China Update

China Commodities Weekly for the Week of April 20 - April 24, 2009

Base Metals – Are These Imports Sustainable?

■ Last week, China released the detailed trade data for March. The base metals imports data were extremely strong. In March, China imported 296,843 tonnes of refined copper, 85,965 tonnes of primary aluminum, 12,620 tonnes of refined nickel, 25,370 tonnes of refined lead, 121,027 tonnes of refined zinc, and 2,463 tonnes of refined tin, up 137.63%, 1,486.53%, 28.68%, 7,003.64%, 1,193.76%, and 106.55% year over year (YOY), respectively.

■ As we have repeatedly discussed in our recent China Commodities Weekly reports, there were three reasons that have driven China’s buying spree for base metals: (1) strategic stockpiling by the Strategic Reserve Bureau (SRB), (2) commercial restocking ahead of the seasonal spring demand (and demand incurred by the stimulus package), and (3) domestic production curb due to the shortage of scrap, the sharply lower by-product revenue from sulphuric acid, and the lower treatment charges/refining charges (TC/RC).

■ After months of strong imports, investors are asking a very legitimate question: Given the global economic backdrop, are these strong Chinese imports sustainable? To this question, if we take a deeper look at the three reasons mentioned above, we would argue not.

■ First, the SRB is not buying at this level – its job is to buy the dip, not chase the momentum. In fact, it is lending out the materials it bought to traders (Minmetals) to calm down local markets now. We notice that there has been much rumour surrounding the SRB selling in the past two weeks. A lot of observers have dismissed the alleged selling as “smoke without fire,” a view with which we would agree. In our opinion, the SRB may be delaying the delivery of some booked tonnage and lending out some materials it bought to traders to calm down the market. But its ultimate goal is to buy more at cheaper prices.

■ Second, the bears could argue even commercial restocking is about to come to an end: spring is already here and it is the time for real demand to show up, proving restocking back in the winter months was right.

■ And third, with pricing rallying, local production is ramping up. Last week, we wrote that Chinese aluminum producers are restarting at least 750,000 tonnes of annual capacity, and Chinese zinc output was already up 8.2% YOY and 30.1% MOM in March.

■ That said, we still refrain from downgrading our overweight call for the raw materials sectors, for three reasons. The first and the more fundamental reason is China’s huge loan growth seen in the winter months – eventually this should translate into economic activity and commodity demand sometime in the coming months. Yes, restocking demand might be over, but real demand will eventually pick up, in our opinion. The second reason is that in the near term, China’s metal imports are likely to remain at fairly high levels in both April and May, particularly for the flagship metal of copper, simply because the Shanghai-LME price ratio remains supportive.

■ The last reason for our reluctance to downgrade is based on an observation of recent history to answer the question: What would be the most likely market reaction if China’s copper imports prove to have already peaked? Exhibit 2 (sorry I cannot paste the chart from PDF) shows that in the past two years in a row when China’s copper imports peaked in the spring, copper prices stopped going higher, but did remain at a high level for a few months before more serious pullbacks. If history repeats itself, China’s copper imports are indeed highly likely to peak this spring, but even if this happens, LME copper is likely to be stuck in a range of US$1.75-$2.25/lb for a couple of months, allowing the copper-related equities to catch up, in our opinion. After that, the direction of the global and Chinese economy will determine its fate.

Potash – Old Rumour, New Rumour, and New Forecast

The US$200/tonne Indian Rumour Proven Accurate

■ Back on February 23, 2009, we quoted the potash branch of China Inorganic Salts Industry Association (CISIA) as saying: “Recent intelligence indicates that in the coming negotiation, India could bid (counter-offer) for potash as low as US$200/tonne for the 2009 contract. This move might become the catalyst for a pullback of the international potash price.”

■ After we published that rumour, we got much pushback, some very furious. Last week, the CEO of Potash Corporation, Mr. Doyle, in his earnings release conference call discussed the Indian offer at length and this is part of what he said: “The Indians would like US$200 potash to break the price in India from six and a quarter to $200 for the 2009 negotiations…. But if you have $200 potash, like the Indians say they would like to have, and you stop all these potash expansions and you have a much dearer shortage, much more severe shortage of potash in the next year or two, you wouldn’t have $1,000 potash, you’d have $2,000 potash.”Well, here, Mr. Doyle confirmed that our report more than two months ago was accurate.

■ We revisit the Indian rumour for two reasons: first, we were questioned about our integrity two months ago – some investors thought we just made up a rumour to gain undue attention. Now we are so happy that we were proven not to have made up rumours, as we never do. Second, we revisit the Indian rumour and investors’ response to it to show that, indeed, the potash sector is such a well-loved sector. And this is one of the reasons that we do not advise investors to underweight or short the sector – many investors are now willing to look through the 2009 situation and focus on 2010 and beyond.

A New Rumour Without Guarantee of Accuracy

■ With our last reported rumour turning out to be accurate, we are now brave enough to report another rumour against the potash sector. We heard that BPC met with Sinochem and Sino-Agri (or CNAMPGC) on April 17 to discuss contract pricing for 2009. After the meeting, a rumour was circulated in the local Chinese market, indicating that Russian suppliers offered Chinese buyers US$500/tonne (or a US$76/tonne discount to last year’s contract price) for the 2009 Chinese contract, but this offer was rejected by Chinese buyers. We stress that we are not making this rumour up (it is from an important industry information source), but we could not verify its accuracy and we do not know if it is real or not.

Local Market Remains Sluggish

■ What we do know is that local sentiment in the Chinese potash market remains low and spot prices have remained under pressure in recent weeks. As we wrote a few weeks ago, demand for potash has come to a near standstill with the main NPK production season now over. NPK production represents 70% of China’s potash use.

■ On the pricing front, we wrote last week that after a special meeting on April 15, China’s two potash importers, Sinochem and Sino-Agri, had declared that their port quotation for Russian pink, Russian white, and Canadian pink would be RMB3,700, RMB3,800, and RMB4,100/tonne, respectively, for only one week. The importers urged end-users to place their orders during the “promotion” week, as prices for all the grades would be hiked by RMB200/tonne one week later. Last week, as promised, the port quotations by the two importers were indeed hiked by RMB200/tonne.

■ However, our local contacts said the effort of “promotion” failed miserably. Very few transactions were done in the promotion week, and even after the port offer prices were hiked by RMB200/tonne last week after the promotion, local spot prices continued to drop. In certain areas, imported MOP was reportedly sold at port as low as RMB3,500/tonne. The local average retail price dropped again last week to RMB3,875/tonne.

■ As we wrote last week, Chinese importers are stuck with a loss from their import programs last year. For the time being, the importers are trying to clear their inventory at ports, and should have no incentive to book large volumes of potash in the near term if overseas suppliers do not slash prices.

■ Further, we heard a rumour that at least one border trade was recently concluded at US$480/tonne, although the volume was small. And a US$475/tonne quotation is easy to obtain on a delivered at border (DAB) basis. The prevailing border trade quotations imply US$520/tonne seaborne equivalent.

■ Due to the weak local market environment, we are now officially forecasting the China 2009 potash contract price to drop US$51/tonne to US$525/tonne FOB from its 2008 level. We maintain our neutral view on the potash sector from a China perspective.

Look for Potash Overseas

■ A Chinese delegation, led by China Supply & Marketing Co-operatives (China Co-op), visited Laos in early April and signed a “landmark” mine development contract with the Laos government to develop Laos’ huge potash reserve. The Prime Minister of Laos met with the delegation on April 9, 2009 after the signing ceremony, and hailed the project as a milestone of government-to-government co-operation between the two countries.

■ The project will have three phases. The first phase is a 100,000 tonne pilot project to be finished by the end of 2009, the second phase will increase the project capacity to 1 million tonnes by 2013, and the third phase will further increase the project capacity to 3 million tonnes by 2017. This schedule sounds very similar to the three-phase Luobupo project that we first reported to the Western investment community three years ago. The Luobupo project was dismissed by many when we first reported it, but it turned out to be the largest supply-side response during this potash supercycle, and it will likely produce 800,000-1,100,000 tonnes of SOP for China this year.

■ We view the Laos move as an important development for China to solve its long-term potash needs and a prelude for China’s more active overseas acquisitions for undeveloped but proven potash assets.

March Trade Data

■ In March, China imported only 147,484.81 tonnes of MOP, down 61.7% MOM and 71.3% YOY. Among the 147,484.81 tonnes, 61,976.15 tonnes were from Germany, 42,984 tonnes from Jordan, and 36,736 tonnes from Russia.

■ In March, China’s DAP and urea exports slumped 70.7% MOM and 80.4% MOM to 99,862 tonnes and 74,779 tonnes, respectively, due to the prohibitive 110% export tax.

Molybdenum – China Buying Europe Empty?

■ In this section, we review China’s molybdenum market after our upgrade of the molybdenum sector on March 30. Helped by the broader market rally and improved sentiment for the base metals sectors, the molybdenum sector has performed well since our upgrade.

■ On the commodities side, however, shortly after our upgrade, the spot price for molybdenum actually dropped slightly, and then stabilized. The good news is that last week, the spot price for both ferro-molybdenum and molybdenum oxide moved up quickly. One Chinese producer was quoted as saying: “We are surprised about the price change in such a short period of time. Prices are heard quoting within a wide range of US$8.15-US8.50/lb (C&F for oxide) and there are no offers from overseas lower than US$8.15/lb now.” Despite higher prices, the Chinese can’t find any sellers in Europe, according to trading sources. Deals were done at higher prices closer to the end of last week. “Some overseas traders and producers simply have no spot material to sell… And we are waiting to buy,” said a trader. At the end of last week, offers were already seen at US$9/lb.

■ Metal Bulletin reported the same scenario for ferromolybdenum, which rose US$1 at the low end last Friday alone, due to dwindling stock levels and a flurry of China-related activity last week. Ferromolybdenum (basis 65%-70%) climbed to US$20.50-$22 per kg from US$19.50-$20.50 previously. Traders reported business late in the week at the high end of the quote. “The speed at which it’s moving is frightening; you could buy at US$19.50 a week ago,” said a trader. The reason for the move? Again, China, “China is trying to buy Europe empty,” a trader told Metal Bulletin.

■ All this anecdotal evidence is supported by the latest trade data. Official customs tally shows that China’s net imports of molybdenum reached another record high, and is now close to 4,000 tonnes on a metal content basis (see Exhibit 3).

■ On the negative side, major Chinese molybdenum producers held a meeting and agreed last week to call on the Chinese government to impose duties on imports and to launch an antidumping investigation on imports. Further, Chinese producers also said that the government should remove export duties, resume export tax rebates, reduce the mineral VAT to 13% from 17%, and lower or cancel the mining resource tax as a means to help molybdenum mines. In addition, the producers plan to ask the SRB to stockpile molybdenum products. In our opinion, the Chinese government would not listen to the producers, particularly the proposed import restrictions.

■ And last but not least, we observe that as another negative for the molybdenum sector, like copper and other base metals, China is still the only strong buyer for the metal. Traders still see no signs of sustained life in Europe and the United States.

■ We maintain our positive view on the molybdenum sector from a China perspective.

Uranium – China Looks at Australia for Projects

■ China National Nuclear Corp. (CNNC), the country’s body governing all supply of nuclear fuel for power generation, has held preliminary talks with Australian uranium miners, CNNC’s vice president said last Wednesday.

■ “We have contacted counterparts in Australia, and have held preliminary talks. But we need to verify the feasibility of certain projects before making any more details public,” CNNC Vice President Jiangang Qin told Dow Jones Newswires on the sidelines of the World Nuclear Fuel Cycle 2009 conference. “We want to focus on our own production but we’d also like to make investments similar to Japan, to plug any shortage in Chinese uranium supply,” he said.

■ Talk of China seeking large-scale investment in Australia’s uranium miners has intensified in recent weeks. One Sydney-based investment banker said contact from Chinese companies had increased exponentially over the past two months, with inquiries focusing on the coal and uranium sector.

■ As we wrote in our launching report for the uranium sector, A Clear, Long-term Bull Case, dated November 24, 2007, the market is clearly underestimating the speed that China is adding nuclear capacity. In 2020, we estimate that China will consume 15,700 tonnes of uranium a year. At this rate, China’s currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment.

■ After our launching report, China continued to add new nuclear capacity to the list we published in the report. Just last week, China started the construction of another major power plant. The Sanmen Nuclear Power Plant, for which CNNC would be the plant operator, started its first-phase construction on April 19 in eastern China’s Zhejiang Province. For the first phase, the plant will install two third-generation nuclear reactors that use Westinghouse Electric Corp.’s AP1000 nuclear technology. This would make Sanmen the first nuclear facility in the world to use such technology, and it is therefore hailed as “the biggest energy co-operation project between China and the United States to-date” by Zhang Guobao, head of China’s National Energy Agency, at the plant’s groundbreaking ceremony.

■ Investment on the first phase is worth RMB40 billion (US$5.86 billion). The first two generators are scheduled to start operation in 2013 and 2014, respectively. The plant will ultimately run six 1.25 GW reactors when construction of the plant’s three phases is completed.

■ We now forecast that China will have total nuclear capacity of 35 GW by 2015 and 75 GW by 2020, from the 9.068 GW operating today. For the time being, China has over 20 nuclear reactors (mostly 1 GW each) under construction; construction of half of these reactors has been started since last winter.

News in Brief

Methanol

■ China produced 842,000 tonnes of methanol, up 39% MOM but still down 8.4% YOY. In the first three months, China’s total methanol output was 2.079 million tonnes, down 21.7% YOY.

■ In March, China imported 653,000 tonnes of methanol, up 10.45% MOM, with an average import price of US$186.61/tonne. In the same month, China exported only 300 tonnes of methanol. These data pushed China’s methanol net imports to another record high.

Steel

■ China’s large- and medium-sized steelmakers had a combined loss of RMB1.9 billion in March, according to China Iron and Steel Association. Nearly half of the steel majors were mired in red ink last month.

■ “Starting in April, no steelmakers in China are making a profit,” said Ansteel’s President last week.

■ Separately, the Xinhua News Agency quoted an official from the Ministry of Industry and Information Technology as saying: “China may have oversupply of more than 100 million tonnes of crude steel in 2009.”

Electricity

■ Power output declined 3.9% YOY at mid-April, compared with a 3.5% drop in early April, according to the State Electricity Regulatory Commission. China’s power output is now widely followed as an important concurrent indicator for the country’s industrial activities.

Soybean

■ China made it public last week that the National Grain Reserve would continue buying domestic soybeans for stockpiling, until June 30. The reason for the purchases was explicitly to buoy local prices, as well as to protect “planting interest” by local Chinese farmers.

Gold

■ The head of China’s State Administration of Foreign Exchange disclosed last week that China has increased its gold reserve from 600 tonnes in 2003 to 1,054 tonnes currently. This makes China one of the six countries holding over 1,000 tonnes of gold. Gold now makes up 1.6% of China’s FX reserve – this level is actually lower than the 2% back in 2003 (because of the sharp increase in overall reserves in recent years). The increase in gold reserve was achieved by buying in the domestic market and from domestic producers.

■ China was the world’s largest gold producer last year and does not permit exports of gold ingots. China produced 282 tonnes of gold last year.

■ On the central bank’s balance sheet, for the time being, it still shows 600 tonnes of gold, but this will be adjusted to 1,054 tonnes very soon.

Recap of Our Calls

■ Essentially, we are making four calls in our China Commodities Weekly: economic trends in China, our overall sector call, our individual commodity sector views, and our calls for the contract negotiations for certain commodities. We recap our calls as follows:

■ Economic trends: There are three intertwined trends for the Chinese economy – seasonal (the current and next few months), cyclical (the current and next few years), and secular (the current and next few decades). We are currently a seasonal bull, a cyclical bear, and a secular bull.

■ Overall sector call: Our overall sector call is to answer one question: purely from a China perspective, should investors in the Western world be overweight, market weight, or underweight in the global raw materials and energy sectors as a whole? To this question, our current answer is overweight.