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Msg  60410 of 65647  at  5/21/2009 4:46:51 PM  by


China Update


China Update

China Commodities Weekly for the Week of May 18-22, 2009

Macro – PMI to Dip Below 50?

In the past two days, many clients have asked for our opinion on a widely forwarded competitor’s note, which warned that China’s May PMI might fall below 50. This should not be anything new for readers of our China Commodities Weekly, as we have discussed the PMI seasonality repeatedly with the latest discussion dated May 1, 2009, with the coloured chart shown in Exhibit 1. In the past, China’s May PMI always fell from April, with an average drop close to four points. Given April’s reading of 53.5, if history repeats itself, there is a risk of a sub-50 PMI in May. In our report dated May 1, we called May the transitional month from the “Spring Revival” (yellow bars in Exhibit 1) to the “Summer Lull” (blue bars).

That said, the purpose of our May 1 report was to explain why we have decided to hold our ground against this proven seasonality pattern by maintaining our “overweight” call. In short, what encourages us to fight the tape are (1) the strong loan growth; (2) the further roll-out of the stimulus package; (3) the strong home sales and the upcoming restocking by China’s developers; (4) the success in finding higher-floor prices for key commodities in this downturn; and (5) the fact that although China has re-stocked, the rest of the world has not.

The May PMI is to be announced at 9:00 p.m. EST on May 31, 2009. If the PMI does dip below 50, sentiment will be hurt for a while. But 11 days later, people will hear China’s May IP and FAI numbers, which are likely to be stronger than the potentially weak PMI implies. This is because China reports IP and FAI data on a year-over-year (YOY) basis, and May 2008 happened to be the month of the Sichuan earthquake, which offers an easy statistical comparison base.

Copper – Near-Term Market Dynamics

In our China Commodities Weekly published last Thursday, we wrote, “over the past two weeks, the Shanghai-LME price ratio has been falling. In addition, Chinese buyers for spot copper imports are paying less in premiums. These are some early warning signs for slower Chinese copper imports into the summer months.” As these points have been drawing more attention over the past two days, we elaborate on them as follows:

First, we note that the price ratio between Shanghai and LME has dropped to a level where full-tax general imports are barely break-even and no longer hugely profitable (see Exhibit 2).

Another indicator of local market tightness, the premium of spot Shanghai prices to front month SHFE futures, also dropped from over RMB2,000/tonne one month ago to the current RMB330/tonne, indicating the spot market is no longer tight.

Physical import premiums also fell. Singapore and Korea warehouse premiums are quoted at US$150/tonne above LME cash, down from US$250/tonne in recent weeks. In Shanghai, copper premiums hover around US$100-US$125 above LME cash for spot imports, down from over US$200.

On LME, cancelled warrants (metal set to leave warehouses) have been going lower since May, from as high as 84,000 tonnes down to 50,325 tonnes as at May 19.

On SHFE, exchange-monitored stock rose for a third straight week to 35,389 tonnes last Friday (see Exhibit 3).

Fundamentally, as we wrote in last week’s report, China’s scrap imports are recovering (see Exhibit 4). Scrap shortage was one of the key drivers for China’s huge refined copper imports in recent months.

So, will copper prices collapse immediately because of all the above? Not necessarily. As we wrote in our report dated April 27, Exhibit 5 “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-US$2.25/lb for a couple of months, allowing the copper-related equities to catch up.... After that, the direction of the global and Chinese economy will determine its fate.” We maintain our positive view on the copper sector from a China perspective, for the time being.

Oil, Chemicals, and Fertilizer – Adding Mega-Capacity

In its “revitalization plan” for the fuel and chemicals industry, the Chinese government stated on Monday that it will boost state reserves of refined fuels, its first official plan to expand beyond its crude reserves, and help cut high inventories held by oil companies.

Under the revitalization plan, China will also expedite building six refining and eight ethylene key projects during 2006-2010 with an aim to start operations by 2011. China will then have three to four mega-ventures, each with a crude processing capacity of more than 400,000 barrels per day and ethylene capacity of 2 million tonnes per year (tpy).

The plan aims to bring the number of China’s refining bases with a capacity of over 10 million tonnes to 20, and the number of ethylene bases with a capacity of over 1 million tonnes to 11. It will also bring the average operating capacity of China’s refining plants to 6 million tonnes, up from the current 5.7 million tonnes, and the average operating capacity for ethylene plants to 600,000 tpy.

China will at the same time shut down the undersized, inefficient ones – refineries under 20,000 bpd in size.

By maximizing domestic refining facilities, China aims to process 405 million tonnes of crude oil in 2011, or 8.1 million bpd, some 13% above the current rate.

By 2011, China will also be able to produce 15.5 million tonnes of ethylene. In 2008, China produced 9.983 million tonnes of ethylene.

On fertilizers, China aims to boost output to 62.5 million nutrient tonnes, up from 60.13 million tonnes in 2008. The focus will be on growing potash output. By 2011, China aims to produce 4 million nutrient tonnes of potash, a target we would see as very aggressive.

Aiming to curb worsening pollution caused in part by the soaring number of vehicles, China plans to move to the third phase of emission standards nationwide – similar to the Euro III standards in Europe – starting in 2009 for gasoline and 2010 for diesel, according to the plan.

News in Brief

Nickel – Refined Output to Grow

China’s primary nickel output is expected to grow 11% YOY to 230,000 tonnes in 2009, while stainless steel output is to fall 6% to 6.9 million tonnes, state-owned research group Antaike said on Wednesday. China’s nickel pig iron output in 2009 is likely to fall to about 600,000 tonnes this year from 700,000 tonnes in 2008, Antaike said.

In our view, Antaike’s estimate for stainless steel output might prove too conservative. We understand that stainless steel production has been improving in the first five months.

Iron Ore – “Not Giving Ground”

China’s steelmakers have not given any ground in benchmark iron ore price talks, an industry executive said on Wednesday, denying reports that they could soften their insistence on a 40% price cut.

“The position of the Chinese side has never changed,” Shan Shanghua, secretary general of the China Iron and Steel Association (CISA), told Reuters in a telephone interview. “Any news about our changes was speculation.” Shan denied media reports on Wednesday that CISA could accept a price cut of between 30% and 35%. “It is not sustainable if iron ore producers keep a high profit margin but steel mills suffer losses. It is common sense,” he said.

China’s Ministry of Industry and Information Technology issued a notice last week calling on commercial banks to restrict or cut off credit to steel enterprises that were “blindly expanding in disregard of the market.” The notice said steel output was “seriously oversupplied” and imports of iron ore were also showing excessive levels of growth, creating massive risks for the industry. “Why these mills can build up stockpiles without concern about cash flow is because they have bank loans, and we want to cut the chain,” Shan said.

Oil – Jet Fuel Price Hiked

China hiked ex-refinery jet fuel prices by 13% or RMB4,020/tonne. We note that this move will further fuel the speculation that diesel and gasoline prices will be hiked soon.

Macro – More Control on Loans

The China Banking Regulatory Commission will require banks to temporarily hold in escrow any loan to fixed asset investment projects greater than RMB5 million or exceeding 5% of the overall investment, instead of directly giving funds to the applicants, the official Shanghai Securities News reported. Once the borrower has worked out contracts or agreements for the funds, the bank will disburse the money to third parties. The rule is intended to make it more difficult to misuse bank loans.

Although officials have welcomed the loan surge so far this year as vital for boosting the economy, there have also been signs that they are increasingly uncomfortable with how some of the money has been used. The National Audit Office said on Monday that some companies had used fake documentation to obtain low-rate discounted bill financing from banks and re-deposited the money at a higher interest rate, which had affected support for the real economy and bloated bank loans and deposits.

The National Audit Office also said local governments had stumped up only 48% of their share of funding in some cases, as part of Beijing’s RMB4 trillion stimulus package.

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, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, coking coal, thermal coal, potash, wheat, corn, soybean, ethylene, methanol, 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 a 35% drop in the 2009 annual iron ore contract. We expect China’s 2009 potash contract price to drop US$51/tonne from its 2008 level, to US$525/tonne FOB.


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