China Commodities Weekly for the Week Of October 20-24, 2008

Na Liu, MBA, CFA, Scotia Capitals

■ Last week, China's base metals, iron ore, chemicals, fertilizers, grains, coal, and oil products prices were all weaker. The steel (and aluminum) markets tried to form a bottom after the sharp price decline in the past few weeks and a flood of news regarding output cuts by leading producers.

■ In this report, on the commodity side we focus on the recent sharp decline of steel, iron ore, and coke prices. We discuss our expectation for 2009 annual contract prices for iron ore and coking coal. We also focus on the high coal inventory in China as the country heads into the winter. We size up the potash supply and demand in 2008 as the year draws to an end. On the macro side, we discuss the rescue package announced by the Chinese government that targets the property sector, the key drag on the ongoing cyclical downturn in the Chinese economy.

■ In the News section, we discuss the output cuts by Chinese copper and aluminum producers and the September output data for methanol, ethylene, and fertilizers. We also elaborate on the increased pressure for the Chinese government to cut prices on oil products.

Steel, Iron Ore, And Coking Coal – Prices Dropped

■ In the past few weeks, we have reported that China’s steel and iron ore spot prices have been in free fall. How severe is the fall? In the charts of the week on pages 1 and 2 of this comment, we show the recent price levels and how far they have dropped. Readers can see easily that China’s rebar prices dropped back to the levels of July 2007; iron ore prices dropped to levels last seen in September 2006.

■ We note that last week, CVRD was still asking for an ore price hike for this contract year. This is simply ridiculous, in our view. The reality is that during the negotiations for this contract year, suppliers used the huge jump in Chinese spot market prices, which rallied over 100% from Q2/07 to Q1/08, to justify the 71%-97% contract price gain. Now, the Chinese spot price has given up all of these gains and reached an even lower level. In theory, the Chinese steelmakers can say that contract iron ore prices for 2009 should give up all the gains of 2008. We do know this is unrealistic, as the suppliers can argue from another angle – even after the recent drop, the spot market price is only slightly lower than the 2008 contract price, and suppliers have been pushing for a convergence between spot prices and contract prices in recent years. But even from this angle, the contract price should drop by some 10%-20% in 2009 if spot prices remain at the current level for the rest of the year and if the contract price and spot price do converge to a level where the contract price offers only a small discount.

■ As for coking coal, we note that Chinese coke export prices dropped to some US$540/tonne last week. In theory, this price still implies a coking coal value of over US$330/tonne. However, we observe that when BHP and Posco struck their benchmark coking coal contract price for this year on April 7, 2008, the prevailing coke price at that time was US$565/tonne. Therefore, we would argue that today’s coke price already implies a drop in coking coal contract prices for 2009; in addition, the Chinese coke export price might continue to fall entering into the end of this year, as the momentum for coke and coking coal prices is still firmly in a downward trend.

■ All this being said, after the sharp selloff in related equity sectors, we are not sellers in these sectors here. In our opinion, steel prices in China should bottom out at around the current level. Last week, China’s rebar price actually registered a small weekly rebound, the first weekly rebound since early September. We acknowledge that we have been wrong on our positive view on steel in recent months, but we do expect the significant output cuts announced by Chinese producers (see next section) to set a floor price for major categories of steel products in the near future; for this reason, we maintain our positive view on steel. If steelmakers continue to cut output to shore up prices, China’s iron ore demands are likely to remain sluggish and inventory is likely to remain high (still over 70 million tonnes at major ports now). Therefore, we have no choice but to maintain our neutral view on iron ore. In our opinion, iron ore contract prices for 2009 are likely to decline some 15%. Regarding coking coal, as we noted above, implied spot prices have been holding up remarkably well so far. Although we do expect spot prices to fall further, we maintain our positive view on the coking coal sector. We now look for a US$225/tonne hard coking coal contract price for 2009. The equity markets have already discounted a price lower than this, in our opinion.

CISA Sees More Cuts

■ China’s steel production will barely rise this year, according to Shan Shanghua, Secretary General of China Iron and Steel Association (CISA), last week, scaling back previous forecasts of 5%-10% output growth. China will produce about 500 million tonnes of steel this year, he said, up just 10 million tonnes from last year. “About 30%-40% of small steelmills in the Tangshan area, home of small and medium-sized Chinese steel mills, have shut down due to losses,” he added.

■ Separately, a senior advisor to CISA said Friday that “Chinese steel mills are facing a cost crisis. Almost all Chinese mills are suffering losses on the basis of current steel prices and long-term iron ore prices this year. Metal demand is sliding seriously globally, as people lose confidence.” This view is largely correct, in our opinion: 23 out of the nation’s 71 large and medium-sized companies reported losses in September.

CISA Talks Tough as Iron Ore Negotiation Begins

■ With spot iron ore prices below term prices for the first time in years, China’s steel industry has good reason to hope that prices for term iron ore contracts for fiscal 2009 may finally retreat. “It is time for the iron ore prices to return to a rational level,” CISA Secretary General Shan said last week in a conference in Qingdao. The conference in Qingdao unofficially kicks off annual price negotiations.

■ “China will increase investment in domestic iron mines, raising domestic iron ore production, in order to replace imported ore and restrict the price increase of imported iron ore,” Shan told the conference.

■ Also, Shan made it clear that China wants to overhaul the way iron ore prices are negotiated next year to unify the price of imports from all countries, reversing the industry move in 2008. “There are spot and contract prices, Asia and Europe prices… We need one price for all imported ores... We need to rethink the (negotiation) mechanism for next year,” he said. The association has already approached the three major suppliers on possible changes, he added. On fixing prices using an iron ore price index, on which BHP Billiton Ltd. (BHP) is keen, Shan said: “That’s a trap.”

■ We observe that China’s best hope is to unify the Australian and Brazilian ore prices on an FOB basis, an industry practice that was followed for 28 years until this year. As there are so many miners in India, it’s almost impossible for them to be involved in the talks to achieve a unified price (unless India chooses an industry leader to represent all exporters).

VAT Rebates to Increase?

■ The Chinese government is planning tax rebates on high value-added steel to cushion the impact of falling steel exports, the China Securities Journal said last week, citing a top official of CISA.

■ Most steel exports currently benefit from no export tax rebate at all. The news came two days after China announced it would raise rebates on more than a quarter of taxable goods, including textiles and toys, from November 1.

■ We observe that if China does increase the rebates, it will generate more trade disputes with the United States. In fact, last Wednesday, a spokeswoman for the U.S. Trade Representative’s office said that, “the United States will press China this week to stop government subsidies, tax breaks and other heavy-handed industrial policies that are distorting the steel market and are causing serious concerns in segments of the U.S. industry.”

Coal – Inventory Remains High, For Now

Power Generation

■ China generated 289.2 billion kilowatt hours of electricity last month, up only 3.4% YOY, according to data from the National Bureau of Statistics (NBS). That was below August’s already sluggish growth of 5.1%, making it the lowest this decade.

■ Thermal generation, which provides around 80% of the country’s power, grew a meager 2.7% YOY. Hydro power generation was a bit better, up 5.7% YOY.

■ We note that given China has consistently posted double-digit increases in electricity use in recent years, the September rate is unusually weak even for a month when consumption traditionally falters. The weak data does indicate that China’s economic activities slowed down sharply in late summer.

Thermal Coal Inventory

■ According to the NBS, China’s coal production rose 3% MOM and 10.8% YOY in September to 228.7 million tonnes. Higher coal output, together with weak power generation growth in the past two months, has pushed coal inventory at major power plants to normal levels of 15-20 days of coverage, as compared with seven days back in the snowy winter this year.

■ Coal stocks at 541 major coal-fired plants connected to State Grid were now up nearly 45% from two months earlier, according to data released by State Grid. The 541 plants have a combined generating capacity of 416 GW, or nearly 60% of China’s total. “Coal stocks have reached the best level of last year, which is also a record high,” said an official at State Grid. The current coal stocks can last 16 days. In some regions, coal stocks are high enough for 20 to 24 days, the official said.

■ We note that we are in the “shoulder season” for coal demand right now, after the summer heat and before the cold snap in the winter, and coal inventory in China usually climbs during this season. Therefore, the coming winter will still pose a challenge for China’s coal supply. That said, as economic activities slow down, the current high inventory prepares the country’s generators a lot better than they were before last winter.

■ Supply growth by big miners is also easing China’s coal shortage. China’s largest open pit coal mine, located in Haerwusu, Inner Mongolia, is set to start production very soon. The official Xinhua News Agency said that the US$1.02 billion project, which belongs to China’s largest coal producer, China Shenhua Group, is forecast to produce 7 million tonnes of low-sulphur, low-ash thermal coal in Q4/08, and 20 million tonnes a year thereafter (or 0.8% of China’s annual output) for a service life of 79 years. To counter the supply growth by large producers, as we noted before, China’s small coal mines are under safety scrutiny and output growth from small coal mines are likely to disappoint.

Potash – Sizing Up The Import Gap

■ We have been cautious on the potash sector for a long time, ever since the spring of 2008. After the recent sharp selloff in the potash sector, we are getting more comfortable, as “everything has a price tag.” In this section, we assess the balance of China’s potash supply and demand in 2008, as the year draws to an end.

■ In normal years, China needs to import about 8.5 million tonnes. Last year’s 9.4 million tonnes of imports, up 33.5% YOY, was largely driven by re-stocking due to a very low Chinese contract price; thus, the import number was inflated last year.

■ So far this year, China has imported 3.3 million tonnes in the first eight months (down 50.7% YOY); for all of 2008, we expect total imports to top 5.3 million. (In recent months, China’s potash imports have been over 500,000 tonnes per month and will remain so.) Therefore, compared with the normal import level of 8.5 million tonnes a year, China’s imports this year are likely to be down some 3.2 million tonnes.

■ In our judgment, we can break down this 3.2 million tonnes by the following: domestic output grows 0.6 million this year, demand destruction this year is about 1.6 million tonnes, and de-stocking is about 1 million tonnes.

■ On demand destruction, our 1.6 million tonne estimate, which is about 13% of total Chinese annual consumption, is conservative. Most local consultancies are talking about 15%-25% demand destruction. (In Potash Corporation’s conference call last week, its CEO said that “China has to date used 20% less potash and still have 3 million tonnes of inventory.”) In contrast to the comment above, the demand destruction might well continue into next year, as farmers might have learned the wrong lesson this year – farmers reduced potash application this year but saw that their crop yields for corn, wheat, and rice were all up. The better yields were actually because of cooperative weather this year, but the wrong lesson may have been learned.

■ After 1 million tonnes of de-stocking, for the time being, Chinese inventory is about 1 million tonnes lower than at the end of Q1/08, when China was in negotiations for the 2008 contract price. This is the major point that China’s overseas suppliers would argue for an even better contract price for 2009. But we would note that the de-stocking this year is a lot lower than suppliers initially expected, due to demand destruction and local output growth.

■ And for the Chinese negotiators, their counter-argument for the lower inventory is local supply growth. In 2009, China will have supply growth of about 900,000 tonnes from the Luobupo project in Xinjiang Province.

■ The above reasons are why we have been cautious on the potash sector – supply growth, demand destruction, and lower-than-expected inventory drawdown. But again, everything has a price tag. With the recent market selloff, we are getting more constructive for the potash sector. Unlike urea, potash supply is highly concentrated; as a result, suppliers can “control” pricing to a certain degree. At the end of the day, China depends on imports for 65% of the country’s potash needs.

Economy – Propping Up Demands For Homes

■ Over the course of last week, different ministries and government agencies in China vied to flesh out the 10-point pro-growth package endorsed the week before by the State Council, China’s cabinet. (Please refer to our China Commodities Weekly, dated October 20 for details of the 10-point package.)

■ The State Council said in its 10-point package that it wanted to “increase the scale of construction of low-cost housing, lower transaction fees and taxes for residential properties, and to support home purchases by residents.” All of these promises materialized last week.

■ From November 1, 2008, the property deed tax will decline to 1% from 1.5% for people buying their first home if it is smaller than 90 square metres (970 sq. ft.), the Ministry of Finance said last week. The Ministry also removed the 0.05% stamp tax and land value added tax for home purchases.

■ Separately, China’s central bank, the People’s Bank of China, said that starting October 27, 2008, for those buying their first home, regardless of the size, the down payment requirement will be lowered to 20% from 30%. Also, banks will be allowed to charge as little as 70% of benchmark lending rates for such mortgages.

■ The Chinese government is also focusing its efforts on reviving the property sector by enabling poorer people to buy homes. To that end, the government may launch a RMB1 trillion (US$146 billion) fund to build houses for poorer citizens, China Business News reported last Wednesday. The Chinese-language newspaper said the plan had been initially proposed at the beginning of the year by the Ministry of Housing and Urban-Rural Development. It was revived last week after the State Council meeting. The report, which did not identify any sources, said the National Social Security Fund and the Finance Ministry would contribute about RMB200 billion each to the fund. Currently, there is demand for over 30 million units of housing from China’s low-income population, the newspaper said.

■ The easing of property follows steps to help exporters, another decision made in principle by the cabinet.

■ Last Tuesday, China said it would raise the export tax rebates for a wide range of goods including textiles, toys, and machinery. The export tax rebates, to take effect November 1, will be raised to between 5% and 17% on export items that cover about a quarter of China’s taxable customs goods. The main categories for the rebate hike include goods in labour intensive industries, drug manufacturing, and high value-added sectors.

■ Also last week, the Ministry of Finance said that the government would take other steps to help the disadvantaged, including setting aside more than RMB40 billion for the education of poor students and those from earthquake-hit areas.

■ Furthermore, there were local media reports that a tax-reduction package in the magnitude of RMB150 billion-RMB200 billion has been approved in principle by the State Council. The package will include the long-awaited reform on China’s value-added tax regime. The reform will allow companies to deduct capital expenditures for value-added tax purposes.

■ Observations on the rescue package for the property market. We observe that last week’s cuts to taxes, interest rates, and down payment requirements for first-home buyers marks an initial unwinding of property market tightening measures that the government put in place over the last few years to counter what were then rapidly rising prices. Arguably, this is the largest rescue package for the property sector in China’s modern history and marks a U-turn in government policy and attitude on this sector.

■ That being said, we note that the initial market reaction to the rescue package was lukewarm at best. The Shanghai Composite Index actually declined on the day after the measures were announced.

■ Indeed, these measures, which mainly address first-home buyers, will save only a tiny amount of money for Chinese home buyers, and as long as expectations that prices will fall continue, the wait-and-see sentiment will prevail. It is hard to fight against market expectations, which have turned sour.

■ Also, we argue that the rescue plan still lacks three key components. First and most importantly, there is no promise to scrap the more stringent borrowing requirements for a second home. These stringent requirements have acted as a strong brake on the market since last year. Second, the measures failed to address the cash flow constraints faced by developers. And third, the general public does not seem to support the plan, as most residents who do not yet own an apartment still hope prices will drop further. Indeed, by international standards, home prices in first-tier Chinese cities are still high relative to income (this is not true for most of China’s urban areas, though).

■ Although we are a bit cautious on the effectiveness of the rescue packages announced so far, we note that in China, the government’s attitude has a larger impact on local market expectations than in the Western world. We further observe that real estate investments represent over 20% of China’s urban fixed-asset investments and account for 40% of China’s steel demands.

News In Brief

Copper – Some Smelters Cut Production Amid Low Prices

■ According to Antaike, an industry consultancy, Tongling Nonferrous Metals Group Co., China’s biggest copper smelter, cut copper output by 11% MOM to 51,000 tonnes last month. Yunnan Copper, China’s third- largest smelter, cut output 23% to 30,000 tonnes. Daye, the fourth largest, reduced output 1.4% to 20,800 tonnes last month. Antaike expects “more output cuts this month and next.”

■ Vice-President of Jiangxi Copper Co., Wang Chiwei, told Bloomberg that the company had

no plans to cut production.

■ Separately, Ningbo Gold Resources Copper Industry Group, a Chinese copper and semifinished products maker, has cut output as demand for copper falls, although the firm denied reports it had financial problems that had forced it to shut much of its copper production. The firm, also known as Jintian, had laid off some workers as a result of reduced orders for its products and now has 5,950 workers versus around 6,500 previously. The firm has annual capacity to produce 200,000 tonnes of copper using scrap as feed, or about 5% of China’s copper production.

■ Why did smelters in China cut output instead of lowering prices? We draw our readers’ attention to the fact that prices for sulphuric acid, an important and profitable by-product this year for copper and zinc smelters, have fallen over US$200/tonne in China in recent months, almost like a cut in TC/RC by US$100/t and 10 U.S. cents/lb.

Base Metals – SHFE Copper Inventories Fell

■ Shanghai copper stockpiles fell 10.7% this week to 31,053 tonnes, while aluminum and zinc inventories were relatively unchanged at 204,407 tonnes and 72,693 tonnes, respectively.

Aluminum – More Clarity on Chalco’s Output Cut

■ Aluminum Corp. of China Ltd. (Chalco) aims to cut its aluminum capacity by 18% annually, as China’s largest producer of the metal reels from plummeting prices worldwide and tries to slash costs.

■ The planned reduction of about 720,000 tonnes of output appeared to fall below smelter officials’ initial expectations for output cuts of 1 million tonnes – about a quarter of capacity. The company said, however, that it may cut production further depending on market conditions.

■ Chalco did not say if the capacity reduction was permanent, nor did it describe how long it would last. We expect Chalco to restart capacity as soon as the market recovers.

Methanol – Monthly Output Topped Million Tonne Benchmark

■ In September, China produced 1.046 million tonnes of methanol, up 19.6% YOY and representing the first time China’s monthly methanol output topped 1 million tonnes. In the first nine months, China produced 8.544 million tonnes of methanol, up 24.2% YOY.

Ethylene – Monthly Output Dropped for the Second Month in a Row

■ In September, China produced 809,000 tonnes of ethylene, down 8% YOY and 4.6% MOM. In the first nine months as a whole, China produced 7.887 million tonnes of ethylene, up merely 1.1% YOY.

Fertilizer – High Potash Output Growth

■ In September, China produced 4.554 million tonnes of urea, down 2% MOM and flat YOY. In the first nine months, China’s urea output grew 6% to 42.6 million tonnes.

■ In September, China produced 651,000 tonnes of DAP, up 8.1% MOM and 22.8% YOY. In the first nine months, China’s DAP output grew 17.4% YOY to 6.09 million tonnes.

■ In September, China produced 467,000 tonnes (nutrient) of potash, up 28.3% MOM and 62.2% YOY. In the first nine months, China’s potash output grew 26.5% YOY to 2.329 million tonnes.

■ We observe that China’s DAP output was on the high side in September, and China’s potash output rose significantly, likely due to the ramping up of the Luobupo project. The project is likely to add up to 1 million tonnes of new potash supply in 2009.

Fertilizer – The Winter Storage Program

■ For the 2008-09 winter storage program, the Chinese government at central and local levels is set to store 11 million tonnes of fertilizer through state enterprises, up from 8 million tonnes in 2007-08. A total of 8.25 million tonnes of urea is included, up from 6 million tonnes in 2007-08, with the balance allocation mostly for DAP.

Oil – Price Cut Soon?

■ As we speculated last week, Chinese policymakers are considering cutting domestic fuel prices for the first time in almost two years. The tumble in global crude prices has dragged gasoline prices in the United States to below Chinese rates for the first time in years, piling pressure on Beijing.

■ Two oil industry sources told Reuters that state-owned oil companies under pressure to fulfill their social obligations had submitted a proposal to cut fuel prices by an undisclosed amount to the National Development and Reform Commission (NDRC), which sets energy policy and regulates energy prices. The NDRC could submit the initiative to the State Council for a final decision as soon as this week, one of the sources said.

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 oil, coal (both thermal coal and coking coal), copper, steel, methanol, urea, DAP, and hardwood pulp. We are neutral on aluminum, zinc, nickel, molybdenum, iron ore, wheat, corn, soybean, potash, and ethylene. From a China perspective, we are cautious on paper products on a relative basis.