Coal mines such as this one in Shanxi, China, are being shut down for environmental reasons. Credit:Kevin Frayer "They [the government] miscalculated a lot of things and they basically just created a massive shortage," said Brad Potter, head of Australian equities at Nikko Asset Management, who recently returned from a fact-finding trip to China. "Coking coal was effectively the innocent bystander of the regulatory forces trying to manage price and volume in the 3.2-billion-tonne thermal coal market. "So it's really nothing to do with fundamental supply and demand, it was based around a policy decision that went wrong." The spike in prices in coal meant Chinese steel mills went from spending 20 per cent of their total costs on coal to 40 per cent, pushing them in turn to seek higher grades of iron ore to make the steel making process more efficient.

For every 1 per cent increase in the grade of iron ore, the amount of coking coal required is reduced by roughly 2 per cent. "What was originally just a China-centric event then spread out to the seaborne market," Mr Potter said. Compounding this situation is the mass closure of mines across the country for environmental reasons, primarily water contamination from acidic mine runoff. The province of Shanxi accounts for almost over a quarter of Chinese coal production, yet output is at risk after the local environmental protection bureau found 29 out of 100 water sources were unfit for human contact because of excessive pollution. Additionally, authorities have clamped down on overloaded trucks, further increasing coking coal costs.

These regulations combined amass to what Mr Potter describes as a "large policy error" that has caused "severe" shortages. "The NDRC is now scrambling to fix the coal shortages and price escalation caused by the 276-day rule," he said. "However, the strength in the coal price is not motivating producers to increase production to bring the price down." The backdrop of a housing boom and speculation on the commodities market has also helped iron ore prices. As steel production in China winds down and prices increase, iron ore prices have also increased on the assumption of increased demand. "Everyone's started scrambling to get high-grade iron ore, and that just pulled up iron ore prices, and in addition to all that you just have this complete speculative bubble that occurs in China," said Mr Potter, adding that this has in turn boosted local iron ore miners.

Iron ore has climbed more than 53 per cent since the 276-day rule was introduced in April, passing the $US80 per tonne mark this week. This has been passed on to local miners, with Fortescue shares climbing almost 170 per cent in the same period. As coal prices have also increased, South32 shares have climbed per 105 per cent, with the company attributing increased coal exports to China to the 276-day rule. Rio Tinto and BHP Billiton have also climbed around 50 per cent each over the same period. Although the NDRC has reversed some of the new rules, Mr Potter believes it will be some time before prices recalibrate to prior levels.

"This was one of the first really big decisions they made around trying to reduce capacity of any business, and unfortunately they got it wrong in the short term," Mr Potter said. "My longer-term view of China is that the government is in a long-term process of reducing reliance of fixed asset investments and moving to a more balanced economy, and on that basis consumption of commodities will reduce."