China Update

China Commodities Weekly for the Week of November 23-27, 2009

Methanol and Urea – Cost Pushes Prices Higher

■ In China, about 75% of Chinese urea and methanol output is coal based, with the rest 25% natural gas based. Over the past few weeks, coal prices continued to rally, while an acute natural gas shortage emerged. In this section, we focus on these developments.

Coal – Coal Prices Continue to Move Higher

■ Spot thermal coal prices in China’s top coal port Qinhuangdao continued to rise this week to nearly one-year highs, after a recent fatal coal mine blast. Prices for coal with calorific value of 5,800 kcal/kg (NAR) rose nearly 3% from a week earlier to RMB700 to RMB715 (US$102.5-US$104.7) a tonne in Qinhuangdao. Coal with calorific value of 5,500 kcal/kg rose about 3% to RMB660 to RMB680 a tonne.

■ A gas blast erupted in the early hours of last Saturday in the coal mine at Hegang in China’s far northeast Heilongjiang province, when 528 workers were working in the mine. Latest news said that 420 workers had been rescued and some four miners remained trapped, while the death toll from the disaster had reached 104 by Monday night.

■ The blast was the latest big accident to hit the world’s deadliest major coal mining industry. An explosion in a mine in central Henan province back in September left 79 workers dead.

■ Even though the mine in Hegang produced only a million tonnes of coal in the first 10 months of this year, the mine accident could tighten coal supply elsewhere in China, as the latest fatal accident is likely to trigger another round of nation-wide safety checks and further delay the production resumption of small coal mines in Shanxi province. As such, as we are now positive for the thermal coal sector from a China perspective.

■ Higher coal prices and tighter coal supply are bullish factors for the urea and methanol markets in China, as about 75% of Chinese urea and methanol output is coal based. In China, 1 tonne of urea output requires on average 1.6 tonnes of coal (0.7 tonnes of thermal coal and 0.9 tonnes of anthracite coal). One tonne of methanol production requires 2 tonnes of coal (0.6 tonnes of thermal coal and 1.4 tonnes of anthracite coal). Since late July, Chinese thermal coal prices have climbed by about RMB110/tonne at Qinhuangdao. In the same period, Chinese anthracite coal prices have lagged but also biased higher recently. We estimate Chinese coal-based production costs for urea and methanol have climbed by RMB110/tonne and RMB130/tonne, respectively.

A Severe Shortage of Natural Gas

■ In addition to coal, the recent shortage of natural gas is also supportive for methanol and urea prices, as about 25% of Chinese methanol and urea output is natural gas based.

■ The shortfalls of natural gas began this month when early, heavy snow hit northern China, spiking up heating demand and forcing PetroChina to divert south China’s supplies northwards. The cold spell then hit the south, adding to demand and slowing supplies.

■ Emergency reaction procedures have been declared in some of China’s biggest cities, including Chongqing, Wuhan, Hangzhou, Xian, Nanjing, etc. In Wuhan, the majority of industrial use of natural gas has been shut in. In Hangzhou, natural gas supply has been stopped for all entertainment venues. In southwestern Chongqing, taxis lined up for compressed natural gas (CNG) as the sudden drop in temperatures slowed pipeline flows, lengthening refuelling time.  Many were reluctant to shift to gasoline, which costs three times as much.

■ PetroChina, the country’s leading natural gas supplier, said on Tuesday it would make a second cut of 3 million cubic metres (mcm) in the daily amount it delivers to industrial users in northern China, reducing its volumes by another 10%. PetroChina has also cut 3 mcm per day, or 8%, from supplies to firms in the Yangtze River delta and the provinces of Hunan and Hubei, as well as trimming flows to industries in the southwest and northwest, the main gas producing regions.

■ As demand peaks in December and January, gas shortages are expected to reach 8 mcm daily in north China and 5-6 mcm per day in the south, China Petroleum Daily, an in-house newspaper of CNPC, PetroChina’s parent, said on Tuesday. “Gas for household needs and for heating can be guaranteed in the winter and spring by further reducing supplies to industrial users,” Lin Changhai, general manager of PetroChina’s gas sales unit in northern China, was quoted as saying.

■ The National Development and Reform Commission said on Monday that tight gas supplies are gradually easing, thanks to co-ordinated efforts by the government and major gas producers. Industry officials, however, said although improved weather in some regions and the record output fostered a temporary relief, supply capacity could be further tested ahead as the winter weather develops.

■ The implication of the natural gas shortage for urea and methanol markets in China is simple to understand: The cut of supply for industrial users will hurt output. For example, gas supplies to PetroChina’s Lanzhou refinery have been cut by 200,000 cubic metres, to about 900,000 cubic metres a day, forcing the largest refining and chemical complex in west China to reduce its urea production, according to plant officials.

■ Also, the natural gas shortage spilled over into the LPG market, and then to the DME market. Higher DME prices are supporting methanol use. “We were using LPG to fill the natural gas gap, so our production was not affected,” said an official at Sinopec’s Qilu refinery, where supplies were cut by 200,000 cubic metres a day. “But our profits will suffer as LPG is about twice as expensive as natural gas … I think the supply situation will not be eased until the beginning of next year,” he said.

■ All these factors have pushed spot methanol and urea prices higher in the past few days in China. As for urea, the Chinese export quotation for urea has been raised to well over US$270/tonne, up at least US$10/tonne from mid-October. As for methanol, C&F prices rebounded US$10/tonne at the end of last week, and many Chinese producers have been raising their list price in the past few days.

■ Although in the near term the impact should mainly be due to supply cuts, in the medium term, we expect China’s natural gas price to move higher, adding more cost pressure for urea and methanol producers.

■ In theory, the natural gas price is regulated in China. According to PetroChina, it currently realized something like RMB1.15/cubic metre or US$4.7/mmbtu. The price for end-users in China is sharply different from user to user and from region to region. Fertilizer use, like urea production, usually commands the cheapest price in theory, at some RMB0.71/cubic metre, or US$2.9/mmbtu (we estimate that only 30% of natural gas-based producers enjoy this preferential price). City gas prices are also relatively low, at around RMB0.8/cubic metre. Prices for industrial use of natural gas can be as high as RMB1.3/cubic metre or US$5.4/mmbtu. The market consensus in China is that natural gas prices will be hiked by the National Development and Reform Commission as early as the beginning of next year.

■ In China, producing a tonne of methanol will consume about 1,050 cubic metres of natural gas. Urea output consumes a bit less, but still 700-800 cubic metres per tonne. Therefore, if natural gas prices are hiked by RMB0.2/cubic metre, it will increase the cost of natural-gasbased methanol output by some RMB200/tonne (US$29) and urea output by some RMB150/tonne (US$22).

■ Although for the time being we are maintaining our “neutral” view on both the urea and methanol sectors, largely due to overcapacity concerns, we believe the recent cost issues in China can easily cause a tradable rally for the equities of Western producers, which would become more competitive in the near term due to the higher costs faced by Chinese domestic producers. We will monitor the situation closely, and if the coal and natural gas shortage persists even after the recent snowstorm into the winter, we will consider an upgrade for both the urea and methanol sectors.

Commodities – More October Data

■ Overnight, China released the detailed customs statistics for October. In addition to the preliminary data that we have already discussed, the following data are new:

Base Metals – The Mini De-stocking Cycle Continues

■ In October, China imported 27,839 tonnes of refined zinc, down from last month’s 35,652 tonnes and the peak level of 121,027 tonnes seen back in March 2009.

■ Similarly, in October China imported 11,378 tonnes of refined nickel, down from last month’s 20,491 tonnes and the peak level of 47,754 tonnes seen back in July 2009.

■ In October, China imported 2,575 physical tonnes of molybdenum concentrate and ferromoly, down 49% month over month (MOM). China’s molybdenum imports peaked at 7,504 physical tonnes back in March 2009. Industry sources told us that China’s interest in spot purchases seemed to stop in late July, although some spot purchases then may have been negotiated for October delivery. Most of the October volume was under volume agreements negotiated up to the end of December with various Western producers. Local supply continues to come back – last month China produced 18,911 physical tonnes of molybdenum concentrate, up 6% year over year (YOY) and representing a new monthly

output record.

■ We note the zinc, nickel, and molybdenum trade data fit well with our view that a “mini destocking cycle” is ongoing for most commodities in China, particularly for base metals.

Coal – Coking Coal Imports Disappointing

■ Separately, China’s coal imports rose 219.5% YOY but dropped 11.2% MOM to 11.14 million tonnes in October. China’s coal imports hit a record high of 16.07 million tones back in June.

■ Imports of coking coal were 2.12 million tonnes in October, compared with 4.28 million tonnes in September and the peak of 4.9 million tonnes seen back in July 2009. The origin of the coking coal imports is as follows: 1.39 million tonnes from Australia, 0.38 million tones from Mongolia, 0.17 million tonnes from Russia, 0.15 million tonnes from Canada, 0.09 million tonnes from Indonesia, and 0.04 million tonnes from New Zealand.

Fertilizer – DAP/Urea Exports Dropped; Potash Exports Surge

■ In October, China’s urea and DAP exports dropped 63.8% MOM and 74.9% MOM to 290,169 tonnes and 68,222 tonnes respectively. As we wrote two weeks ago, we expect China to turn into a net importer of DAP in the next few months. Our understanding is that China has booked over 400,000 tonnes of DAP to be delivered from November 2009 to January 2010.

■ As for potash, in October China imported only 5,800 tonnes of the material but in the same month exported 79,097 tonnes. China remained a net exporter of potash for the second consecutive month.

Methanol – Imports Lower in October

■ In October, China’s methanol imports dropped to 170,200 tonnes from 311,098 tonnes in September. China’s methanol imports peaked at 659,829 tonnes back in May 2009.

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 bear, a cyclical bull, 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.

■ Individual commodity sectors: On individual commodity sectors, we are now positive on the copper, steel, iron ore, thermal coal, coking coal, uranium, molybdenum, corn, DAP, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, potash, urea, wheat, soybean, methanol, ethylene, and crude oil. We are cautious on paper products. Please note that our positive, neutral, or cautious views on individual commodity sectors are all on a relative basis from a China perspective.

■ Views on annual contract negotiations: We are looking for a 12.5% rise in the 2010 annual iron ore contract. We expect the 2010 benchmark Australian hard coking coal price to settle at US$160/tonne, up from US$129/tonne in 2009. We expect the 2010 China potash contract price to drop US$181/tonne from its 2008 level, to US$395/tonne FOB.