China Update

China Commodities Weekly for the Weeks of December 21 – January 1, 2010

Happy New Year

■ The author of this report wishes all our readers a happy and prosperous New Year. Your continued support for our China and commodities research is crucial to us in 2010.

■ To welcome our readers back from holidays, we offer a quick update of the Chinese commodities markets in the last two weeks of 2009.

■ The author of this report is tentatively scheduled to travel to China in January. After today’s issue, publication of our China Commodities Weekly will resume once the author returns from China.

Commodities – A Quick Market Update

■ Major Chinese commodities prices were strong in the last two weeks of 2009, as economic activity remained robust. China’s official PMI hit a 20-month high at 56.6 in December, up from 55.2 in November.

Coal – Icy Weather Hits Northern China

■ Following the snowstorm in November 2009, another major cold snap hit northern China again over the past few days. Amid heavy snow, capital city Beijing registered the coldest temperature yesterday in 40 years and all schools were closed in Beijing and Tianjin.

■ The cold winter weather further tightened China’s coal and natural gas markets. Thermal coal prices continued to rally; benchmark Shanxi Premium Coal reached RMB820-RMB840/tonne at Qinhuangdao, up over 5% in two weeks. In fact, all major grades of coal finished 2009 at their highest price level at Qinhuangdao, China’s largest coal-handling port (Exhibit 1). On December 28, inventory at Qinhuangdao dropped to just over 5 million tonnes, the lowest level in two months. Inventory at power plants linked to the State Grid is now at around nine days, inching closer to the warning line of seven days.

Iron Ore and Steel

■ With the news that India decided to levy the iron ore export tax of 5%, local iron ore prices finished 2009 at the highest level of the year. Indian 63.5% fines are quoted now over US$120/tonne, up about 20% from early December. India, which supplies nearly a fifth of China’s iron ore imports, increased the duty on iron ore fines to 5% from zero, while iron ore lumps face a 10% duty from December 24, up from 5%.

■ The coke price also rose some RMB20-RMB70/tonne in the last week of 2009.

■ Due to rising input costs like iron ore and coke, Chinese steel prices rallied across board towards year-end. Average rebar prices rose more than RMB200/tonne to RMB3,820/tonne since mid-December, while average hot-rolled sheet prices also rose about RMB200/tonne to about RMB3,930/tonne.

Base Metals

■ Base metals prices rose across the board over the last two weeks of 2009, tracking the rally on the LME. The good news is that the Shanghai-LME price ratio has also improved slightly.

■ We note that Chinese aluminum smelters have agreed to pay more for imported alumina in 2010. Term prices for imported alumina will rise to 14.5%-15% of the LME aluminum price, versus 13.5%-14.5% in 2009. Separately, Chalco just raised its spot alumina prices for the third time in five months. From January 1, the Chalco price will be increased by 5.7% to RMB2,800/tonne.

Potash

■ On the fertilizer front, the BPC settlement of US$350/tonne (delivered) sent a shockwave through the local Chinese market. Almost all local industry contacts view the BPC settlement as lower than expected and some local distributors have begun to fear a flood of low-cost imported materials that may begin to hit the local markets starting mid-February. Most purchasers halted or reduced buying immediately after the BPC settlement news.

■ As we wrote in mid-December, the Chinese potash market had been rallying strongly to over US$400/tonne right before the BPC deal amid dropping port inventory and active purchases by NPK producers. This is why we believe that BPC basically gave up at a time when the Chinese market began to turn in favour of the suppliers, and the Chinese negotiators thus achieved a home run by persistence and patience.

■ Local market participants are now debating the near-term market direction without consensus. On the one hand, the BPC settlement is much lower than prevailing spot market prices and, when imported materials arrive, the local market will have to digest these low cost materials. On the other hand, some observers say that as Sinochem and Qinghai Salt Lake raised list prices just before the BPC settlement, a sharp price pullback is unlikely, especially in the near term. Also, some observers believe that Sinochem and Sino-Agri might control import volume to avoid flooding the local market with cheap material, so the market could actually tighten up a bit into the planting season. This would enable Sinochem and Sino-Agri to sell their high-cost inventory from 2008 imports, and their low-cost newly booked 2010 imports altogether.

■ In short, the local market is digesting the BPC settlement news. Although the recent rally had suddenly ground to a halt, the spot market did not crash to the new import parity price. Nominal wholesales prices dropped only RMB50-RMB100/tonne, or about US$10/tonne, in the last week of December. Average retail prices dropped RMB50/tonne in the same week to RMB2,940/tonne.

■ On the global market, the Chinese settlement remains the most important price-setting event, despite suppliers’ comments that “China will become less relevant compared with Brazil and India for the potash market.” We note that on December 28, Potash Corp. said it would cut its U.S. Midwest price to US$390/tonne for the January 4-February 28 period from US$515/tonne at present. With this move, Potash Corp. adjusted downward its prices, essentially to reflect the lower China settlement.

DAP

■ In contrast to potash, urea and DAP prices continued to rally in China. DAP prices, in particular, rose strongly at both the wholesale and retail levels. Nationwide average retail DAP prices rose about RMB120/tonne in the last two weeks of 2009 to over RMB2,730/tonne.

■ The market over the past two weeks supports our long-held relative preference of the fertilizer sector in the sequence of DAP, urea, and potash.

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, soybeans, 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.