ON holiday, hard to use daughter's notebook to reformat. Excuse the lack of editing.

China Commodities Weekly for the
Week of August 18-22, 2008
■ Last week, China’s base metals markets climbed, but underperformed their
LME counterparts. The steel and iron ore markets continued to correct. On
grain prices, wheat and corn were down, while soybean was up. On
fertilizer, urea continued to moderate and potash and DAP were stable.
Chemicals markets were mixed, with ethylene prices down, but methanol
flat. The oil price in China was stable, while coal prices moderated slightly.
Chinese export coke price quotations climbed sharply after the Chinese
government hiked export taxes.
■ In this report, on the macro front we upgrade our call for global raw
materials and energy sectors to “overweight” from “market weight”. On the
commodity side, we discuss the July output and trade data for zinc, nickel,
molybdenum, and fertilizer. We also examine the latest hike of electricity
on-grid rates and steel demand for the reconstruction efforts for the Sichuan
earthquake victims.
Strategy – An Upgrade from a True Believer
■ The closing ceremony of the Beijing Olympic Games was held yesterday
and, according to some China bears, the “post-Olympic bust” in China will
now begin. For us, although we do forecast a steady slowdown of China’s
economic growth in the next eight quarters – in other words, we do believe
growth has peaked for this economic cycle in China – we do not believe
there will be a “bust” or recession in China. In our opinion, the secular trend
for China’s urbanization will remain intact, even during the ongoing softlanding
process, and China’s GDP growth should remain well supported at a
level over 8% at the trough. In short, we remain a “secular bull” for China.
■ To make a strong statement as a secular bull, we have intentionally waited
until today to make an upgrade. Today, the first post-Olympic day, we
upgrade our call for the global raw materials and energy sectors to
“overweight” from “market weight”. This is an upgrade from a true believer
of the “China story”, at a time when China’s economic growth has passed its
peak in this economic cycle, at a time when there is a synchronized ongoing
global slowdown (driven by the slowdown in the United States, Japan,
China, EU, etc.), and at a time when a “post-Olympic bust” is supposed to
start, according to the “China bears”.
■ In the rest of this Strategy section, we first discuss the reasons for our
upgrade (we repeat all our Strategy section of last week entitled “Changes
Since Our Downgrade”) and then discuss the potential arguments against our
upgrade – we do realize serious risks still exist in the near term for a retest of
trading lows. And, at the end of this section, we discuss the post-Olympic
issues, from a historical perspective, and our sector-specific views.
Reasons for Our Upgrade – A Reprint of Comments Last Week
■ On June 16, we downgraded the global raw materials and energy sectors to “market weight”
from “overweight” from a China perspective. As we have explained repeatedly, the
downgrade was based mainly on macro concerns and, to a lesser extent, on the weak
commodity-related seasonality in the summer months.
■ On the macro side, we were concerned about the lagging effects of the tightening program,
the high inflation rate’s impact on real fixed asset investment growth, the pressure on
China’s property sector, the slowdown of external demand, and the psychological fear of
investors when they finally realize that the Chinese economic growth has already peaked for
this cycle and the much-hyped Olympic Games are over.
■ On the commodity-related seasonality, we were concerned about seasonal construction
slowdown during the hot summer months, which has been exacerbated by the looming
electricity crisis and Olympic-related shutdowns. We were also worried about the destocking
cycles for key commodities such as copper, stainless steel, galvanized steel, general
steel, and iron ore.
■ As of today, more than two months have passed since our downgrade and many important
changes have taken place, both on the macro side and the commodity-related seasonality side.
■ As to macro, the peaking and the downside risk of the Chinese economic growth have been
well noticed by both global investors and the Chinese government. Global investors have
apparently sold off the global raw materials and energy sectors, making some of the risk
“priced in”. The Chinese government has responded to the downside risk by changing its
policy bias from wholehearted tightening to a little more pro-growth. Last month, it listed
“ensure sustainable and relatively fast economic growth” as a new policy priority, in addition
to “prevent full-blown inflation”. The Chinese central bank has increased the loan quota for
2008 by 5%. The NDRC reintroduced export rebates for certain sectors, especially the textile
sector. In reaction to the risk in China’s property sector, the Chinese government has made it
clear that there will be no further tightening for this sector in the near future.
■ Overnight news indicates that China is considering RMB370 billion of tax cuts and fiscal
spending to stimulate the economy, according to the Economic Observer, citing unnamed
sources. The paper said the proposal, which calls for RMB220 billion of government
spending and RMB150 billion in tax cuts, has gained the support of the Central Leading
Group on Economic and Financial Affairs. The paper added that the details of the proposal
still need to be worked out by the Ministry of Finance and approved by the Cabinet, or the
State Council. The tax cuts also need to be approved by the country’s lawmaking body, the
National People’s Congress.
■ On the seasonality side, the summer heat will eventually fade, bringing back a seasonal
strength in construction activity in the autumn. The Olympics-related shutdown will also
come to an end in late September when the Paralympic Games are over. Two weeks ago, the
Chinese government disclosed a detailed, three-year, one-trillion yuan reconstruction plan
for the Sichuan earthquake region. The implementation of the plan is expected to gain full
momentum in the autumn. As to key commodities, we estimate that the de-stocking cycle for
copper, general steel, stainless, and galvanized steel is probably at least 70% done. In the
past two weeks, the Shanghai-LME price ratio for copper rebounded to a level at which spot
commercial imports are at least feasible again, although still not very profitable (see the
Chart on copper page).
■ In conclusion, some of the macro risks that triggered our downgrade have been either pricedin
or are being addressed by the Chinese government. On the commodities side, the weak
seasonality is still ongoing during this hot Chinese summer, but it will eventually run its
course over the next one-and-a-half months and be replaced by stronger seasonality going
into the autumn.
Arguments Against Our Upgrade
■ We intentionally choose today, the first post-Olympic day, to make our upgrade, just to make
a strong statement as a true believer of the “China story”. From a trading perspective,
however, we do expect the market to retest the previous lows of the raw materials sectors or
even reach new lows, which will be “bear traps”. In other words, today may not be the most
ideal day for an upgrade from a trading perspective, for the following reasons:
■ First, two important sentiment drivers have not turned up. In the past, when we have made
key recommendation changes, we have usually waited for two sentiment drivers to turn
around – the H-share in Hong Kong and the Baltic Dry Index. On the H-share side, the
following legitimate question can be asked: if the local Hong Kong and Chinese investors
have been so pessimistic about China, why do investors in the Western world become
excited? For the time being, both the H-share in Hong Kong (Bloomberg ticker: HSCEI
Index) and the A-share in Shanghai are trying to form a bottom, but have not turned around
yet. On the freight side, the challenge for the bulls could be this: if the freight market for dry
bulk commodities (Bloomberg ticker BDIY Index) is still dropping, does that show the
physical cross-ocean transaction volumes have not improved yet? We know a lot of hedge
funds focus on freight rates to get a clue as to where the physical markets for bulk
commodities are heading.
■ Second, on the fundamental front, it would have been much easier to make our upgrade
today if the local Chinese steel markets had stopped slipping lower and the Shanghai-LME
price ratio had rebounded further. Furthermore, to be frank with our readers, we really hate
to see the sharp rebound of crude oil and copper prices earlier last week. A sharp rally amid
huge volatility does not help to restore physical consumption. The author of this note worked
in the physical commodity trading area for almost a decade and he understands a little bit
about the behaviour of physical commodity buyers. If crude oil hovers around the US$110
level and copper stabilizes at the US$3.20/lb level for more than one month, this will
increase the confidence of physical buyers to re-enter the market, to bottom-fish, or to
restock. However, if crude oil and copper touch the key support levels for only a few days
and then rebound sharply, as they did earlier last week, the time window is too short to make
a buy decision for commercial buyers and they are more likely to choose to continue to destock
if possible. In other words, if crude climbs sharply higher for geopolitical reasons and
copper tops US$3.50/lb again simply on a weaker dollar in the next few days, one or two
months later we might not be able to see a rebound of imports in Chinese customs data, as
the market did not give buyers the time window to book oil/copper, sign contracts, and
charter vessels/tankers to deliver the commodities to Chinese ports.
■ Lastly, from a technical perspective, we would characterize the sell-off over the past two
months as a well-controlled selling process – we never saw the process of a final capitulation
where things went no bid. Under the backdrop of a synchronized global slowdown, the lack
of capitulation does not make a solid foundation for a sustainable rally.
■ Because of the above concerns, we advise investors who follow our buy call today to load up
the raw materials and energy sectors in a gradual, buy-the-dip manner. There is no need for
any panic buying or momentum chasing.
A Historical Perspective – “Buy Back Everything When the Games Are Over”
■ If we have so many concerns, why do we still make the upgrade today, other than to make a
“statement” as a secular China bull on the first post-Olympic day? It is because no matter what
kind of trading pattern unfolds in the near term, it is our firm belief that investors should begin
to load up global raw materials and energy sectors for a relief rally into 2009. This relates to a
historical perspective on the investment theme surrounding the Olympic Games.
■ As we have written many times in the past, during the past 40 years the GDP growth of
countries hosting the Olympic Games usually peaked in the Olympic years (6% GDP growth
on average), particularly for countries undergoing urbanization. For example, Japanese GDP
peaked in the Olympic year of 1964 at 11.2% and then slowed down to 5.7% in 1965. South
Korean GDP peaked in the Olympic year of 1988 at 10.6% and then dropped to 6.7% in
1989. This phenomenon, according to the bears, is called “post-Olympic bust”. As a result, the easy investment strategy is “sell everything when the Games are still on”. This strategy
explains why in the hosting countries, although GDP showed the strongest growth in the
Olympic years, equity markets faced heavy selling pressure, particularly in the months leading
to the Games. Arguably, the same investment behaviour has been seen this year in the
Shanghai A-share markets and, more recently, in the global raw materials and energy sectors.
■ However, in the years right after the Olympic years, when the “bust” really happened (GDP
growth slowed down sharply to 3.7% for all hosting countries in the past 40 years), not a
single hosting country had a bust in its stock market. Average equity market return for
hosting countries in the years right after the Olympic Games in the past 40 years is 24.2%. In
other words, the sell-off in the Olympic years only laid the foundation for a relief rally into
the years right after the Olympic years when the “bust” really took place. This is because
when the slowdown was already in process, investors would argue there was nothing wrong
with Japan still growing GDP at 5.7% and Korea still growing at 6.7% in GDP. Yes, the
growth rates were slower, but the growth was based on larger bases.
■ We would not be surprised to see the same argument next year for local equity investors and
global investors in the raw materials and energy sectors – yes, China’s GDP is growing at
8% rather than 12.6% in Q2/07, but the country is still growing rapidly by any standard, on
an ever-larger base. The secular trend of urbanization is not over yet.
■ In short, if back in June, the right trade was “sell everything when the Games are still on,”
then today, the right trade might be “buy everything back when the Games are over.”
Our Sector Views
■ Regarding sectors, we maintain our bullish stance on the oil, coal (both thermal coal and
coking coal), steel, methanol, urea, DAP, and hardwood pulp sectors. Today, we upgrade
copper, the flagship for base metals, from “neutral” to “bullish” due to the improving import
economics, falling local inventory, and better consumption seasonality into the fall. We also
downgrade our view on soybean from “bullish” to “neutral” from a China perspective, as
China’s 2008 output is likely to grow as strongly as 4.7 million tonnes to 17.5 million tonnes
this year (see details from our comments last week).
■ The Chart of the Week below illustrates all our recommendation changes since we launched
our China Strategy Research, using the S&P Super-Composite Metals and Mining Index.
News in Brief
Nickel – Low-grade Nickel Ore Imports Down Sharply in July
■ In July, China’s net refined nickel imports were 8,936 tonnes, up 19% month over month
(MOM) and 28.8% year over year (YOY). Refined nickel output was 11,403 tonnes, up
0.1% MOM and 16.5% YOY.
■ Noticeably, China’s low-grade nickel ore imports dropped sharply to 530,983 tonnes, from
1.18 million tonnes in June and 2.03 million tonnes in May. This represents the first time
China’s low-grade nickel ore imports have been below 1 million tonnes since March 2007.
Zinc – Strong Imports in July
■ In July, China imported 31,369 tonnes of refined zinc, up 116.9% MOM and 90.2% YOY. In
the same month, China’s zinc exports went down 78% YOY to 5,314 tonnes. In the month,
China produced 331,200 tonnes of refined zinc, up 18.6% YOY. In the first seven months as
a whole, China’s zinc output grew only 8.3% YOY to 2.25 million tonnes.
Molybdenum – Lower Output in July
■ We calculate that in July, China exported 2,343 metal tonnes of molybdenum, in line with
market expectation and quota constraints. On the output side, China produced 13,158
physical tonnes of molybdenum, down 29.3% MOM but up 11.6% YOY. The MOM output
slowdown is related to the capacity shutdown due to the Olympic Games.
Base Metals – SHFE Copper Inventory Dropped
■ Shanghai copper stockpiles fell 12.2% this week to 21,796 tonnes and aluminum inventories
fell l.3% to 193,514 tonnes. Zinc inventories were relatively unchanged, up 576 tonnes to
72,327 tonnes.
Steel – Quantifying Demands from Sichuan Rebuilding
■ China’s Sichuan province will need 37 million tonnes of steel to rebuild towns, roads, and
factories damaged by the May 12 earthquake in the next three years, the local government
said last week.
Steel – Baosteel Cuts Q4/08 Prices
■ China’s Baoshan Iron and Steel (Baosteel), China’s largest steel mill, has cut its fourthquarter
sales prices for cold-rolled steel products by RMB300 per tonne from the third
quarter, the first cut in a year, while keeping its hot-rolled steel product prices unchanged,
according to local traders.
■ The price for cold-rolled steel, excluding value-added tax, is RMB6,496 (US$949.30) per
tonne for September, while the price for hot-rolled steel is RMB5,742 per tonne. Traders
have said Baosteel recently began adjusting its quarterly offer prices each month to more
closely reflect market conditions. The fourth-quarter prices will be in comparison with the
revised September figures.
■ We observe that the price cut on cold-rolled steel products is in line with market expectation.
Fertilizer – Output Growth Stronger Than Consumption
■ In July, China produced 4.74 million tonnes of urea, up 10.2% YOY. In the first seven
months, China’s urea output grew 6.4% YOY to 33.4 million tonnes. We observe that
although the output growth so far this year is weaker than last year due to coal shortage, it is
still higher than the weak consumption growth so far this year (estimated at around 4%).
■ In July, China produced 601,000 million tonnes of DAP, up 20.2% YOY. In the first seven
months, China’s DAP output grew 13.6% YOY to 4.62 million tonnes. We observe that the
output growth is a lot stronger than the consumption growth so far this year, which is
actually down on a YOY basis for DAP.
■ In July, China produced 307,000 million nutrient tonnes of potash, up 8.9% YOY. In the first
seven months, China’s potash output grew 19.9% YOY to 1.5 million tonnes.
Fertilizer – Tax Decisions from Rumour Mills
■ Reports at the end of last week from our local sources indicate that the urea export tax will be
hiked from 135% today to 175%-185% for September 1 through December 31, 2008. Export
tax for DAP, MAP, and TSP will remain at 135% (rather than reduced to 110% as previously
speculated) until December 31, 2008. A public announcement is expected this week.
■ In addition, the Chinese government is expected to scrutinize all attempts to move material
via bonded warehouses. Market sources estimate 250,000-300,000 tonnes of urea is now
stored at “bonded” facilities in anticipation of the announcement boosting the export tariff.
Electricity and Coal – Higher Price for Thermal Plants
■ Last Tuesday, China announced an RMB0.02/KWh price hike for electricity price paid to
generators (called the on-grid price). Until retail prices are raised, the state-run power grids
have to absorb the higher cost.
■ This move represents the second power price increase in two months. Back on July 1, China
raised on-grid rates by 5% and retail tariff for industrial users by 4.7%. As a result of these
two hikes, China’s on-grid rates have been increased by 10%, after a two-year price freeze.
■ We observe that the two hikes of on-grid rates are aimed at improving the margin of power
generators. Chinese generators are facing a margin squeeze by high coal prices and low
regulated on-grid electricity rates. An improved margin and cash flow for generators will
encourage them to restock coal.
Electricity and Coal – Electricity Shortage Easing
■ In recent weeks, the thermal coal inventory at generators has increased somewhat. At the
peak of the power shortage this summer, 16.35 GW of installed capacity linked to the State
Grid was shut down due to a coal shortage. The number was 12.96 GW as of August 24.
Though recovering (up 15% MOM), coal inventory at major generators remains on the low
end, or two-thirds of last year’s highest level.
Coal – China Tells Coal Exporters to Cut Back
■ China has asked its coal exporters to reduce exports, local traders said last week. The
government did not issue a written order, but made the request orally to the four Chinese
coal exporters in a meeting held the week before last just before it hiked export taxes on
coal. The extent of the export reduction sought by the government was not clear. Traders
said the order, together with the imposition of a 10% tax on coal exports, has the potential to
send export shipments sharply down in Q4/08.
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”.)
■ On sectors, 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.