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Msg  59974 of 65647  at  4/21/2009 11:26:34 AM  by


China Update

China Update                               Na Liu, MBA, CFA, Scotia

China Commodities Weekly for the Week of April 13 - April 17, 2009

Macro – Investments Grew strongly

Q1 GDP Likely to Be Lowest in 2009

China’s GDP expanded 6.1% year-over-year (YOY) in the first quarter of 2009, the lowest quarterly GDP growth in almost twenty years, after a 6.8% gain in Q4/08. We observe that the Q1/09 GDP is highly likely to be the lowest quarterly GDP figure in 2009, for two reasons: fundamentally, going into the rest of this year, the huge loans addition in the winter months and the stimulus package implemented by the government will gradually show their full impact in the real economy; and statistically, China reports its GDP data on a YOY basis – the Chinese economy was strong in Q1/08, but had slowed down markedly since then throughout the rest of 2008, offering a statistical base that is easier to compare with for the rest of 2009.

Although we believe the Q1 GDP figure is likely to be the lowest in 2009, whether it is the trough for this economic down cycle is still unclear, much depending on whether the Chinese economy follows a “V” shape or “W”shape recovery. We note that, historically, Chinese economic growth, once peaked, usually suffers from a multi-year slowdown. For the time being, we continue to call ourselves “a cyclical bear” (while remaining a “seasonal bull” and a “secular bull”).

Strong Fixed Asset Investment Growth

As for other key data, as Chinese Premier Wen Jiabao already leaked last weekend, industrial production (IP) expanded 8.3% YOY in March, compared with 3.8% in the first two months. We note that this pickup in IP growth came despite a steep fall in exports, which were down 17.1% YOY in March.

With the IP data already known to the market, the urban fixed-asset investment (FAI) data is the only bright spot in last week’s National Bureau of Statistics (NBS) report. In March, China’s urban FAI climbed 30.3% YOY, up from 26.5% in the first two months. Noticeably, China’s fixed asset investment continued to move into the interior regions of the country. In Q1/09, FAI in the costal region (eastern region) was up 19.8%, in mid-China region it was up 34.3%, and in western China it was up a massive 46.1%.

All other data for March are essentially in line with market consensus, with retail sales up 14.7% YOY in the month, CPI down 1.2% YOY, and PPI down 6% YOY.

With the strong IP and FAI data, we maintain our “overweight” call for the global raw materials sectors from a China perspective.

Electricity Output Still Sluggish

As we have pointed out repeatedly, electricity output is a key concurrent indicator of the strength of near-term industrial activities in China. In the second half of March, China’s power output was not as strong as it was in the first half, resulting in a 1.3% YOY drop of power output in March overall.

This sluggish electricity production continued in April. Nationwide, electricity supplied via major grids fell 3.57% YOY during the first ten days this month, compared with decline of 1.3%, 2.2%, and 2.7% in the first, second, and third ten-day periods of March, according to the National Electricity Dispatching and Communication Centre, a unit of the State Grid.

Although we do not read too much into one data point, as electricity output is also heavily influenced by weather conditions, we do note that the sluggish output does not confirm the reported strength in IP and FAI growth. Similarly, the steel price in China, another key indicator, remains under pressure and does not point to strong construction activities overall. These are the two disconcerting signals from the real economy which run against the strong macroeconomic data and which commodity bulls (us included) should be aware of. On the positive side, however, we note that China reported some small drawdown of steel inventories in the past two weeks and the freight market begins to recover slightly.

Wen’s Assessment

Over the past weekend, Premier Wen Jiabao shared his assessment of the Chinese economy and indicated his policy bias. “A series of economic stimulus measures adopted by China have shown initial results and there have been positive changes in economic performance, which has been better than expected,” he said.

But Wen also cautioned that China would still err on the side of the caution, sticking to its active fiscal policy and moderately loose monetary policy. “We would rather overestimate the severity of the situation and fully consider difficulties in making longer-term preparation for bigger difficulties,” he said.

Similarly, central bank governor Zhou Xiaochuan also emphasized that, even though there were positive signs that the economy is starting to recover, China is still at the stage of struggling against the global economic slowdown and financial crisis.

Time to Tighten Up a Bit?

Even though the policy bias from the top leadership remains expansionary, it seems that Chinese banks are beginning to tighten loan rules and increase scrutiny on the use of borrowing, as explosive growth in lending fuels risk concerns. For example, the Bank of China has issued guidelines to its branches to monitor borrowers and the flow of loan capital. Construction Bank has started to inspect consumer loans to ensure they are used for their intended purposes and not for speculation on the stock market.

Liu Mingkang, chairman of the China Banking Regulatory Commission (CBRC), warned banks to step up their vigilance in managing the credit explosion last week. “We should pay close attention to risk accumulation as bank lending surges,” he said. The CBRC will soon issue stricter lending guidelines to banks to ensure proper use of loans, according to the official China Securities Journal.

Fertilizer – Prices Fall

In the past few weeks, Chinese fertilizer markets have been falling across the board. The seasonal factor is partially accountable for this, in our opinion. For the time being, the fertilizer application for the spring planting season in Northern China is almost completed, but the major application season in Southern China has yet to start.

Urea – Domestic Prices to Drop More to Match Export Orders

On the urea market, mainstream ex-factory prices have dropped to RMB1,750-1,850/tonne. In certain regions, prices have dropped to RMB1,700/tonne or even lower. We note that starting July 1, China will reduce its export tax for urea to 10% from 110% 10%. Assuming RMB1,700/tonnes, ex-factory, we calculate that Chinese urea export quotation should be around US$290/tonne including tax. We note that recent offers from China to Bangladesh reflected export prices no higher than US$265/tonne. This indicates that Chinese traders and exporters expect urea prices to continue to drop in the coming months into the off season.

In China, producing one tonne of urea requires 0.7-1 tonne of coal (most likely to be anthracitic coal) as input. The production process further consumes some 0.5-0.9 tonnes of thermal coal as fuel. For the time being, delivered price (to urea plant) for anthracite coal is about RMB800-850/tonne, and delivered price for thermal coal is about RMB480/tonne. Based on this, we calculate the coal cost for urea producers in China is about RMB900-1,250/tonne. Including other costs, we believe China’s average urea production cost is at around RMB1,500/tonne. This is why, if coal prices remain stable in China, due to excessive competition we expect the Chinese urea price to eventually drop below RMB1,500/tonne exfactory at off-season, indicating an export value of lower than US$255/tonne. At this level, Chinese exporters would be able to make some exports during the off-season, if the international market maintained its current level in the coming months.

DAP – Domestic Prices to Drop More to Match Export Orders

In recent weeks, ex-factory prices for DAP (64%) have dropped to RMB2,600-2,700/tonne in China. As the high-priced sulphur inventory depleted and sharply lower sulphur price (now close to US$50/tonne CFR China) begin to reflect in production costs, we expect China’s DAP production cost to drop to around RMB2,000/tonne into the off-season. Officially, China’s export tax will be cut to 10% beginning on June 1, 2009 (one month earlier than urea). At 10% export tax and RMB2,000/tonne ex-factory price, we calculate China’s DAP could be offered at US$335/tonne.

We note a market report that China’s YTH and Wengfu are negotiating a large supply deal with India’s IPL and IFFCO, with a proposed tonnage of 400,000-600,000 tonnes. Prices were offered by the Chinese side at US$370-375/tonne but were rejected by the Indian side. The Indian side, in turn, is now hoping to pay around US$350/tonne, but this is reportedly being rejected by both Chinese suppliers.

Potash – SinoChem and Sino-Agri Tried to Support Market

Last week, China’s two potash importers, Sinochem and Sino-Agri, tried to halt the quick slide of domestic potash prices. After a special meeting on April 15, the importers declared that their port quotation for Russian red, Russian white, and Canadian red 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 week, as prices for all the grades will be hiked by RMB200/tonne one week later.

We note that this move shows that the importers are panicking. Chinese importers now hoard over 3 million tonnes of potash inventory left on hand after China’s major NPK production season. The import cost for the majority of this inventory was well over RMB4,250/tonne. Last week, China’s average retail potash price dropped to RMB3,916/tonne. In other words, Chinese importers are stuck with a loss from their import program last year, as Chinese NPK producers and farmers refuse to pay sky-high potash prices. For the time being, the importers are trying to clear their inventory at ports (through the move mentioned above), and should have no incentive to book large volumes of potash in the near term if overseas suppliers insist on a higher price. We maintain our call for a flat import price in 2009 versus 2008.

Nickel and Molybdenum – A Storage of Value?

Last week, led by the 304 series, China’s stainless steel market spiked higher, helped by the sharply higher nickel prices (see Chart of the Week).

It is debatable whether the nickel price rally is sustainable. Some local observers believe that it is investors, not real end users, who have been buying nickel lately. As Antaike puts it, “Compared with copper and aluminum, nickel is more valuable. When you want to use 1 million yuan to buy physical metal, you could get about 10 tonnes of nickel only, it is a small amount and easy to store.”

As the argument goes, nickel is twice as valuable by weight as copper, and eight times more valuable than aluminum, making it a metal that can be stored by private investors who normally do not have large storage space. Unlike gold, it’s an industrial metal that offers leverage to the Chinese economic recovery.

“We sold an average of 100 tonnes of refined nickel a day in the past two weeks, compared to the normal 30 to 40 tonnes level,” a nickel sales manager at a trading house in Shanghai said. “About 90% of the sales were to people whose businesses are not nickel.” It is rumored that investors such as rich businessmen in coastal Zhejiang and Jiangsu provinces were interested in stocking up on nickel as part of their investment portfolio.

Some local investors were also expecting the government’s State Reserves Bureau to buy nickel after it bought copper, aluminum, and zinc in the past few months. In early March, industry sources said the SRB could buy 10,000 to 20,000 tonnes of refined nickel, but there has been little evidence of action so far.

In our opinion, although investment demand plays a role in the recent nickel price rally in China, there are also some fundamental reasons for it that should not be ignored. First of all, although it was initially the nickel price rally that triggered the stainless steel price spike, the sharply higher stainless steel price could in turn trigger re-stocking demands for it, and thereby push nickel demands higher. Secondly, like copper, we understand that there is a severe shortage of stainless steel scrap. As the secondary supply dries up due to low prices, demand for primary nickel has to make up the void. Thirdly, sharply lower nickel prices have virtually killed nickel pig iron production in China, which was a very important (albeit high cost) supply of nickel content when primary nickel was in shortage two years ago. And lastly, maintenance work at Jinchuan Group, China’s largest nickel producer, might also have contributed to the recent local shortage. The latest NBS data shows that China’s nickel output dropped 5.9% month over month (MOM) in March to 16,063 tonnes.

In the very near term, the Chinese market is likely to remain tight, and the Shanghai-LME price ratio continues to support imports. China’s imports of refined nickel and nickel alloy surged 66% MOM to 12,690 tonnes in February. Data for March is expected to be released next week. We expect the imports to top 20,000 tonnes in March. Given the prevailing Shanghai-LME price ratio, we expect China’s nickel imports to remain high in April and May.

On the negative side, however, it is apparent that the LME inventory remained at a very high level and the global nickel industry is running at a low capacity utilization ratio (around 70%). As we have written repeatedly, for any given commodity, its inventory and its spare capacity are the two components of its supply cushion. If the supply cushion is too high, the commodity price is likely to be capped on the upside. Unfortunately for the bulls, nickel fits this description very well; and this differentiates nickel from copper, for which the supply cushion is much lower, with one week of demand LME inventory, very low SHFE inventory, and a 90% industry run rate. And this difference explains why we maintain our bullish view on copper and our neutral view on nickel.

Finally, a word on molybdenum. If nickel is viewed as a way to store value, why not molybdenum, which has a higher value? In the form of ferromoly, the metal is very stable and easy to store (although in oxide form one has to make sure the material is kept dry). The only fatal disadvantage for molybdenum as a storage of value is that it is not traded on the LME, and it is perceived to be illiquid and less tradable. But if and when the demand for stainless steel picks up both metals will benefit.

Commodities – March Output Data Review

Last week, the NBS released the production data for key commodities. China’s copper output grew 5.2% YOY but dropped 0.2% MOM in March, to 319,400 tonnes. The sluggish domestic output data supports our bullish view on copper.

As for aluminum, domestic output dropped 16.4% YOY but grew 0.9% MOM in March to 902,300 tonnes. Domestic production is likely to gradually recover, however. We estimate Chinese producers are restarting at least 750,000 tonnes of spare capacity to take advantage of the recent price strength.

The NBS also reports that China’s zinc output grew 8.2% YOY and 30.1% MOM in March to 344,200 tonnes.

China’s iron ore output remained abated on a YOY basis, down 1.1% to 61.722 million tonnes. As we wrote last week, sharply lower iron ore prices have pushed some small, high cost iron ore producers to shut down production. On the crude steel side, however, the NBS reported a monthly output of 45.101 million tonnes, or 531 million tonnes on an annualized basis, much higher than the 505 million tonnes reported by the China Iron and Steel Association. Over the past weekend, BaoSteel’s chairman said that China’s steel prices will fluctuate at a low level this year because of the industry’s overcapacity.

As for coal, China produced 233.427 million tonnes of coal in March, up 10.3% YOY and 18.8% MOM. We note that the strong coal output growth was mainly driven by large state owned producers. For example, Shenhua Energy, China’s largest coal producer, saw its commercial coal output shoot up 26% YOY and 28% MOM in March.

On the oil side, China’s crude run was up 0.7% YOY and 13.9% MOM to 29.375 million tonnes. At 6.92 million barrels per day, the March run rate is the highest since October 2008 and represents the first YOY rise in five months. The stronger run rate explains the strong crude oil imports last month, which rose to the second highest on record. Separately, local media reports indicate that China’s oil products inventory might finally have begun to decline. Fuel inventories held by China’s top refiners fell 14.7% in March, the first sharp decline in over two years, according to the China Petroleum and Chemical Industry Association (CPCIA). Sales rose by 21% versus February, an increase likely due in part to the longer month of March.

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.

Individual Commodity Sectors: On individual commodity sectors, we are now positive on the copper, steel, iron ore, uranium, molybdenum, urea, DAP, methanol, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, coking coal, thermal coal, potash, wheat, corn, soybean, 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 now look for 35% drop in the 2009 annual iron ore contract. We expect the 2009 China potash contract price to be flat versus 2008 contract at US$576/tonne.

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