China Update

China Commodities Weekly for the Week of September 17-21, 2007

Na Liu, MBA, CFA - 416-945-4235 na_liu@scotiacapital.com

■ China’s base metals markets were firmer last week, while steel markets were largely down, except for stainless steel. The iron ore market hovered at high levels. Among fertilizers, urea and DAP prices climbed modestly. Last week, Chinese coke exporters raised their quotation to US$270/tonne.

■ Overnight, China released its final base metals trade data for August. If anything should draw investors’ attention among these data, it is China’s strong imports of input materials, i.e., copper concentrate, copper scrap, bauxite, nickel ore, and zinc concentrate.

■ In this issue, we focus on the strong Chinese coke export price, the “damaging price hike” asked for by Australian iron ore producers, and the feasibility of China’s corn imports. We also briefly discuss the slow ethylene output growth in China over the past two months and the sudden spike of methanol production growth in August. On the energy front, we discuss the recent comments on uranium imports by a top Chinese official, as well as the confirmed price cap on diesel and gasoline prices. Last but not least, we will discuss the import tax cut for soybean imports.

Coking Coal – Coke Price Rose Again

■ Latest data shows that in August, China’s coke exports increased 27.3% month over month (MOM) to 1.24 million tonnes. The sharp increase in August exports is partly due to market rumour that the Chinese government will raise the coke export tariff to 30%. China introduced a 5% export tariff for coke at the end of 2006, and later raised it to 15% effective June 2007.

■ The same rumour pushed Chinese coke export quotations to a new high. Latest reports indicate that Chinese coke export prices are now quoted at US$270/tonne, compared with US$255/tonne in early September.

■ Although we do not believe the export tax will be raised to 30% in the near term, we note that higher export prices for Chinese coke, whatever the reason, are very supportive of our bullish view on coking coal. China is the largest seaborne coke supplier in the world, shipping 14 million tonnes of coke to international markets each year. If we assume 1.5 tonnes of coking coal to produce one tonne of coke, the US$270/tonne spot coke price translates into an implied coking coal price of US$180/tonne FOB China. After adjusting for freight, it implies US$150/tonne for coking coal FOB Australia.

■ Separately, China’s coking coal trade data in August is also supportive of our bullish view. In the month, China imported 435,570 tonnes of coking coal, up 15.4% MOM and 2.1% year over year (YOY). In the same month, China exported only 82,730 tonnes of coking coal, down 58.4% MOM and 78.8% YOY.

Base Metals – Strong Imports of Input Materials

■ Overnight, China released its final base metals trade data for August. There are no major surprises on the refined metals side, in our opinion. If anything should draw investors’ attention, it is China’s strong imports of input materials, i.e., copper concentrate, copper scrap, bauxite, nickel ore, and zinc concentrate. Generally, we believe the August trade data is largely supportive of our bullish view on the base metals, especially copper, aluminum, and zinc.

Copper – Concentrate Imports Surged

■ China’s refined copper net imports were at 66,212 tonnes in the month, down 8.2% MOM but up 45.1% YOY. As we commented when the preliminary data was issued, we believe China’s copper imports in August were higher than market expectations and should be taken as bullish, as the market has already done. In the first eight months, China’s refined copper net imports amounted to 991,144 tonnes, up 207.7% YOY. We expect China’s refined copper imports to rebound on a MOM basis beginning in September.

■ The real news for China’s copper trade is on the materials side. In August, China imported 556,444 tonnes of copper concentrate, up 51.4% MOM and 97.9% YOY. In the first eight months as a whole, China’s copper concentrate imports surged 35.8% to 3.192 million tonnes. It seems that so far this year, global mine output growth has been able to meet China’s robust concentrate demand. To a lesser degree, China’s scrap imports were also strong. China imported 499,076 tonnes of copper scrap in August and 3.49 million tonnes in the first eight months of the year, up 23.5% YOY and 18.5% YOY, respectively. The strong August imports were achieved amid the Chinese government’s efforts to clamp down on scrap smuggling (and under-reporting of copper content). Strong concentrate and scrap imports explain why China was able to grow refined copper production by 8.2% MOM and 26.4% YOY in the month.

Aluminum – Bauxite Imports Hit Record High

■ On aluminum, China’s primary aluminum net exports were at 13,020 tonnes, up 123.6% MOM but still down 76.2% YOY. In the first eight months, China’s primary aluminum net exports declined 84.2% YOY to 56,587 tonnes.

■ On the input materials side, China imported 402,435 tonnes of alumina in August, down 8.7% MOM and 40.4% YOY. Year-to-date, China’s alumina imports have dropped 24.3% YOY to 3.5 million tonnes. As we observed in past issues, China has established a trend this year of reducing alumina imports due to sharply increased domestic production. However, at the same time China has had to aggressively grow its bauxite imports to feed some of those non-Chalco (Aluminum Corporation of China Limited) refiners who rely on overseas bauxite. In the first eight months, China imported 15.51 million tonnes of bauxite, up 160.1% YOY. In August alone, China’s bauxite imports surged 169.4% YOY to a record 3.02 million tonnes. Among these 3.02 million tonnes, Indonesia sold 1.93 million tonnes to China, India sold 0.83 million tonnes, and Australia sold 0.26 million tonnes.

■ Given the emerging bauxite supply disruption in Indonesia, we expect China’s alumina imports to rebound and alumina prices to bottom. In fact, the total supply of alumina in China (production plus net imports) grew “only” 24.7% YOY in the first eight months to 16.206 million tonnes. This compares with the 33.8% YOY growth in primary aluminum production during the same period. The discrepancy between these two growth rates indicates that China has been de-stocking alumina so far this year. As we have stated repeatedly, de-stocking cannot last indefinitely and usually establishes conditions for price and import rebounds in related commodities.

On the product side, China’s aluminum semi exports continued to decline in August. In the month, China exported 133,297 tonnes of aluminum semi products, down from 165,831 tonnes in July and 220,420 tonnes in June. Apparently, China’s semis export business has been curbed by the elimination of the value-added tax (VAT) rebate for exports of extrusion items effective July 1, 2007.

Zinc – Huge Concentrate Imports

■ On zinc, not surprisingly, China was a net refined zinc exporter of 16,122 tonnes in August. It is worth noting, however, that this was driven more by lower imports in the month (down 64.2% MOM) than by greater exports. In fact, China’s gross zinc exports in the month were down some 9% MOM and 39.3% YOY.

■ As we repeatedly noted, the price ratio between the Shanghai zinc market and the LME has rebounded sharply over the past two months, improving China’s zinc import economics. It is our opinion that China is highly unlikely to grow its net exports of refined zinc towards the end of the year. If China’s exports remain modest, the ex China world might continue to face a refined zinc deficit, largely due to a bottleneck in refining capacity outside China.

■ On the raw materials side, China imported 208,293 tonnes of zinc concentrate, up 25.9% MOM and 56.6% YOY. In the first eight months, China increased its zinc concentrate imports by a whopping 161.5% YOY to 1.262 million tonnes.

Nickel – Imports Moderated MOM

■ On nickel, China imported 7,058 tonnes of refined nickel, down 15.5% MOM and 10.3% YOY. We expect China’s refined nickel imports to rebound only modestly in September, as the country has become increasingly reliant on nickel pig iron for its nickel supply. In addition, Chinese stainless steel producers are all trying to reduce nickel use in production.

■ Given the huge existing port inventory of nickel ore, China’s nickel ore imports declined to 1.73 million tonnes in August, from the record level of 2.28 million tonnes in July. In the first eight months as a whole, China imported 11.02 million tonnes of nickel ore, of which 5.61 million tonnes was from Philippines, 4.43 million tonnes from Indonesia, and 0.81 million tonnes from New Caledonia.

Corn – China to Import?

■ It was market-moving news last Thursday that the National Development and Reform Commission (NDRC), China’s top planning body, said China will encourage “a proper amount of corn imports”. What the market ignored is that this sentence appears in a longterm policy guideline for the corn processing industry. In China, this type of long-term guideline, though significant, does not suggest any near-term action. In fact, as we discussed on August 13, there is almost no chance for any Chinese buyers to buy U.S. corn on commercial terms, as import economics do not exist at all. In fact, in the first eight months of the year, China’s corn exports were up 83.4% YOY to 4.147 million tonnes.

■ Extremely high freight rates are a major hurdle for imports for the time being. Currently, the quotation for U.S. No. 2 Yellow Corn is at US$165/tonne FOB U.S. Gulf of Mexico for December delivery. To ship a tonne of corn from the Gulf of Mexico to China will cost almost US$95/tonne using a Panamax vessel. Therefore, the price for U.S. corn CNF China ports exceeds US$260/tonne (or RMB1,952/tonne) before discharging costs and tariffs. This is much higher than local Chinese prices (domestic corn is currently quoted at RMB1,730/tonne at Guangzhou). Last week, we reported that the Chinese government has stopped issuing export quotas for the rest of the year. This is probably the most plausible thing the government can/should do to ensure sufficient local supply for now.

■ Although commercial imports are not economical, we would not rule out the possibility of the Chinese government importing corn for national reserve purposes. Last week, the Chinese government announced that it will release 1 million to 3 million tonnes of corn reserves at slightly lower than market prices to the country’s major feed consumption provinces. Although imports for reserve replenishment can be conducted at a loss for political reasons, we still doubt it will happen in the near term, given the high freight rate and landed costs.

■ If imports are not feasible in the near term, will they become economical a few months from now? This will largely depend on the size of China’s corn output this year. Because of a severe drought in northeast China, the estimate of China’s corn production this year is a subject of fierce debate. The most pessimistic forecast calls for a production decline of over 5 million tonnes from last year’s level. However, China National Grain and Oils Information Center (CNGOIC), an official think tank with a solid track record, insisted last week that China is now harvesting a bumper autumn corn crop. China’s 2007 corn production is still estimated at 149 million tonnes, up 3.52 million tonnes on the year, said CNGOIC. “Although drought reduced corn yield by 8%-15% in Inner Mongolia, Jilin Province, and Heilongjiang Province, the approximate 17% growth in the acreage will offset the influence of lower yield”, it claimed.

■ In fact, the more important message in the NDRC guideline document is its policy for the corn processing industry (such as ethanol and sweetener producers). In the document, the NDRC said that China’s corn consumption would grow 14.3% by 2010 from 2006, surpassing expected output growth of 3.5% to 150 million tonnes in 2010. To ensure corn supply for China’s feed industry, the commission said that it aims to cap corn consumption by the processing industry within 26% of the total consumption of the grain until 2010. The processing industry used 35.89 million tonnes of corn in 2006, or 26.8% of total consumption last year.

News in Brief

Ethylene – Production Growth Slowed

■ In August, China produced 847,000 tonnes of ethylene, up 7.5% YOY. This is the second consecutive month of single-digit growth in ethylene output this year. In the first eight months, China’s ethylene output was up 14.7% to 6.907 million tonnes. The high feedstock price has hurt the producers’ incentive to put crackers in full capacity.

Methanol – Output Surged in August

■ In contrast to ethylene, the recent sharp rebound of methanol prices in China apparently induced a supply response. In August, China produced a record 907,000 tonnes of methanol, up 58.1% YOY. In the first eight months, total output reached 6.302 million tonnes, up 38.4% YOY.

Uranium – China to Tap Global Uranium Supply

■ Two weeks ago, after discussing the first market-price deal of uranium in China, we observed that “China might be preparing the domestic market participants for a significant rise in uranium imports in the future to meet its nuclear power ambitions”. This speculation was confirmed last Thursday. In an interview with Reuters, Zhang Guobao, an NDRC deputy chief, said that “China plans to tap the global uranium market to feed the rapid expansion of its nuclear power sector.”

Iron Ore – Suppliers Seek 50% Increase in Contract Price

■ BHP Billiton and Rio Tinto are asking for a 50% price hike for next year’s iron ore contracts, according to the latest market rumours. Both companies argue that the iron ore market is tight and, in addition, that Australian suppliers should share some of the savings the Chinese buyers are enjoying as a result of buying Australian rather than Brazilian ore due to cheaper shipping costs. In response, Zhang Xiaogang, Chairman of the China Iron & Steel Association, warned the two companies against “abusing their position as major suppliers by demanding damaging price rises.”

Soybean – Import Duties Cut to 1%

■ China will cut the import duties for soybeans to 1% from 3% for three months, beginning October 1, 2007, according to the NDRC. Separately, the State Council, China’s cabinet, met last Wednesday to discuss measures to boost domestic soybean production and set up a soybean and soy oil reserve system. China’s soybean crop has been hurt by a severe drought in northeast China. Output is likely to drop to below 15 million tonnes from 16.2 million tonnes last year.

Oil – Price Control to Hurt Refiners and Oil Imports

■ As we speculated on August 13, China has decided not to hike diesel and gasoline prices till at least the end of the year. Last week, the NDRC said in a notice that “in principle, there will be no new price-adjustment measures before the end of the year”. Although the NDRC did not specify for which products prices have been frozen, we note that the NDRC, in consultation with related ministries, controls China’s water, electricity, diesel, and gasoline prices.

■ As we have discussed repeatedly recently, this price cap on domestic oil products has and will continue to hurt Chinese refiners’ working enthusiasm to meet domestic demands. This is also the reason we believe that Chinese crude oil import growth is likely to moderate a bit in the next few months, as discussed in detail last week.

Property – Down Payment for Second Home Raised

■ To cool China’s residential property market, China will raise the minimum down payment for a second home to 40% from 30%. After the increase, there will be a three-tier scheme for investors who buy a home with a mortgage in China. Anyone buying a second home, regardless of its size, will have to pay a 40% down payment. Those buying a first home larger than 90 square metres will need to put down 30%, while those buying a first home smaller than 90 square metres will pay at least 20% upfront.

■ In the first eight months, the average property price in 70 major Chinese cities increased 8.2% YOY. Cities such as Shenzhen, Beijing, and Shanghai have seen double-digit price increases.

Recap of Our Calls

■ Effective August 16, 2007, purely from a China perspective, we changed our recommendation on the raw materials sectors to “Overweight” from “Market Weight,” a position we usually hold as a secular bull.

■ On sectors, we are now bullish on coking coal, iron ore, copper, zinc, aluminum, oil, and hardwood pulp. We are neutral on grains, ethylene, potash, methanol, and nickel. We are cautious on steel, urea, and paper products on a relative basis from a China perspective.