China Update

China Commodities Weekly for the Week of February 1-February 5, 2010

■ This week, China's nickel and DAP prices were up; iron ore, steel, urea, potash, chemicals, and oil product prices were flat; and copper, aluminum, zinc, grains, and coal prices were down.

Macro – The Collective Wisdom of a Market

The Two Finishing Lines

■ Since the beginning of 2009, the performance of the Chinese stock market has been fascinating in two major aspects: its overall performance and its sector rotation.

■ On the overall performance side, it is fair to say that in the first half of 2009, the Shanghai market led the global equity market rally. In fact, one can argue that the Shanghai Composite Index, which peaked in October 2007 and bottomed in November 2008, had led the S&P 500 Index on all the major market turning points in the past three years. This is why the fact that the Shanghai market peaked on August 4, 2009, has worried many bulls in the global raw materials sectors.

■ And if the bulls look at the underlying sector behaviour in the Shanghai market, their worry would grow further. The materials sector finished first (up 141% since January 2009), followed by energy (up 131%), then by property (up 121%), and by financials (up 109%). The consumer discretionary, IT, and industrials sectors are the key laggards. This result might seem intuitively right to Western observers. In many investors’ minds, Chinese growth was driven by a simple fact: huge loan growth has supported a huge construction boom in the infrastructure and housing sectors, so the materials, energy, financials, and real estate property sectors should outperform.

■ However, this situation was totally reversed in the following five months. At the second “finishing line,” on January 29, 2010, the consumer discretionary and IT sectors finished in first and second place, while the materials and energy sectors suffered a major pullback, financials and property sectors dropped even further, and industrials still finished last. Indeed, the pullback for the materials, energy, financials, and property sectors since December 2009 has been very drastic.

The Collective Wisdom of the Market

■ Recent history tells us that we should not totally dismiss the collective wisdom of the Chinese investment communities. It is undeniable that in the past few months, local Chinese investors lost faith in the financials sector over concerns about the sustainability of easy credit growth; they also lost faith in the property sector over concerns about the sustainability of strong home sales and an “asset bubble”, and they lost faith in the materials and energy sectors over concerns about the sustainability of the construction boom, which was driven by easy credit and strong home sales.

■ And in contrast to the Western perception that the Chinese economy is all about construction rather than consumption, in the past few months Chinese investors have put their money into consumption sectors such as consumer products, electronics, autos, tourism, and information technology.

■ We would refrain from drawing major conclusions based on a few months of market performance. Indeed, if our call for a major construction boom in the spring materializes, the sector rotation might well reverse back again in favour of materials and energy. That said, we would at least take notice of what the local market is telling us.

More Loan Restriction News

■ Back on January 12, in an interview with The Globe and Mail, we commented on the RMB600 billion in new loans in the first week of January by stating: “Superficially, it is very bullish because it shows liquidity is ample in China but that could draw the attention of the central bank that may decide to do something to stop it.” Indeed, the Chinese authorities have not only done something to stop it, they have done a lot since mid-January.

■ Entering February, after a lending pause in late January, Chinese commercial banks have resumed their lending to clients. But both local media reports and bank sources indicate that the renewed lending is now subject to some “soft restrictions.” For example, local financial media CBN said yesterday that “loans to developers will be temporarily tightened, according to sources from several commercial banks.” The 21st Century Business Herald, another local newspaper, reported that Chinese banking authorities have asked commercial banks to carefully review and strictly control loans to the steel industry and steel traders, because of perceived high inventory risk and overcapacity concerns. We also understand that the Bank of China has officially terminated the 30% interest discount for personal mortgage loans. The best interest rate offered by the bank to first-time home buyers is now a 15% discount on the benchmark lending rate.

■ The 21st Century Business Herald also said that the government has set a sector-wide ceiling of RMB2.4 trillion in new loans for the first quarter. That would be about one-third of the full-year target of RMB7.5 trillion. Also, the newspaper said that authorities have allocated full-year loan quotas to each of the country’s biggest banks. This is contrary to the official comments by the China Banking Regulatory Commission. Last month, the commission denied that it was implementing bank-specific loan quotas.

■ With the increased policy risk and signals from the Chinese equity market, we choose to remain a seasonal bear, despite the recent pullback in global raw materials sectors. We will watch the situation closely on the post-Spring Festival market behaviour to determine our short-term, seasonal views. We remain a cyclical and secular bull for the time being.

Commodities – Fertilizer vs. Steel

■ Last week, we upgraded our view on potash and urea to “positive” from “neutral,” and stressed that DAP remains our preferred play. We also downgraded our view on the steel sector. The developments so far this week strongly support these changes.

Fertilizer – The “Physical/Equity” Divergence

■ We note that Belarusian Potash Co. said this week that it has raised potash prices by US$25/tonne to benefit from a recovery in demand, bringing the price in Asia to US$410/tonne on a C&F basis. Separately, the Fertilizer Monthly Bulletin said that there has also been a “huge” surge in demand from Brazil, Europe, and some Asian markets since BPC agreed to a US$350/tonne sale to China in December.

■ On the DAP and urea side, we note that since the beginning of February, China’s export tax has been raised to 110% from 7%, as the country enters planting season.

■ For the fertilizer sector as a whole, we would like to observe that this is a sector where the equity market sold off when physical commodities rallied in January, particularly DAP, and now potash. This is a rare divergence – other sectors, such as copper and steel, are facing a symmetric pullback in both physical commodity prices and related equities.

Steel – The Loan Restriction’s Impact

■ As we wrote in the Macro section, the 21st Century Business Herald, a respected local newspaper, reported on Wednesday that Chinese banking authorities have asked commercial banks to carefully review and strictly control loans to the steel industry and steel traders, because of the perceived high inventory risk and overcapacity concerns. The paper wrote that all commercial banks in Sichuan province had received an internal document from the Sichuan bureau of the China Banking Regulatory Commission. The document, dated January 25, 2010, said that all financial institutions should review outstanding loans to the steel industry and control risks accordingly. The risk is high in the steel industry because “steel mills and steel traders, with the support of bank credit, are betting on higher steel prices in 2010 as a group by stockpiling. The steel inventory level in the country has swelled and risk has accumulated.” The document said that at the end of 2009, the total steel inventory in China was 70 million-80 million tonnes, up by about 20 million-30 million tonnes on a YOY basis. As total steel output in 2010 is likely to top 700 million tonnes, the high inventory and strong output will put pressure on steel prices, according to the document. The document also said that if steel prices go lower, banks will face “severe financial risks.”

■ We observe that in China, many steel traders use bank loans to facilitate trade. A common practice is to secure bank loans using steel inventory as collateral. For collateral purpose the steel inventory is usually valued at 65%-70% of market value by the banks. If the banks want to tighten loans to steel traders, they can lower this collateral ratio from 65%-70% to, say, 55%. Also, as steel prices have dropped in January, the banks can also mark-to-market the value of steel inventory held as collateral. All these moves can force traders to sell some inventory to pay back some bank loans. If this happened on a large scale (not yet), it could start a de-stocking cycle in the market.

■ As we have written repeatedly, we still believe that construction activities will come back strongly in the spring after the seasonally slow winter and spring festival. The only risk that concerns us is inventory levels. Local traders have built inventories counter seasonally so far in the winter months in anticipation of stronger demand and higher prices in the spring. A de-stocking in the rest of the winter is therefore very desirable. Otherwise, the country will face sufficiently high inventory for key commodities in the spring, when construction eventually starts. This would undermine the bullish case for the spring rally that we foresee.

■ Investors who like the overall construction theme in China should continue to put their money in the iron ore and coking coal sectors, in our opinion. We note that iron ore prices rose slightly in the past few days after the recent pullback, and coking coal prices were slightly higher in major producing areas last week.

Oil – CNPC’s Forecast for 2010

■ China’s crude throughput will grow 5.1% YOY this year to keep pace with oil demand, which is set for expansion at a similar pace, state-run top energy group CNPC said in an annual research report.

■ The run increase, equivalent to about 380,000 barrels per day (bpd), compares to a Reuters poll

that showed China’s top 22 oil plants would add 560,000 bpd crude throughput this year.

■ CNPC expects China’s crude oil imports to increase 9.1% YOY to 212 million tonnes in 2010, or 4.24 million bpd. The forecast, however, was not consistent with the 2009 base figure released by China’s Customs department that showed China imported 203.79 million tonnes or 4.07 million bpd of crude last year. Net oil imports, including crude and refined oil products, could rise 8.3% to 234 million tonnes.

■ China’s apparent oil demand will grow more than 5% to 427 million tonnes this year, or 8.54 million bpd, CNPC said.

■ The country is expected to add 31.5 million tonnes of crude refining capacity in 2010, raising overall capacity to 10.3 million bpd by year-end, according to the report compiled by CNPC’s Research Institute of Economics and Technology.

■ Domestic crude production will gain some 2% to 193 million tonnes, while gas output is expected to rise to nearly 100 billion cubic metres (Bcm), CNPC said, an amount some 20% above last year’s level. China’s crude output inched down 0.4% to 189.5 million tonnes in 2009 and gas output gained 7.7% to 83 Bcm during the same period, data from the National Bureau of Statistics showed.

■ Ethylene production capacity is expected to increase by 2.57 million tonnes from a year earlier to 15.27 million tonnes by the end of this year, and actual output could top 12 million tonnes, the CNPC report said.

■ Natural gas imports will top 10 Bcm in 2010, the report said.

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, iron ore, thermal coal, coking coal, uranium, molybdenum, corn, DAP, urea, potash, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, steel, 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.