Investment Theme COAL. Coal prices to stay high. Asset Class: Commodity. UBS Wealth Management Research / 03 June 2008

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1 ab Investment Theme Coal prices to stay high UBS Wealth Management Research / 3 June 28 Analyst UBS AG Dominic Schnider Co-Analyst UBS AG Si Min, Yuen COAL At a glance Rising energy demand from developing countries has pushed oil prices to historic levels. After oil, coal is the next largest source of primary energy. Demand for coal is underpinned by increasing power needs of developing countries and rising steel production. While there are ample coal reserves worldwide, supply is constrained by infrastructural bottlenecks, which should continue to plague the coal market. Given these fundamentals, we expect coal prices to rise gradually. Coal prices continued their upward trend since our last report. Coal consumption growth is mainly influenced by demand from China and India, which tends to be inelastic as both countries are highly reliant on coal for electricity generation. The seaborne market should tighten as domestic coal production is no longer sufficient for China and India. Robust steel production should reinforce demand for coking coal. Supply remains constrained due to infrastructural bottlenecks and recent short-term supply disruptions. Coal benefits from structurally higher oil prices as a cheaper, but more emission intensive, alternative. Given our energy outlook, we believe there is potential for a 1-15% increase in coal prices in the next months. Investors can gain exposure to coal via structured products, equity positions in coal-related companies, or an ETF on coal companies. Coal prices continue to trend upward Since our last investment call on coal, steam coal futures prices in the US have exceeded our expectations, increasing by 3% and breaching the USD 11/ton mark. Although spot prices for Australian and South African coal have shaved off slightly, they remain on track with their upward trend. Likewise, coking coal prices have witnessed a phenomenal jump till now in 28. New negotiations for coal supply between miners and steel producers during the second quarter of this year saw prices increasing by 35%, averaging USD 35/ton in Australia. This exceeds our estimation of a 1% increase in our last report (see Fig. 1). While coal surged ahead of crude earlier this year, the pace has now slackened (Fig. 2). Coal had previously traded at a ratio of 1.6x of oil. However, these peaks were rarely sustainable. Currently, coal to oil spot prices are approaching parity, as oil prices managed to rise substantially. As we expect crude oil prices to consolidate towards USD 15/barrel in 9-12 months, this caps the upside potential of coal. Investors should keep in mind that as there is very low correlation between coal and oil prices, consolidation in oil prices is unlikely to create a drag on coal prices (see Fig. 3). Moreover, the structural story for coal remains fundamentally strong. We believe the price momentum should stay slow but expect coal to trade again at a higher ratio versus oil. We expect coal prices to rise by 1-15% in the next months. Asset Class: Commodity Fig. 1: Coal prices continue on an upward trend Steam coal spot prices and generic coal futures (USD/ton) Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 Newcastle (AU) Coal Spot FOB Generic coal futures Richards Bay (SA) Coal Spot FOB Fig. 2: Acceleration of coal spot prices has slowed Newcastle spot prices relative to WTI crude spot prices Coal spot/ WTI spot Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication. This report has been prepared by UBS AG. Please see important disclaimer and disclosures at the end of the document.

2 Coal markets Coal markets are highly heterogeneous. Supplies are found all over the world, but quality varies in terms of heat, sulfur and ash content. Consequently, spot prices of coal can differ significantly. According to the World Coal Institute, international trade of coal accounts for only 16% of coal produced. This can be attributed to the high transportation costs, which sometimes account for 7% of the total delivered cost of coal 1. The largest exporters are Australia, Indonesia, Russia, China and South Africa, while the largest importers are Japan, Korea and Taiwan. However, accelerating energy demand has led to greater activity in seaborne trade and we expect this trend to continue. Coal versus Crude Both coal and crude oil are primary sources of energy: crude oil constitutes about 4% of world fuel consumption, while coal accounts for about 3%. Of late, rising oil prices and concerns about energy security have shifted attention to coal as an alternative source of energy. In Europe alone, 5 coal fired plants are expected to begin operations in the next five years. For instance, Italy is expected to increase its reliance on coal from 14% to 33% 2 ; in Japan, the world's largest coal importer, high coal prices have put the high-cost mines in business again. Although, both coal and oil are often perceived as energy substitutes to each other, we believe the substitution effects are relatively low in the short run (2-3 years). This stems from several reasons. - Different uses: Steam coal is mainly used for electricity generation and coking coal is used for steel production. Crude oil, on the other hand, is refined to produce fuels for transportation, power plants, and heating. - Vastly different costs of generating electricity: At current prices, coal is cheaper than crude oil on a unit energy basis. This is because coal has higher energy content: 1 ton of coal generates 71 kwh of electricity, while 1 barrel of crude oil generates 17 kwh of electricity (refer to Fig. 4). This relates to an energy ratio of around 4.. Coal prices, however, are not traded four times higher than one barrel of crude oil. Coal is 15-2% heavier than oil for the same energy content 3, resulting in higher transportation costs. Nonetheless, the cost of generating electricity from coal is only 25% that of crude oil. This minimizes the competitiveness of crude oil as compared to coal. These factors explain, in our view, the reason for a low substitution effect and thus, the low correlation between oil and coal spot prices. Low correlation does not imply any spillover effects from structurally higher crude oil prices to higher coal prices. Both energy sources are driven by high emerging market growth over the last few years. Investment Case Consumption growth highly skewed towards emerging markets China and India remain the core driver in world coal consumption (see Fig. 5). Since 21, the growth in coal consumption in these two economies has consistently outpaced the world's consumption growth. Average growth in consumption from for the world, excluding China and India, was 1.1%. This paled in comparison to Fig. 3: Low correlation between oil and coal 3M/6M rolling correlation between oil and coal spot prices Jan 1 Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 AU Coal/ WTI 3M AU Coal/ WTI 6M Fig. 4: Coal remains a cheaper source of electricity Cost of generating electricity from different energy sources in the US (US cents/kwh) US cents/ KwH Coal Gas Nuclear Petroleum Fig. 5: China and India are key drivers in coal demand Growth in coal consumption in China and India outpaced the world's growth in coal consumption Growth Rate (%) 4.% 3.% 2.% 1.%.% -1.% -2.% Total excl. China, India China India 1 World Coal Institute 2 The New York Times 3 1 ton of coal, with energy content of ~22.4mmBtu=1kg; 1 barrel of oil, with energy content of 5.8mmBtu=125kg-155kg, US Department of Energy, Wikipedia Investment Theme 2

3 China's average growth of 14.5% and India's average of 7.1%. The International Energy Outlook 27 (IEO27) estimates that China and India together will account for 72% of the projected increase in world coal consumption from 24 to 23. Inelastic demand for coal for electricity generation IEO27 estimates that the share of coal in the electric power sector will increase from 43% in 24 to 45% by 23. Developing countries are highly reliant on coal for electricity generation as coal remains one of the cheapest sources of energy (refer to Fig. 6). At present, there are very few alternatives with competitive costs. In the US, the current production cost of electricity from coal is USc 2.47/kWh, about a quarter of oil's production cost at USc 1.26/kWh 4. Although production costs vary across countries, the large discrepancy in costs highlights the reluctance of developing countries to switch to more costly alternatives. In addition, the high switching costs to other means of electricity production and the long lead-time suggests inelastic coal demand. With structural power shortages in China and India, the demand for coal should remain strong, even if global economic growth were to slow down. Rising steel production further drives demand for coal Coking coal is a key input in steel production. Rising steel production and the lack of substitutes for coking coal further reinforces its demand. Steel production remained robust for the first four months of 28, growing 5.7% year-on-year 5, although production growth in China has slowed. Emerging economies like China, India and Brazil continue to increase their steel making capacities to meet demand from ongoing infrastructure development. Seaborne market tightens as largest producer turns importer While coal is found all over the world, production is highly concentrated, with 85% of world coal production contributed by seven countries (more in Fig. 7). Traditionally, due to high transportation costs involved in international trade, domestic coal demand was met by domestic production. However, China, the world's largest producer and consumer of coal, is now barely self-sufficient and increasingly relies on imports. Similarly, India has been importing coal since 1997, despite being the world's third largest producer. Indonesia and Vietnam have also indicated that they will divert more coal production to meet domestic demand. With lesser coal available for export and greater demand in international imports, a tight seaborne market should persist. Moreover, the price differentials between FOB and CIF spot prices indicate a three-fold increase in transportation prices (Fig. 8). In addition, current trade patterns are likely to be disrupted. Japan, Korea and Taiwan who currently import from China, will have to turn to exporters located further away, like Australia and Indonesia. This again suggests higher transportation costs. Supplies are constrained by infrastructural limitations Unlike oil which has limited reserves, the underlying problem with coal is the inefficient supply chain. As highlighted in our previous report, electricity outages in South Africa, snow storms in China and floods in Australia have disrupted coal supplies in the short-term, driving prices up. Nonetheless, these disruptions are temporary and less pressing than the industry's infrastructural bottlenecks. Australia and South Africa have reached their production capacity limits and do not have Fig. 6: High reliance on coal for electricity % of electricity generated from coal (25) % of electricity from coal 1.% 9.% 8.% 7.% 6.% 5.% 4.% 3.% 2.% 1.%.% World China India Poland Indonesia US South Kazakhstan Africa Source: US DOE/EIA, UBS WMR, as of 26 May 28 Fig. 7: 85% of coal is produced by 7 countries World coal production (mn tons) mn tons 7, 6, 5, 4, 3, 2, 1, US Russia South Africa Australia China India Indonesia Rest of the world Total World Fig. 8: Rising transportation costs drives up coal prices Spread between FOB and CIF steam Asia-Pacific coal spot prices USD/ton Jan Jan 1 Jan 2 Jan 3 Jan 4 Jan 5 Jan 6 Jan 7 Jan 8 CIF-FOB 4 Nuclear Energy Institute 5 International Iron and Steel Institute Investment Theme 3

4 enough rail and port capacity to meet rising demand in the near term. Inadequate transportation networks continue to impede Indonesia's and China's production capabilities. Rectifying these limitations will take considerable amount of time; as such we believe that the tight market conditions are here to stay. Though there are ample coal reserves, the deteriorating quality and limited accessibility to existing coal reserves is a cause for concern. Prices should increase, but gradually Coal reserves are estimated to last another years, significantly greater than the lifespan of oil reserves. As such, we do not expect prices to overshoot like crude oil, yet. Moreover, the demand for coal is highly correlated to China's and India's consumption, highlighting the concentration risks involved. Hydropower, the next largest source of electricity generation in these two countries, provides about onefifth the amount of electricity generated from coal. Although it is unlikely for coal demand to fall, we do recognize that hydropower generation will increase its share with time in the electric power sector. Environmental groups have lobbied against coal due to higher carbon dioxide emissions per unit of energy output as compared to oil and natural gas. Environmental protests against coal have thus resulted in the evolution of "clean coal", which are technologies to enhance efficiency and reduce harmful emissions in coal production. Nonetheless, we believe that the energy security concerns will take precedence over environmental concerns. As such, we expect environmental protests to have limited impact on the demand for coal. Recommendations We maintain our positive stance on coal. The structural story for coal remains very strong and we believe that there is a potential for coal prices to increase by 1-15% in the next months. However, given our view of an impending consolidation in the crude oil market, we believe the upside will be gradual from current levels. Investors who would like to gain exposure to coal can do so through an equity position in coal-mining companies. In general, coal-related companies should benefit from higher coal prices, but returns will not be 1:1 to coal prices. For investors who favor a broader exposure, ETFs (exchange-traded funds), which track coal companies from mining to power generation, are a good alternative. Unlike futures, an ETF investment does not have negative roll yields, and introduces diversification due to a broader range of companies. Despite the high correlation with coal spot prices, thus far we have witnessed sharp deviations within a short period of five months as investment in coal-related companies also introduces other firm specific exposures (Fig. 11). Alternatively, investors can gain exposure via structured products, with coal futures as the underlying asset. We still favor a digital plus payoff strategy, which allows investors to benefit from small increases (please refer to our previous Investment Theme on coal, dated 14 February 28). Please keep in mind that the coal futures market is still very small and relatively less liquid than other energy futures. Fig. 9: China consumes 4% of world coal World Coal Consumption (mn tons) mn tons 7, 6, 5, 4, 3, 2, 1, USA Russia South Africa Australia China India Indonesia Rest of the world Total World Fig. 1: Domestic coal production is insufficient to meet China and India's rising demand Net consumption in coal (mn tons) Coal Net Consumption (mn tons) (2) (4) Net Consumers Net Producers US Russia South Africa Australia China India Indonesia 2 26 Fig. 11: Correlation between coal ETF and coal spot prices 1M rolling correlation between coal spot prices and coal ETF Feb 8 Mar 8 Apr 8 May 8 1M rolling correlation Investment Theme 4

5 Appendix Back to "At a glance" Terms and abbreviations Abbreviation Description Abbreviation Description Backwardation A situation when spot prices are above future prices Natural Gas HB Natural Gas Henry Hub CBOT Chicago Board of Trade NYBOT New York Board of Trade CFTC Commodity Futures Trading Commission NYMEX New York Mercantile Exchange COMEX Commodities Exchange (New York) OPEC Organization Petroleum Exporting Countries Contango A situation when spot prices are below future prices RICI Rogers International Commodity Index CRB Index Commodities Research Bureau Index U.S.D.A United States Department of Agriculture DJ AIG Index Dow Jones AIG Commodity Index USc/lb USc per Pound D.O.E Department of Energy USD/BBL USD per Barrel E.I.A Energy information Administration USD/GL USD per Gallon Excess Return The most common type of return on the commodity indices which is defined as: Excess return = spot return USD/MMBtu USD per 1 million British Thermal Unit + return on rolling the futures GSCI Goldman Sachs Commodity Index USD/MT USD per Metric Ton I.E.A International Energy Agency USD/oz USD per oz, (1 oz = 31.1 grams) LME London Metal Exchange WTI Crude Oil West Texas International Crude Oil MGMI Index Metallgesellschaft Metals Index If the date of this report is not current, the investment opinion and contents may not reflect the analyst's current thinking. UBS Financial Services Inc. is a subsidiary of UBS AG. Required Disclosures Analyst Certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. Any price of securities written in this publication is taken as at the close of business on the main market of listing on the date shown unless otherwise stated. Disclaimer This report has been prepared by Wealth Management Research, the Financial Analysis Group of Global Wealth Management & Business Banking, a Business Group of UBS AG (UBS). In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or groups of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realisable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, groups or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realisation you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. Investment Theme 5

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