China's Yanzhou Coal Mining Co. (YZC) is in initial talks with Gloucester Coal Ltd. (GCL.AU) to merge their Australian coal assets and create a miner worth up to 8 billion Australian dollars (US$7.9 billion), three people familiar with the matter said Tuesday.

The move is a bold step by China's third largest coal miner by output to secure a listing on Australia's main exchange and meet undertakings given to the Australian government in 2009 to seal a A$3.5 billion takeover of Felix Resources Ltd. It also gives it access to producing coal mines, boosting its production growth profile at a time when output at its mines in China's Shandong province are stagnating.

Analysts said the proposed deal is unlikely to encounter opposition from Australia's foreign investment watchdog, despite previous big investments by state-backed Chinese companies triggering criticism from some politicians.

Gloucester is worth A$1.44 billion (US$1.42 billion) based on Monday's closing share price, and its 1.8 million metric tons of coal production represents less than 1% of Australia's total 406 million tons output in the year to June 30.

"I don't think Gloucester is a big enough a producer for the Foreign Investment Review Board to knock any potential deal back, if they approved the Felix takeover you think they'd easily allow Gloucester to be absorbed into the entity," Royal Bank of Scotland analyst Tom Sartor told The Wall Street Journal.

In a statement to the Australian Securities Exchange, Sydney-based Gloucester said it had requested trading in its shares be halted until Thursday, by when it expects to make an announcement in connection with a "possible change of control transaction."

Gloucester, which operates two open-pit mines and holds exploration licenses, said it wasn't yet in a position to make such an announcement.

Yanzhou's board secretary and deputy general manager, Zhang Baocai, last week said the company was considering a reverse takeover to fulfil a commitment to Australian regulators that it will float at least 30% of its Australian assets, known as Yancoal Australia, by the end of next year.

Gloucester and Noble Group (N21.SG), Gloucester's majority shareholder with a 64.5% stake, declined to comment on a possible deal.

UBS and Citi are advising Yanzhou, and Lazard is advising Gloucester.

Demand for Australian coal has intensified in recent years as companies seek sources of the commodity both for fuel and a key steelmaking ingredient to feed China, India and other rapidly industrializing countries.

In a recent wave of consolidation, Rio Tinto PLC (RIO) and partner Mitsubishi Corp. (8058.TO) bought the remaining shares they didn't hold in Coal & Allied Industries Ltd. in a deal that valued the target at A$10.8 billion. Among other deals, U.S. coal miner Peabody Energy Corp. (BTU) in November gained control of Macarthur Coal Ltd. with a A$4.9 billion bid, and Whitehaven Coal Ltd. (WHC.AU) this month agreed to buy smaller Aston Resources Ltd. (AZT.AU) for almost A$2.3 billion.

E.L. & C. Baillieu analyst Adrian Prendergast said the potential merger was very positive.

"Since the Felix takeover in 2009, I think Yancoal has been sizing up all of the potential fits for them as a way of backing in the assets and listing," he told The Wall Street Journal. "From the product point of view, it gives it substantial scale and really broadens their market ability in terms of coal type."

Prendergast said the combined entities of Yancoal-Gloucester, as well as Whitehaven-Aston, would both be attractive targets for global players. However, Chinese companies have little track record of selling out of assets that they control.

Yanzhou shares were placed in trading halt on the Hong Kong Stock Exchange pending the release of an announcement which is price sensitive in nature and on the Shanghai Stock Exchange due to a proposed transaction.

-By Gillian Tan, The Wall Street Journal; gillian.tan@wsj.com

--Robb M. Stewart of Dow Jones Newswires in Melbourne contributed to this article.

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