China Update

China Commodities Weekly for the Week of November 30 – December 4, 2009

Fertilizers and Chemicals – Market Firmer

■ Two of our November reports focused on chemicals and fertilizers. Our report on November 5, 2009 covered DAP and potash, and our report on November 24, 2009 discussed urea and methanol. In today’s report, we are not going to revisit our investment themes – we just would like to offer a quick update on the market developments after these reports.

■ Following our note on November 5, in which we wrote that “China might become a net importer of DAP” (section “DAP – Two-way Trade”), we now understand that China might have booked 600,000 tonnes of DAP for delivery in December-January. With this booking, China would surely become a net importer of DAP in the foreseeable future. We note the local market remained tight and the price is still on the rise (see Exhibit 1). Chinese imports have obviously tightened up the international market. Yesterday, Mosaic said that “we are seeing early signs of a recovery… This is especially true in the phosphate market right now, but there is also activity in the potash market.”

■ As to potash, we understand that a delegation from BPC is in China now holding talks with Sinofert, Sinochem, and Sinoagri. As we wrote on November 5, “from a trading perspective, we also agree that a China settlement, at whatever level, is likely to trigger some buying interest in the potash sector, as investors will see the China settlement as the bottom, which should remove price uncertainty in the near term.”

■ We also note that NPK producers in China have been more active in purchasing potash recently. This is hardly surprising, though, as NPK producers tend to buy potash in November-January for production in late winter and distribution in early spring to meet the demands of the spring planting season. As a result, we note that although producer inventory remained very high in China, well in excess of 2 million tonnes, port inventory has fallen rapidly in recent weeks (see Exhibit 2). The local wholesale price has recovered by about RMB200/tonne in the past two weeks. The port wholesale price has firmed to RMB2,700-2,800/mt

(US$395-US$410/mt) ex-warehouse. MOP from Qinghai Salt Lake, with 60% K2O, is still quoted at RMB2,400/mt on a C&F basis.

■ Urea and methanol markets are also on the rise in China, supporting our “tradable rally” call dated November 24, 2009. We understand that Chinese urea export quotation is over US$290/tonne now, up another US$15 in the past two weeks, driven by higher coal and natural gas costs. Local wholesale and retail prices are also in an uptrend (see Exhibit 3).

■ For methanol, C&F China price is now quoted at US$283/tonne overnight, up from US$250/tonne in the middle of November (see Exhibit 4). Methanex’s Asian Pacific price is now listed at US$330/tonne for December, up 10% MOM.

■ Purely from a China perspective, DAP is our preferred play, followed by methanol and urea, and then followed by potash. From a global perspective, our Fertilizers, Biofuels & Chemicals analyst, Sam Kanes, is more positive on potash.

Gold – Will China Buy Gold?

■ Every once and a while, the gold bulls become excited about the potential of China’s diversification of its foreign exchange reserve into gold. Back in November 2008, the talk was that China had “announced” that it would like

to diversify its foreign exchange (FX) reserve into gold by buying 4,000

tonnes of gold. That was proven to be fake news, though it did move the

market for a few sessions.

■ One year later, gold bulls are finding more excitement. A few days ago, China Youth Daily quoted Ji Xiaonan, who chairs the supervisory board for big state-owned companies under the State Council’s state assets commission, as saying that a team of experts from Beijing and Shanghai had set up a task force last year to look at the issue of gold reserves. “We suggested that China’s gold reserves should reach 6,000 tonnes in the next three to five years and perhaps 10,000 tonnes in eight to ten years,” the paper quoted him as saying.

■ Although we do acknowledge that Ji Xiaonan is a high-ranking official in China, and therefore his words have more credibility than the rumours of one year ago, we would still observe that it is the central bank, not the State Assets Commission, that determines China’s gold holdings in its foreign exchange reserve. And the central bank officials do not seem to be impressed by gold. The recent sales from the IMF to the Indian central bank were a good example: the People’s Bank of China (PBOC) did not compete with India to buy gold, although PBOC was tipped to be the top candidate on the purchasers’ list for the 400 tonnes of gold offered by the IMF.

■ Yesterday, Hu Xiaolian, a vice-governor of PBOC, weighed in by calling the current gold price a “bubble.” “We must keep in mind the long-term effects when considering what to use as our reserves,” Hu told reporters in Taipei, when asked if China had plans to increase its

gold holdings in its foreign exchange reserves. “We must watch out for bubbles forming on certain assets, and be careful in those areas.”

■ In our opinion, the comments from Hu are a lot more credible than those from Ji, as PBOC has the authority to determine China’s gold holdings. And as we have long argued, the judgment of PBOC is reasonable. To us, although China does need to diversify its FX reserve, a purchase of 4,000 or 5,000 tonnes of gold is too big to implement, but too small for China to diversify.

Too Big to Purchase

■ It is almost impossible to buy a few thousand tonnes of gold in the spot market. Just to draw a comparison, the global annual gold demand is about 4,000 tonnes and the gold annual mine output is about 2,500 tonnes.

■ Some may argue that China can buy the gold through inter-central bank swaps. However, even for this channel, 4,000 tonnes is still too large an amount. For the time being, the United States holds the largest amount of gold in reserve, at 8,134 tonnes, followed by the German central bank, which holds 3,408 tonnes. Therefore, among the world’s central banks, only the U.S. Fed could do a 4,000-tonne swap in one deal with China, but this is highly unlikely, unless the Fed needs money in a desperate way (and if the Fed is indeed desperate, it can always print money).

Too Small for Diversification

■ We calculate that 6,000 tonnes of gold is about 192.9 million ounces; at a gold price of US$1,200/ounce, it is worth some US$231 billion. Given the size of China’s FX reserve, which is now over US$2.27 trillion, the proposed diversification is only slightly over 10%. In other words, even if China buys 5,000 tonnes of gold to top up its existing reserve holding of 1,054 tonnes to just over 6,000 tonnes, it would not serve the purpose of diversification very well.

News in Brief

Aluminum – Import Tax?

■ China may impose a tax on aluminum after imports surged and pressured domestic producers. The rising imports led to lots of pressure on the domestic market, said Yu Dongming, a director at the industry coordination department of NDRC, the country’s top planning commission. The nation doesn’t have an import tax on the metal currently. “We haven’t made a decision but we’re closely watching it...This has aroused attention from the cabinet,” Yu said. Chinese imports of aluminum jumped to 1.4 million metric tons in the first ten months of 2009.

Grain – GMO on the Go?

■ China has approved its first strain of genetically modified rice for commercial production, two scientists involved in the approval process told Reuters last Friday, potentially easing the way for other major producers to adopt the controversial technology. The Chinese Ministry of Agriculture’s Biosafety Committee issued biosafety certificates to pest-resistant Bt rice, with large-scale production to start in two to three years. Bt rice would help reduce the use of pesticide by 80%, while raising yields by as much as 8%.

■ China’s Academy of Agricultural Science also developed phytase corn, which will help pigs digest more phosphorus, enhancing growth and reducing pollution from animal waste and fertilizer runoff.

■ China, which wants to raise grain production 8% to 540 million tonnes a year by 2020, has splashed out on GMO research, with US$3.5 billion being spent on rice, corn, and wheat.

■ The rice and corn strains are China’s first GMO grains approved for commercial production, although it already permits GMO papaya, cotton, and tomatoes. The strains still need to undergo registration and production trials before commercial production can begin in restricted areas, which may take two to three years, the scientists said.

Oil – Imports to Remain High

■ China’s crude oil imports are expected to stay at a high rate of around 18 million tonnes per month, or around 4.3 million barrels per day, in the coming two to three months, the official Xinhua news agency reported in a newsletter on Tuesday. With new oil tanks, pipelines, and refining projects set to commence operation in coming months, crude throughput would likely hover around 33 million tonnes per month, or about 8 million bpd, the report said.

■ Domestic oil processing hit a high of 33.29 million tonnes in October, while crude imports, at more than 19 million tonnes in October, were the second highest in history.

■ “The petroleum and chemical industry may enter an expansionary period before the end of the year,” the report said, citing the China Petroleum and Chemical Industry Association.

■ Crude oil inventories were estimated to have risen 800,000 tonnes in October, the China Oil, Petrochemical, and Gas newsletter added.

Coal – Shanxi’s Plan

■ Shanxi Province plans to limit its coal output to between 670 million tons and 700 million tons in 2010, state media reported on November 30.

■ The Shanxi Coal Industry Bureau (SCIB) estimated that coal supply and demand will rise steadily with the recovering economy, prompting an 8% YOY increase in coal output next year, Xinhua news agency reported.

■ SCIB estimated that the province’s coal output will fall to about 620 million tons in 2009, from about 656 million tons in 2008, due to the bureau’s efforts to consolidate the coal mining industry this year. So far, the number of coal mines in the province has dropped to 1,053 from 2,598, as coal mines with an annual output below 300,000 tons have been eliminated.

■ The province also plans to expand its railway transportation capacity by 50 million tons to 400 million tons a year.

Macro – November PMI

■ The headline Chinese PMI for November was flat MOM at 55.2. Although the headline number is still very strong, there is a little weakness underneath. This is because the forward looking sub-indices, like new orders, were slightly weaker, while inventory sub-indices were visibly higher.

■ The New Orders Sub-Index moderated by 0.1 points to 58.4 last month, while the New Export Orders Sub-Index is down by 0.9 points to 53.6.

■ The Sub-Index of Major Inputs Inventory rose by 2.4 points last month to 51.4 points, the first reading over 50 since May 2008. This shows that China has stocked enough raw materials after months of strong imports since early 2009 and record domestic output since early summer. In particular, the inventory survey confirmed our view that the inventory for base metals is particularly high (inventory reading 62.9, the highest among all 13 sectors surveyed) and a mini destocking cycle (reduced imports) will likely last until at least the end of the winter.

■ Also, the Sub-Index of Finished Goods Stocks rose by 2.0 points last month to 45.4.

■ In summary, the flattish headline PMI seems to be boosted by higher inventory levels, while new orders moderated slightly.

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.