Macquarie hosted its bi-annual China Commodities Tour in the week of 26 April. More than 20 corporate and industry consultants presented their views on the Chinese macro economy as well as the outlook for the main resource commodities. The presentations in Hong Kong, Beijing, and Shanghai were followed by a site visit to the city of Ningbo – a second tier city with a population of 2.2 million, situated some 300 km South of Shanghai. A clear takeaway was that the Chinese government is actively taking steps to slow the economy.

Under these measures, the government has raised bank reserve requirements, put in place various measures to curb “speculation” in the (mainly high end) property market, and (imminently, according to feedback at the conference) will allow gradual RMB appreciation (from as early as June/July). Macquarie feels that “at the headline level, these measures are aimed at bringing GDP growth down from its extremely strong first quarter 2010 rate towards the 8-9% 2010 target.

“Given the responsiveness of the Chinese economy to the government’s tightening measures in mid 2007 and the stimulus put in place in late 2008, we believe the extrapolation of this recent policy move (at the headline level) is clearly bearish. Indeed, the recent sell-off in commodity prices – in particular the base metals – in part reflect concerns regarding Chinese policy tightening, as well as risk aversion related to concerns over instability of the Euro zone.

” While we agree that the Chinese economy is set to slow over the next six months, we view that the policies put in place are not overly aggressive, and ex-PBOC member Dr Fan Gang, who presented on Monday at the Hong Kong leg of the Tour, agreed with this. In particular, fiscal stimulus measures to encourage consumption of consumer durables remain in place, some of the money not flowing into high end construction could flow into consumption, the build out of second and third tier cities remains a robust underlying driver of economy, and exports to developed world are reportedly looking set to remain strong (and could pick up further over the next six months).

“Indeed, the fall in base metals (and resource equity prices) is a continuation of the trend which we have seen over the past year – sentiment towards demand has been driving markets throughout the global recovery, rather than supply and demand balances (ie, copper prices doubled in 2H09 while stocks rose every day on the LME).

“As a result of our view that the Chinese economy is set to slow and not collapse (this is reflected in our consumption forecasts for steel and the base metals we cover), we expect any pullback in commodity prices to be short lived, and will be using it to recommend investors raise exposures to such commodities as copper and hard coking coal. Supporting this view was the general feedback from the 65 delegates who attended the tour that they were still comfortable regarding the outlook for commodity consumption growth from the Chinese economy over the next one to four years (urbanisation, industrialisation and modernisation underpin the medium-term outlook). While the copper and coking coal markets still have the best fundamental outlooks, aluminium, zinc and nickel have become more attractive investment propositions following the recent 10-20% correction over the past week (although prices need to fall further before we change our view).

“On the Ningbo site tour, we visited one of Geely Automotives car production plants, as well as a “high-end” property development being built by China Resources Land (located around 15 minutes outside of Ningbo proper). Before we arrived at our destination, much had already been seen and learned by the group. In our opinion, one cannot go to Beijing and Shanghai and come away anything other than bearish on the outlook for commodity demand, given the cities are already built (we only saw one crane in either city). In that context, the views of numerous roads,  highways and buildings being constructed, as well as many underdeveloped areas, supports the notion that China still has some way to go with regard to commodity consumption.

“The most notable point from the Geely site visit was the company‟s expectation that sales would rise by 15-20% in 2010.” 

Copper

“The most interesting information we heard on the copper market was that Chinese copper demand growth from the State Grid (~10-15% of total consumption in 2009) over the medium to long term is set to be underpinned by new investment in Transmission and Distribution (T+D). Together with similar comments made by some participants at CESCO, we heard that in the 12th five-year plan, the budget for the State Grid would likely be raised substantially (by over 50%) from current levels. The 12th five-year plan is expected to be released later this year – in October/November 2010. The additional funds are set to be used to upgrade and build out the national grid in order to better transmit and distribute the substantial generating capacity that has been developed in China over the past decade. A major issue expected to be tackled is the transmission and distribute power from the West of China to the East.

“China Metals pointed out that it expects China to continue to be the key driving force of the global copper market, especially for the long term, given its strong commitment of industrialisation and urbanisation. However, the growth rate may not be as high as in previous years, although absolute amount of increase will still be impressive.

“China metals also noted that domestic mine supply continues to lag behind metal production leading to further rise in copper concentrate deficit in the domestic market as well as a much poorer copper ore treatment and refining charge (TC/RC). Spot TC/RCs are well below Chinese smelters’ average breakeven cost of approximately $40-50/t and $0.04-05/lb.

“Therefore, the copper imports growth into China in 2010 will be mainly in the form of raw materials-concentrates due to continuous strong growth in domestic smelting capacity. China Metals forecast of refined copper net imports in 2010 will be 2.1 Mt only, down by 1.0 Mt from previous year of 3.1 Mt. This compares with Macquarie forecast of net imports of 2.5-2.6 Mt for 2010.

” China Metals forecast of real copper consumption in China last year was only 5.6 Mt compared with 7.1 Mt of apparent consumption leading to a stock built up of 1.55 Mt in 2009. China Metals estimation of real copper consumption in China in 2009 is much lower than Macquarie forecast of 6.6 Mt with only 550,000 t built up of copper stock over the year given our different understanding of copper stocks at speculators hand. China Metals believe Chinese copper demand growth will slow down in 2010 because of the slowdown in power sector investment this year and tightening liquidity supply in domestic market. Their forecast of real copper consumption in 2010 will be 6.25 Mt, 12% up YoY with apparent supply of 6.7 Mt leading to a further rise of copper stock of 450,000 t in China.

Aluminium

”Most of the discussion on aluminium market focussed on excessive Chinese output and large stock build in China. According to Chalco, Chinese aluminium production in 2009 was 12.98 Mt, 1.5% down YoY compared with 19.5 Mt of installed smelting capacity. And by the end of 1Q10, output was running at 16.11 Mt, representing an 83% utilisation rate.

“China shifted to a net importer of aluminium in 2009 due to a sizable cut in its high cost production at 1Q09 along with price collapse over the period. According to China customs, Chinese net imports of aluminium in 2009 were 1.4 Mt. As a result, the total apparent supply of aluminium in 2009 was 14.4 Mt compared with Chalco estimation of domestic consumption of 13.8 Mt leading to a stock increase of 600,000 t for the year as a whole. In our view, the stock built up in 2009 was much higher at around 900-1,000,000 t reflecting under reporting of domestic production by 300-400,000 t (ie, higher output from Shandong and Hubei provinces in particular).

“Since the China Commodities Tour, aluminium prices have fallen sharply and now prices are putting substantial pressure on high cost Chinese producers. At sub $2,000/t, we expect Chinese producers to slow down their expansion plans but it is still quite difficult to force them to cut the production from existing operation, which is quite essential to balance the market taking a 6-12 month view.

“According to China Metals, in 2009, 35% of Chinese aluminium demand will come from construction, 15% from transportation, 12% from power, 9% from consumer durables, 9% from machinery, 8% from packaging and the remaining 8% from others.

Bauxite

“Alan Clark from Clark and Marron delivered a presentation which highlighted that Chinese bauxite resource reserves are perhaps higher than many give credit for, and should see China relatively self sufficient through 2015. The company’s detailed research within China shows that bauxite reserves (12,400 Mt+) are much higher than the official resource reserves published by the government (2,900 Mt). Very recently though, the government announced some large resource reserves in Henan, Shanxi and Guizhou totalling over 20bnt, which suggests that China may have even more resource reserves than even Clark and Marron have identified (although these are yet to be verified or investigated).

“Alan noted that the Chinese bauxite is high in alumina content, but also high in silica, which is an issue when using the traditional bayer process to refine bauxite into alumina (when the ratio of alumina to silica is below 5-6 to 1). In the past, China has been ‘high grading’ and using its high alumina/silica ratio bauxite resource reserves first, so despite higher than widely regarded resource reserves, China is expected to gradually become more import reliant, particularly beyond 2015. Technical advancements or new processes to reduce the silica content in Chinese bauxite may emerge in the meantime however, extending the ability of China to use its own domestic bauxite (thus reducing freight costs – ie, the most expensive alumina is produced using foreign bauxite, mainly in Shandong, and higher costs typically reflect freight costs).

Zinc and Lead

“Chinese zinc demand has been growing strongly since mid 2009, especially from the construction, appliance, machinery and automotive industries. However, it still lags behind the growth rate in domestic supply, leading to a major build up of zinc metal stock in China. Penfold estimated that there is a total of 900-1,000,000 t of refined zinc stocks in the country (reportedly, the majority of the material is being held at speculators for the purpose of investment). The risk associated with stock overhang in China look set to limit price gains looking forward.

“Penfold highlighted the strong growth of Chinese zinc smelting capacity in recent years against limited growth of raw material supply from both domestic and international market. By the end of 2010, total installed capacity in China could reach 6 Mt with most of the capacity expansion coming from new entrants like Jiangxi Copper, Tongling, Minmetals and Citic Resources (without a secure supply of raw materials).

“Domestic mines have recently been producing at record high levels and there is limited new concentrate supply growth expected from current levels in China (due to a lack of quality resources). The international market is not an option either for Chinese producers because several large mines are coming towards to the end of their lifecycle. A number of existing operations are also locked into long-term contracts with major western smelters. Overseas mine acquisitions also seems challenging for Chinese companies given difficulties associated with competing with multi-national firms for limited supply of economic projects and a general lack of industry experience and knowledge about global M&A.

“As a result, there are great uncertainties associated with Chinese raw material supplies in the future, relative to the expansion of zinc smelting capacity.

Stainless steel and Nickel

“Eramet expressed a bullish view for the global stainless steel and nickel market for 2Q10. However, the company sees the nickel market in surplus by the 4Q10 (consistent with Macquarie’s own view). The anticipated catalyst for a 4Q10 surplus is an end of the restocking cycle in the western world after the strong buying in 1H10.

“Eramet expects global stainless steel production will be 29.6 Mt in 2010, up by 18.6% YoY, with China up by 18% YoY, Japan up by 25% YoY, Europe up by 21% YoY and US up by 34% YoY. World stainless steel production is already back at pre-crisis levels owing to a strong pick up in demand from the machinery and automotive sectors, together with restocking (especially in the western world).

“Eramet highlighted that the demand recovery in China in the 1Q10 and 2Q10 reflects new orders coming from the end users directly like industrial users, consumer appliance and consumer durables sector, rather than from traders for the purpose of restocking. Indeed, they estimate the total reported stocks at Wuxi and Foshan warehouses at end April were about 450,000 t. It was slightly higher than historical average but still less than two weeks of consumption in China.

“There was discussion about Chinese nickel pig iron in the conference, with Eramet forecasting that Chinese production of nickel pig iron in 2010 would be 150,000 t compared with 98,000 t in 2009. They estimate the break even cost for Chinese nickel pig iron production is around $18,000-19,000/t ($8.1-8.6/lb) for blast furnace producers and slightly lower for electric arc furnace operators. They suggest the average cost of production for Chinese producers including both blast furnace and electric arc furnace producers are around $7.7/lb. Therefore, their margins are strong at the moment despite a large discount for their products compared with refined nickel. We hear Chinese nickel pig iron producers are only selling their product at $20,000/t level compared with refined nickel price of $24,000-25,000/t quoted on the LME (since the conference, the nickel price has dropped to $22,000/t).

“Another interesting point is the re-export of Chinese nickel material – Eramet suggested some major stainless steel producers are re-exporting their long-term contracts of nickel material to Korea and LME warehouses in Asia to gain the benefit of higher selling prices there (trading the nickel export arbitrage).

“Overall, Eramet believes world nickel consumption in 2010 will be 1.408 Mt, up by 12.1% YoY (13.3% rise YoY for stainless steel sector and 9.8% for non-stainless steel application). China would represent 38% of the world nickel consumption at 532,000 t in 2010, up by 12.7% YoY.

Steel and Iron Ore

“We had four external speakers covering the steel and iron ore markets: Vale, Steel Business Briefing, Wubo Steel and Mysteel. In general, the speakers highlighted their bullish view towards the steel prices despite the strong rally in 1Q10 and recent government measures clamping down on the residential housing sector.

“Mysteel predicted that hot rolled coil prices could go up to the level of Rmb5,000/t ($733/t) including VAT in the coming months on the back on continued strength in the order book from the construction, machinery, transportation and manufacturing sectors. However, they believe the gradient of price rise growth will be slower compared to 1Q10.

“Mysteel also expect Chinese GDP growth in 2010 to be 10%, FAI growth to rise 25% YoY and steel demand to be up by 10% YoY. Chinese crude steel output in 2010 will reach 630 Mt in their opinion compared with the 643 Mt forecast made by Macquarie. They believe Chinese net exports of steel products will recover significantly in 2010 with net exports forecast at 20 Mt for the year as a whole (in line with our estimates) compared with virtually nothing in the previous year. Furthermore, the growth rate of Chinese steel capacity expansion is slowing with total installed capacity at 713 Mt at end 2009 and capacity utilisation rate at 86.2% on average for 2010. In their estimate, raw material purchase prices at Chinese steel mills have risen by 25.6% YoY thus far in 2010.

“Steel Business Briefings’ (SBB) presentation included the results of their recent steel mill survey. This highlights that producers are very optimistic about both growing production and increasing export orders in the coming months. SBB believe steel exports will further increase in 2Q10 given the current price spread between China and the international market. They also made the point that demand levels from some intensive users of flat products tends to fall in the summer months, although this is mostly driven by the production of air conditioners that typically see production peak in June ahead of peak sales in July and August.

“In the case of iron ore, according to Mysteel, 30-40 Mt of domestic iron ore (62% Fe content) could come back to production if the price exceeds Rmb1,000/t ($147/t) including VAT ($125/t CFR equivalent excluding VAT). This estimate fits in well with our own feasibility study on the iron ore industry during mid-April of this year, which highlighted that high cost domestic miners’ required incentive price to restart exceeds $120/t CFR basis excluding VAT. This compares with current spot price for 62% of Australian material at $172/t delivered to China.

“Vale also confirmed 100% of their contract customers had now agreed ‘in concept’ to the quarterly pricing system for their 2010 deliveries and that the annual benchmark system will not return. The company also reiterated their support for the index pricing formula used and suggested contract performance is now a key issue in considering future delivery options. For July-September contracts, the price will be based on the Platts’ IODEX index average over March-May. For anyone who reneges on contract terms, no further tonnages will be given. This comment will particularly affect the Chinese customers rather than anyone else on the seaborne market given their poor contract performance in 2009.

“In terms of adjustment for grades/products, Vale suggested the average price it was receiving for fines was around 16.5% above the 62%Fe material index due to the grade escalators in the contracts. Also, they stated that “today’s pellet price is much better” and they are receiving $170/t FOB for iron ore, presumably pellets. This would equate to a rise in pellet contract prices of ~130% over 2009 levels.

“Overall, it is fair to say that sentiment on the steel and iron ore sector was mixed. Industry participants were certainly worried about the effect of property sector tightening measures; residential construction represents around 14% of China’s steel consumption at the present time (~85 Mt/y) and is very important for many of the smaller, local mills. In contrast, all speakers put their faith in the medium-term story, with continued steel (and thus iron ore) demand growth from China in the next 2-3 years. Furthermore, the general belief was that prices were set to rise further.

“In our perspective, while sentiment has taken a hit, the market fundamentals for steel and iron ore in China remain robust. While the previously prevalent tower cranes have disappeared from Shanghai and Beijing, on our trip to Ningbo, there was considerable evidence of building and infrastructure construction. Furthermore, in the Q&A various speakers confirmed that, due to the time-based nature of building leases, anything currently under construction will be finished (and will be relatively price insensitive in terms of steel). Thus, with manufacturing growth continuing, albeit at a slower pace, the short-term demand outlook for steel is bullish. Moreover, with availability of seaborne iron ore to China set to fall further, all the factors which have driven the iron ore price up remain in play.

“We expect prices for steel and iron ore to drift along in the short term looking for direction, before the fundamentals kick back in. The worry in the sector comes towards the end of the year, as if construction new starts continue at low levels, and current projects move through the steel intensive phase, demand growth may weaken significantly. Thus, both steel and iron ore could move from deficit to surplus, and test the cost support floor. However, we do believe the government will ‘get it right’ (as did the vast majority of our speakers), and will cycle back towards a growth phase and restimulate. We would therefore expect any demand pullback to be reasonably short lived.

Coal

“Presentations on the coal industry highlighted the positive outlook for thermal coal prices in the next 2-3 months, in light of the start of the summer peak demand season and the strong growth of the domestic economy. Production restarts in Shanxi province was also an important theme widely discussed within the conference. China Coal World believes reported raw coal production from Shanxi in 2010 will exceed 700 Mt compared with 615 Mt in 2009. For the 1Q10, Shanxi reported raw coal production was up by 37.6% YoY at 158 Mt compared with 115 Mt only in the previous year.

Shanxi, the leader in national coal mine consolidation, has gained significant progress last year with the share of the production from the small coal mines down to the level of 25% in 1Q10 from 28% in the year 2009. Production from the key state owned coal mines increased to the extent of 58% in 1Q10 from sub-50% in 2009. The start of the coal mine consolidation in Henan province this year will definitely hurt the supply from the region with coal output expected to be flat from 2009 at 235 Mt at the best case.

“According to China Coal World, the major growth in coal production in 2010 should come from Inner Mongolia, Guizhou, Heilongjiang and Anhui province with national total reported production up by 8% YoY at estimated 3,300 Mt.

“Coal stocks in China have been falling across the nation reflecting the Daquin railway maintenance work during the month of April (completed on 28 April). A slow down in supply (especially for the projects under construction due to the central government safety inspection work in April and May) and higher thermal coal demand following the drought in Western China, have also combined to bring about this situation.

“All speakers tended to agree that consolidation in Shanxi was likely to be a multi-year event, which would continue for the next three years. Furthermore, other provinces look set to follow this lead, with CCTD predicting that any mines with annual capacity less than 150,000 t would close in Hunan. This would lead China to continue imports of thermal coal into the medium term. The cost structure for Chinese mines is also increasing, with safety and labour costs leading the way.

“Furthermore, across various presentations at the conference, it was highly apparent that any switch away from a thermal coal-powered economy was likely to be limited (in this decade at least) and that overall consumption would continue to grow strongly, closely matching the forecasts 8% GDP growth targeted by the government. The Songbin Group confirmed that, at around $0.20/kWh, coal projects still came in cheaper that nuclear and renewable alternatives. Thus, while coal generation represents only 74.5% of capacity in the country, it accounts for 82% of electricity generation.

“The closure of the small coal mines has had more impact on coking coal supply (especially for premium hard-coking coal) than on thermal coal. More than half of the coking coal produced in China is from the small coal mines. Moreover, Shanxi province accounts for roughly 40-50% of Chinese premium coking coal supply. The coal consolidation in Shanxi has led to a dramatic increase in Chinese coking coal imports in 2009 of 37 Mt in 2009 compared with 7 Mt only in 2008 (including Mongolia). Macquarie believes Chinese met coal imports will rise up further in 2010 and net imports will hit 42 Mt by the end of the year with a major rise in supply coming from the Mongolia and North America markets.

“This view was shared by the industry speakers, who suggested that of the new production coming on in Shanxi, extremely little will be hard coking coal. Limited investment is being made in this area, as coking coal seams account for only 20% of China’s reserves and are deemed too difficult to bring to market, In addition, the average hard coking coal ratio in Chinese blast furnaces has risen from 45% to 50-60%, according to CCTD. As a result, the tour has reinforced our structurally bullish metallurgical coal view into the medium term.