China Commodities Weekly for the Week of January 18 - January 22, 2010

■ Last week, China's nickel, DAP, chemicals, coke, and coal markets were up; grain and potash prices were flat; and copper, aluminum, zinc, iron ore, steel, and urea prices were down.

Macro – Like This Pullback

■ Last week, China announced its GDP data for Q4/09 and macroeconomic data for December 2009. The data showed robust economic growth in the country, due to both improving economic fundamentals and low statistical base effects (recall that China reports macroeconomic data on a YOY basis, and Q4/08 offers a very easy comparison base). That said, we note that the market reaction to this data has been muted, largely due to the higher-than expected CPI data (1.9% YOY in December), fears about further tightening, and two specific emerging headwinds: loan restrictions and a correction in China’s property market.

Loan Restrictions

■ We understand that several major Chinese commercial banks, including the Bank of China and the Bank of Agriculture, have received verbal orders from authorities to halt new lending (including bill financing) in the remainder of January, as total new loan additions in China may have already exceeded RMB1.1 trillion in the first two weeks of 2010. The China Securities Journal wrote that since January 18, the Bank of China’s lending system has been “shut down,” so technically no loans can be issued in the remainder of January. Over the weekend, local media (e.g., Guangzhou Daily) reported that in the cities of Nanjing, Hangzhou, and Fuzhou, even personal mortgage loans have been halted for the rest of the January by some (but not all) local banks.

■ The restriction of lending has been partially confirmed (or partially denied) by Liu Mingkang, Chairman of the China Banking Regulatory Commission (CBRC). Liu said in Hong Kong last week that Chinese regulators had asked some of the nation’s banks to limit lending after they failed to meet

requirements including those for capital. However, the CBRC hasn’t asked all Chinese banks to halt lending. Chinese regulators track more than 10 regulatory requirements for the nation’s banks, Liu said. “If you fail one of them, your loan expansion will be limited. That said, financing for good existing projects will be guaranteed,” he said.

A Correction in the Property Market

■ Latest housing statistics showed that in Beijing, secondary home transactions were down 72% sequentially in the first half of January 2010. In Shanghai, new home transactions were down 53% sequentially in the same period. In Hanzhou, a second-tier city, the number of cancellations has increased sharply since mid-December.

■ The situation is more mixed for the country as a whole. It seemed that in the first week of January, transaction volume dropped in 23 cities of the 31 cities surveyed by China Index Academy, but prices largely increased. The situation reversed in the second week, in which 20 cities saw transaction volume increase sequentially, but prices drop in most cities.

■ In our opinion, the fundamentals for the Chinese property market have not changed – inventory is low in most cities and land value is increasing. Therefore, the property prices are not likely to drop significantly in the near term, and construction should pick up strongly in the spring. That said, we note that the Chinese government has launched various measures to cool the Chinese property market since December, including higher interest rates for second home mortgages, a 40% down payment requirement for a second home, prohibition of land hoarding, and a 5% sales tax for “flipping homes” within five years of purchase. Some home buyers are now willing to take a “wait-and-see” attitude in the near term (rather than line up in front of the sales offices one day ahead). They want to see how the market evolves with the recent government interventions.

Like This Pullback

■ In our thematic piece for 2010, entitled “Focus 2010 – China Outlook, The Three Economic Trends” dated January 11, 2010, we wrote:

■“We note that the raw materials sectors have rallied hard since last March without any serious pullback (and our recommendation has been “overweight” all the way along). If any deep pullback in the raw materials sectors were to happen in the next few months, we believe it would most likely happen sometime in January-February 2010 … If some investors decided to take some profit in early 2010, we believe that this could become a very good buying opportunity for a potentially powerful rally in the spring of 2010, when Chinese construction activities come back.”

■ Indeed, it would be nice to see a pullback in a number of areas: the global raw materials sectors, Chinese loan growth, the Chinese property market, and China’s physical raw materials imports. A pullback in all of these areas will help contain inflation expectations, asset bubble formation, and further policy tightening, and it will also offer investors a better entry point for the raw materials sectors.

■ Take Chinese imports, for example – preliminary data showed that in December, China imported a record 21.26 million tonnes of crude oil, or 5.02 million barrels per day. This is the first time that China’s crude oil imports topped 5 million bpd on a daily rate basis. In the same month, China imported 62.16 million tonnes of iron ore, up 80% YOY and 22% MOM, representing China’s second-highest monthly import on record. And China imported 369,368 tonnes of unwrought copper, up 27.3% MOM and 28.9% YOY.

■ Although strong import data are naturally bullish for related commodities, our only concern is that these imports are made by Chinese importers based on a very high expectation for the spring revival of economic activities after the seasonally slow winter. Latest data show that property construction slowed down sharply in December (up only 8.3% YOY versus up 40%-66% YOY during August –November 2009), likely due to the adverse weather in the country. This shows that the strong commodities import in December is counter-seasonal. A large portion of these imported materials are being built into inventory. The risk for the bulls, us included, is that when spring comes and construction activities take off, inventories for key commodities, after months of building in 2009 and early 2010, could be found to be on the high side. In the meantime, higher commodities prices will also encourage local production growth for commodities such as low-grade iron ore, nickel pig iron, or coal from small mines. With a comfortable inventory level and higher local output, commodities imports might not be as strong as the bulls would like to see in the spring, even if economic activities pick up strongly in March and April as we expect.

Investment Strategy

■ We have been calling ourselves a “seasonal bear,” so the pullback last week did not surprise us. In the meantime, we remain a “cyclical bull and secular bull” for the fundamental of the Chinese economy. Therefore, our bottom line is that any serious pullback in January and February will present investors with a buying opportunity for a strong spring rally.

■ That said, given the concerns we discussed in the preceding section, our near-term investment strategy is: if the pullback last week, triggered by policy fears, continues and becomes more meaningful, and if the Chinese commodities imports moderated in the rest of the winter, we would aggressively buy the dip and load up for a strong spring rally; on the contrary, if the pullback proved to be just a blip and the raw material sectors continue to rally to new highs during the rest of the winter, and if the Chinese imports continue to swell, we will sell some winning positions in early spring to bring raw materials positions to “market weight” from “overweight.”

Commodities – Key Trends in Early 2010

Coal – High Prices; Premiers Talk about Higher Imports

■ China coal imports reached 16.4 million tonnes last month, up 29.5% MOM and setting a new monthly import record. Coking coal imports were 3.5 million tonnes in December, up from 2.86 million tonnes in November. Among the 3.5 million tonnes of coking coal imports, 2 million tonnes were from Australia, 377,000 tonnes from the United States, 376,000 tonnes from Mongolia, 314,000 tonnes from Indonesia, 215,000 tonnes from Canada, and 207,000 tonnes from Russia.

■ We expect China’s coal imports to remain at lofty levels through March 2010. We note that last Tuesday, both Premier Wen Jiabao and Vice Premier Li Keqiang said that China will appropriately increase imports of thermal coal to ease the country’s power shortages. “Easing demand and supply strains on coal, power, and gas is crucial to making adjustments to the operation of the economy,” Wen said in a high-profile economic policy statement. He also said that China would restrict power supplies to energy-consuming firms.

■ Coal prices remained firm this week, amid a port disruption at Qinhuangdao. Qinhuangdao port, China’s largest coal handling port, was closed at the beginning of last week due to heavy fog. Coal inventories at power stations linked to the State Grid remained low at eight days of use.

Chemicals – Prices Continued to Rally

■ Methanol, ethylene, and styrene prices have been strong recently on higher coal and natural gas costs. Local media reported that the National Development and Reform Commission is working on a new pricing policy for natural gas, and the draft of the policy indicates natural gas average prices will be hiked by at least 20%, and will be linked to crude oil prices.

Fertilizer – Strong DAP Prices

■ In the fertilizer market, urea suffered a small pullback last week, potash prices stabilized at a level some $25 higher than the import parity price, and DAP prices continued to move higher.

■ We see limited downside risk for urea in the near term as coal and natural gas prices are likely to remain high. The DAP market is now supported by multiple factors: the power outage is curbing capacity utilization in Southwest China; the railway bottleneck in the winter months is reducing DAP transportation to consuming regions; and the higher raw materials cost, with recent sulphur sales to China topping US$140/mt C&F, is limiting the downside risk for the commodity. Therefore, we believe the Chinese DAP market will remain tight into the spring. We continue to prefer DAP to urea and potash from a China perspective. Latest statistics showed that China imported 97,793 tonnes of DAP in December, up from 0.48 tonnes in November; while the country’s DAP export dropped 40% MOM to 155,323 tonnes.

Molybdenum – A Tick Down

■ In our China Commodities Weekly dated December 17, 2009, we wrote about “A Price Uptick” for molybdenum. In the past few days, we noticed a price downtick. Prices for ferromolybdenum dropped about RMB5,000/tonne last week in China to about RMB146,000-RMB148,000/tonne. Molybdenum concentrate was traded at RMB2,100-RMB2,200/tonne at the end of last week, down from RMB2,250-RMB2,300/tonne a week ago.

■ As the end-users’ purchases had visibly dropped in the past two weeks amid high molybdenum prices, the recent price correction, though small, might signal that the molybdenum price will stop rallying in the near term and begin to consolidate at current levels.

Steel and Iron Ore – Price Pullback

■ Both steel and iron ore prices in China suffered from a modest pullback last week, due to seasonally slow demands. In contrast, coking coal and coke prices remained supported. China’s coke export topped US$350/tonne last week.

Base Metals – Shanghai-LME Ratio Improving

■ Although most base metals prices were lower last week, we note that the Shanghai-LME price ratios are recovering, meaning import economics is improving.

Re-Cap 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 re-cap 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.