Wednesday, November 05, 2008
China Commodities Weekly for the Week of October 27-31, 2008
Na Liu, MBA, Scotia
■ Last week, China’s base metals climbed, while steel and iron ore markets continued to drop, except for rebar. Grain markets were mixed, with soybean up, corn down, and wheat flat. Fertilizers, energy, and coal markets remained under pressure. Chemicals markets were in free fall, with styrene prices dropping to a level last seen in March 2002 and ethylene dropping to a level last seen in May 2003.
■ In this report, on the macro side we revisit the three intertwined trends for the Chinese economy – seasonal, cyclical, and secular – and explain the key signals that should be watched for a potential rebound in construction activities. On the commodity side, we update the latest developments in China’s methanol, copper, and coal markets.
Strategy – Signals That Should Be Watched
■ Since June, we have called ourselves a seasonal bull, a cyclical bear, and a secular bull. In this Strategy section, we revisit our calls for the three intertwined economic trends.
No Longer a Seasonal Bull
■ Our seasonal views have been based on a review of historical patterns. In the past few years, China’s manufacturing activities had always strengthened in the last four months of any given calendar year, after the typical summer lulls from June to August. The Chart of the Week on the following page shows this seasonal trend with the Purchasing Managers’ Index. Readers should also note that the same chart shows the typical “spring revival” in March and April after the slowdown for the Chinese New Year in January and February, a trend that we will discuss later in this section.
■ Unfortunately, in contrast to what we saw in the past years, the stronger seasonality that usually prevails in the last four months of any calendar year failed to manifest itself this year. Yesterday, the official October PMI data confirmed the obvious: our call for seasonal strength in the autumn did not play out. The Chinese economy has been slowing down sharply, even after the Olympic Games were over. In October, China’s PMI reading was 44.6, a level not only lower than the readings seen during “the summer lull” and the Olympic months, but also representing the lowest level since the gauge was first introduced in July 2005. Among sub-indices, the output index fell to 44.3 in October from 54.6 in September, while the index of new orders dropped to 41.7 from 51.3. The index of new export orders declined to 41.4 from 48.8, indicating external demand for Chinese goods is also retreating.
■ We acknowledge that we have learned a pricey lesson; that is, when the cyclical trend is firmly in a downturn, seasonality patterns could be overridden easily. In retrospect, this should have been obvious to us, as the global financial crisis has been shaking people’s confidence and the cyclical economic downturn in China has been exacerbated by the sharp slowdown in China’s property sector.
■ As we go into the winter and holiday season in China, seasonality for manufacturing and construction activities will be no longer friendly, particularly for January and February, as shown in the Chart of the Week. And even if the Chinese government wants to sharply increase infrastructure spending, the winter months are not the season for construction. Therefore, we are no longer seasonal bulls going forward.
Still a Secular Bull
■ As repeatedly stated in our recent issues of the China Commodities Weekly, we are still firmly a secular bull on China’s urbanization trend and the “China Story” for the global raw materials sectors.
■ In fact, we believe the recent sharp pullback in commodity prices can only prolong the secular trend, particularly for energy. Take crude oil as an example. If the WTI were to remain over US$100/barrel for an extended period of time, say five years, then we could envisage that, as a result, viable alternative fuels might be developed successfully, people might begin driving electrical cars, homeowners might start selling their cottages and country homes to move back to the city to save on transportation costs, and – as a bonus for the rest of us – employers might allow us to work from home. We would be happy to call all these desirable developments “demand destruction” for oil, which can be characterized as structural change in the economy and permanent change in people’s behaviour.
■ Unfortunately, the WTI merely approached US$147/barrel for a day and traded over US$100/barrel for three months. All we saw back in June and July this year was that people simply drove less and travelled less in reaction to the near-term price shock (and as a result, gasoline sales did drop YOY for a few months in some OECD countries). But this is not “demand destruction”; this is only short-term “demand depression.” It is true that “demand depression” will eventually lead to “demand destruction” if the price remains high enough for a sustainable period of time to lead to structural changes in the economy and human behaviour. But with the WTI trading at over US$100/barrel for merely three months, the depression is not long enough for the destruction to happen. Without demand destruction, the secular trend remains intact and in fact can last much longer.
Still a Cyclical Bear
■ Although our seasonal bullish call has been wrong and our secular bullish views may be elusive, we do believe that the latest economic data and anecdotal evidence supports our cyclical bearish view; that is, this economic cycle already peaked in China in 2007 and we will continue to see lower economic growth numbers in the next few quarters.
■ The main wild card that might alter the cyclical trend is the scale of the stimulation package from the Chinese government. If the government were to begin to aggressively increase infrastructure spending, we may see construction activities pick up earlier than a normal economic cycle in China would indicate. In the past two major economic cycles, one in the 1980s and one in the 1990s, the Chinese economy slowed down for at least four years before bottoming out, and we are already about one and a half years into this down cycle (Chinese GDP peaked in Q2/07). If history repeats itself, we may still have two years of cyclical downturn ahead of us. The key difference this time versus the previous two cycles is that (1) the Chinese economic superstructure is more resilient than in earlier stages of economic reform; and (2) the Chinese government has much deeper pockets – it can re-boost the economy much more quickly and easily. So government policy is the key wild card here.
What to Watch for and When to Buy?
■ In our opinion, investors who share the same secular view with us should be buying into the global raw materials sectors right here. As Warren Buffet recently said, “If you want to wait for the robins, the spring is already over.” That said, for our clients who wish to be more conservative and wish to see the “confirming buy signals” from a fundamental perspective, we suggest they watch for the following indicators (in addition to macroeconomic data) for a potential pickup of economic activities in China:
■ Spot steep price in China: Steel is a commodity that drives the fundamentals for many other commodities. For instance, nickel is basically stainless steel; zinc is galvanized steel; and iron ore and coking coal are steel inputs. Also, the price signal from the Chinese steel market reflects many things, including the latest changes in levels of construction activity, the scale of potential increased infrastructure spending, the scale of rebuilding in the wake of the Sichuan earthquake, and most importantly, the turning point in the property sector, which has been the key drag in this economic downturn and which accounts for some 40% of Chinese steel demand, directly or indirectly. China consumes 35% of world steel, and the turning point in the Chinese steel market is probably the most important signal in terms of the turning point for the rest of the commodities complex.
■ Iron ore inventory in China: Steel prices can climb simply on production cuts. But if steel prices begin to rally with iron ore inventory being drawn down, the strength is more real, as it is not because of supply discipline, but because of increased demands.
■ The price ratio between Shanghai/LME for copper: Apparently, this dictates the import economics for copper, the flagship for the base metals complex.
■ The Baltic dry index: Hedge funds watch this index to gauge the strength of the physical transactions across the ocean. Although this index is now severely distorted by the supply of vessels, it is still driving investors’ sentiment.
■ The Chinese/HK stock market: Another sentiment indicator. The easy question is that if Chinese investors are still pessimistic, why do we get excited on China?
■ Obviously, all of these indicators are covered in our China Commodities Weekly. Also Watch for Policy Reactions
■ As we addressed earlier on, the wild card that could potentially alter/shorten the cyclical downtrend is the Chinese government’s policy reactions to the slowdown. On this front, the past weekend has been very eventful.
■ First, over the past weekend, Premier Wen Jiabao was quoted as saying that maintaining strong and stable growth is now the top priority for his administration, while acknowledging that “unfavourable changes” in the international economy may make it more difficult to achieve that end. He said the country must be crystal clear that, without a certain pace of economic growth, there would be difficulties with employment, fiscal revenue, and social development, and these would be additional factors in eroding social stability.
■ Second, also over the past weekend, in an unusual dispatch carried by the official Xinhua news agency, the spokesman for the People’s Bank of China, Li Chao, stated that “at present, the central bank is no longer applying hard constraints to the lending plans of commercial banks.” We observe that this means that the central bank has effectively abandoned the existing loan quota system, at least temporarily.
■ Mr. Li’s comments are unusual because it marks the first time the central bank has formally acknowledged the actual existence of credit curbs. Although controls on lending were an open secret among businesses and we have discussed this intensively in our reports, the central bank itself never publicly discussed them. Its instructions on how much banks could lend were delivered verbally to top bank executives, a practice that business groups criticized as unnecessarily secretive and arbitrary.
■ “To guard against the economic and financial impact of this crisis on China, we will flexibly adjust economic policies, including monetary policy, when necessary, and strive to minimize the possible negative effects of this crisis,” Mr. Li also said.
■ We note that Mr. Li’s comments followed the central bank’s interest cut just a few days ago. Last Wednesday, the Chinese central bank lowered both the one-year benchmark lending rate and deposit rate by 27 bp. The recent behaviour of the central bank shows that it is determined to react decisively and proactively to the sharp slowdown in the Chinese economy.
Methanol – The Call on Output Cuts
Still a Net Importer, But for How Long?
■ In September, China imported 113,376 tonnes of methanol, up 4.88% MOM. The average import price for the month was US$426.29/tonne. In the first nine months as a whole, China imported 921,558 tonnes of methanol, up 59.61%.
■ In September, China exported 4,904 tonnes of methanol, up 61.54% MOM. In the first nine months as a whole, China exported 348,265 tonnes of methanol, down 19.14% YOY.
■ Thus, China has remained a net importer of methanol in both September and year-to-date.
Price Collapsed
■ China’s methanol imports are likely to drop in the remainder of this year, as domestic prices have dropped significantly in the past month. For the time being, domestic prices have dropped to the RMB1,900-RMB2,350 range, depending on the region. Port prices also dropped to US$270/tonne last week, down a massive $40/tonne week over week.
■ The major drag on the methanol price is that demand for formaldehyde has declined sharply due to the slowdown in the housing sector. About 50% of China’s methanol demand is still driven by formaldehyde.
Calls for Output Cut
■ At current prices, many methanol producers in China cannot cover their production costs, which average RMB2,300 per tonne. The fundamental reason for the shrinking/negative margin is that methanol prices have been dropping much faster than coal prices in China in recent months.
■ To prop up prices, 18 major domestic methanol producers are asking all producers in China to restrict supply, according to industry sources. Already, Shanghai Coking & Chemical Corp. and Inner Mongolia Yuan Xing Energy Co. Ltd. have promised to cut their methanol output targets for this year by 30%, while China National Coal Heilongjiang Coal & Chemical Co. Ltd. has agreed to reduce its output by 5,500 tonnes. The group of 18 also called on all producers to stop lowering prices and end excessive price competition.
■ We observe that the call by the 18 producers is very hard to reinforce in China, given the fact that the methanol industry is very fragmented there. As a potential fuel substitute for gasoline, methanol production capacity has soared in recent years, with many new industry entrants launching projects independently. Last month, China’s monthly output of methanol topped 1 million tonnes for the first time. Consumption, however, has not met expectations, due in part to the government’s slow progress in setting up methanol-gasoline regulations.
Copper – Near-Term Demands Sluggish
Producers Say Demands Are Slow
■ Chinalco Luoyang Copper Co., a division of Aluminum Corp. of China, said last week that its orders fell 20% last quarter. The decline in orders resulted in a drop in monthly production to 7,000 tonnes in the third quarter. The company now expects to produce 105,000 tonnes of copper products this year, well below capacity of 120,000 tonnes.
■ Separately, a top executive at Jiangxi Copper Company Ltd. told Reuters last week that “domestic consumption won’t rise next year. It may be flat from this year. Only infrastructure projects would be invested in next year. The auto and property sectors are not doing well.” The executive also said the financial crisis was reducing overseas demand for Chinese products that contained copper. “People are in a panic. The market may not stabilize and return to fundamentals in two to three years,” he said.
Suppliers Found It Tough to Sell
■ Our specialist in metals sales, Jerrold Annett, who has in-depth contacts on the suppliers side, said that copper suppliers to China “are struggling to sell their production and are having to find new homes.” The LME is the last resort but looks like it is the only option for many producers, he said. This explains the recent inventory build-up at the LME. One supplier told Mr. Annett to “watch the Chileans dump copper on the LME over the next month or two!” That said, suppliers are of the view that next year, “China will step up to the plate and buy copper, which looks to be a requirement for plus-2.00/lb copper for 2009.”
SRB Might Want to Wait
■ China’s State Reserve Bureau (SRB) may postpone plans to buy copper from overseas on speculation that a global recession may push prices even lower, according to two traders quoted by Bloomberg. The bureau won’t buy copper before next year, said the traders, who claimed to have spoken to officials from the agency. The bureau discussed its intention to boost stockpiles with the country’s biggest smelters and traders before the national holiday in the first week of October, they told Bloomberg.
■ Some companies approached by the bureau submitted bids to act as agents for the buying, said one of the traders who participated in the process. The agency considered buying around 300,000 metric tons at that time, the trader told Bloomberg.
■ How much inventory the SRB is holding now is anyone’s guess. Back in mid-November 2005, a senior SRB official told Reuters that the state body then had control of more than 1.3 million tonnes of copper stock. The bureau was required to keep stocks at 1 million tonnes minimum but could buy or sell copper if stocks were above that level.
■ Traders and industry observers estimate that after that disclosure, the bureau released some 400,000 tonnes of copper to the end of 2006 to meet trade obligations and to curb local prices, and then probably purchased as much as 250,000 tonnes of copper back in 2007. This is why we estimate the current inventory of SRB to be at around 1.15 million tonnes.
■ In early October this year, a source “who has commercial links to SRB” told reporters that the bureau “may want to increase total stockpiles to 2 million tonnes eventually over two to three stages, depending on prices.” We feel this intention does make good commercial and strategic sense, particularly with the recent sharp retreat in copper prices. China is not in a hurry under the current environment, however, and the goal could be achieved gradually in two years without pushing up the market, in our opinion.
SHEF Inventory Fell
■ In the very near term, the situation might not be as bad as what suppliers and producers are talking about. We note that the SHEF inventory has been dropping two weeks in a row and the spot market in Shanghai has been trading at a premium to the nearest futures month, a sign that the market might be a little tighter than thought.
Producers Lobbies for Export VAT Rebate
■ Chinese copper smelters and fabricators are expected to push the Chinese government to resume copper tolling trade practices and increase export tax rebates on several copper products. “Hopefully, a proposal will be submitted in early November to the central government suggesting a reinstatement of copper tolling and other incentive policies in a move to support the industry,” Zhao Bo, deputy director of the copper department with the CNMIA, said at the China Copper Conference in Shanghai.
■ China banned copper tolling, which consists of importing copper concentrate and then exporting refined copper at preferential tax rates, at the end of 2006.
■ As for other incentive policies, Zhao said that a possible solution may be to increase export tax rebates on certain copper products to 13%, from the current 5%.
■ We observe that the proposed reinstatement of copper tolling trades and the increase in export rebates go against the government’s resolve to curb excessive exports of energyintensive metal resources and environmental protection policies, so the chances of the industry receiving these incentives is low.
Coal – The Second Batch
■ Industry sources said that the Chinese government had informed coal exporters of the second batch of the coal export quota this year. The amount is 15.9 million tonnes. The quota has not been formally issued yet, but exporters are now allowed to negotiate export shipments with buyers overseas.
■ China issues export quotas each year in two batches. The second is normally granted in the middle of the year, but this year has been delayed since the summer, when China grappled with severe power shortages caused by coal shortages just ahead of the summer Olympics.
■ We observe that the size of the second batch is quite large – larger than previous market rumours of 10 million tonnes. This shows the Chinese government is now confident that major coal shortages in the coming winter can be avoided, given the high inventory now at both generators and at Chinese ports.
■ We doubt that exporters will be able to use up the entire quota. First, exporters have a limited window of time to sign the contract and ship the coal out, as coal export quotas for 2008 can only be used till early 2009. Second, international coal prices have been dropping much more quickly than domestic coal prices, making exports less profitable.
Fertilizer – Export Tariff Under Attack
■ In recent weeks, as both international and domestic urea and DAP prices have dropped, Chinese producers have become increasingly vocal in attacking the existing prohibitive export tariff. Producers and some industry observers have been telling the Chinese government that the export tariff introduced earlier this year has led to a glut in the local market, negative industry margins, and a loss of opportunity to make money from international markets to cross-subsidize local money-losing sales.
Urea – A Quota System?
■ In the past two weeks, there have been talks in China that export tariffs might be cut in 2009, if not earlier, due to the pullback in international prices; more importantly, in 2009, the Chinese government may introduce an export quota system to control overall export levels. For the time being, exports out of China are controlled by a prohibitively high export tariff of 175%. We would interpret these rumours, if they were to materialize, as bearish developments for the urea sector.
DAP – Lower Tax Likely for 2009
■ Last week in Shandong, the Association of Chinese Phosphates and NPK producers held a meeting with officials from the Ministry of Finance. The producers asked for a sharp reduction or a complete removal of fertilizer export tariffs, a request that the Ministry rejected outright for the remainder of 2008 at the meeting. However, officials said the message from the industry had been heard, and would be considered for tax policies in 2009.
News in Brief
Nickel – Output Target Cut
■ Jinchuan Group Co., Asia’s biggest nickel producer, has lowered its 2008 production target by 17%. The company has lowered its 2008 output target to 100,000 tonnes, down from a previous estimate of 120,000 tonnes. The company estimates that production cuts worldwide this year will exceed 100,000 tonnes.
■ On the stainless steel side, Antaike, a local industry consultancy, last week lowered its forecast for stainless steel output in China to about 7.1 million tonnes in 2008, down by 6.6% YOY due to the depressed market and macroeconomic downturn. This will be the first negative growth in stainless steel output in almost 10 years, according to Antaike. At the beginning of 2008, Antaike once forecast that Chinese domestic crude stainless steel output would be 9 million tonnes, according to the planned output of Chinese stainless mills.
■ The biggest stainless steel producer in China, Taiyuan Iron & Steel (TISCO), reportedly reduced production in October by about half compared with that in September due to weak demand. TISCO would put less than 100 kt of stainless steel in the market in October. The reduction in production was likely to continue into November.
Base Metals – SHFE Stock Fell
■ Shanghai copper stockpiles fell 20.2% this week to 24,788 tonnes, while aluminium and zinc inventories were relatively unchanged at 206,415 tonnes and 72,554 tonnes, respectively.
Recap of Our Calls
■ The sole purpose of our China strategy research is to answer one question: purely from a China perspective, should investors in the Western world overweight, market-weight, or underweight the global raw materials and energy sectors? To this question, effective August 25, 2008, our answer is “overweight” (upgraded from “market weight”).
■ We are now bullish on the oil, coal (both thermal coal and coking coal), copper, steel, methanol, urea, DAP, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, molybdenum, iron ore, wheat, corn, soybean, potash, and ethylene. We are cautious on paper products on a relative basis from a China perspective.
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