 years, it still is only 1/16th of that of the US. Being one of the fastest growing emerging countries with a 1.5 billion-population base, China's demand for oil and oil products are mainly driven by income growth and living standard improvement rather than the global oil prices. According to Barclays forecast, China's GDP growth in the following four years will average at 8.5. China's energy demand, on the other hand, will increase to at least 12.0mb/d by 2015 based on our estimates.

Natural gas

The National Development and Reform Commission (NDRC) announced on December 27, 2011 the launch of natural gas pricing reform in Guangdong Province and Guangxi Zhuang autonomous region. Price caps for Guangdong and Guangxi are set at RMB2740/m3 and RMB2570/m3, respectively, while trading prices can be negotiated between buyers and sellers. The new scheme is aimed to steer toward a more market-driven pricing mechanism from the current government-guided pricing mechanism, which is tightly linked with the ex-factory prices. At the first stage, the government will adjust the price caps on a yearly basis, and the adjustment frequency will move toward every six months and eventually to a quarterly basis. As for unconventional gases, the ex-factory prices for shale gas, coal gas and coal-bed gas will be market based. Unconventional gases are currently trading well above the traditional natural gas, thus hurting their competitiveness. We believe the demand for unconventional gases will start to pick up as the price gap narrows.

Despite the price adjustments last May (the third time since 2005), natural gas prices still failed to reflect the scarcity of resources and the balance between market demand and supply. The more market-oriented pricing mechanism will greatly benefit the three oil and gas SOEs, namely PetroChina, Sinopec, and CNOOC. We believe that PetroChina, owning 70% of the total domestic natural gas production, will enjoy the new scheme dominantly.

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