China Update
China Commodities Weekly for the Week of January 14-18, 2008
¦ Last week, China’s base metals markets were slightly weaker, except for aluminum. The steel and iron ore markets were flat. Grain prices were down, while fertilizer prices stabilized at lofty levels. Chemicals were firmer. Both coal and coke prices moved higher.
¦ In this report, we first focus on the ongoing coal shortage in southern provinces, arguably the worst in five years. We then discuss the sulphur shortage in the country and its implication for DAP output. On the strategy side, we try to address some recent concerns/headwinds that investors in global raw materials sectors are facing – the falling freight rate, the ongoing tightening program by the PBOC, the possible U.S. recession, and price controls in China.
¦ In the News section, we discuss the severe drought in middle China and the surging auto sales last year.
Coal – How Tight Is It?
Worst Coal Shortages in Southern China in Five Years
¦ Coal shortages and soaring prices for the fuel have pushed power firms to shut down coal-fired generating capacity across southern China, a senior official from the regional grid told Reuters last Tuesday. Xiao Peng, deputy general manager at China Southern Power Grid, said the closures meant the five southern provinces covered by this network could face a supply shortfall of 6 GW in the first three months of the year, rising as high as 8 GW in the summer. This will represent the worst coal and power shortage in the region in the past five years.
¦ Separately, the Metropolitan Times, a local newspaper, reported that in Yunan Province, coal stocks are at only two-thirds of the required 1.3 million tonnes of reserve to ensure power supply during the Spring Festival.
¦ Although there are many reasons for the shortage, the most direct one is the loss of production in these regions due to the shutdown of small coal mines. According to the State Administration of Coalmine Safety, China closed down 250 million tonnes of relatively inefficient small-scale coal production capacity between 2005 and the end of 2007 due to safety concerns.
Coal Price Hits Fresh Highs
¦ The Chart of the Week shows the average price of coal in the domestic Chinese market. Over the past two weeks, the local market rallied to new highs. Datong Quality Mix Coal in Qinhuangdao Port, the country’s main coal trading port, surged 10% since late December to hit RMB610/tonne last week. The spot export prices of Chinese coal climbed to US$95-US$99/tonne, FOB Chinese ports.
Imports to Surge in 2008
¦ If the current situation continues, we expect China to become a net importer of coal in 2008. In 2007, the country’s 2007 coal imports totalled 51.02 million tonnes, slightly below gross exports of 53.17 million tonnes. Although still a net exporter for the whole of 2007, that year still represents a dramatic drop-off in net exports, to 2.15 million tonnes from about 25 million tonnes in 2006.
Coke Export Quota Issued
¦ On the coke side, last Tuesday the Ministry of Commerce issued an initial 9.62 million tonnes of coke export quotas for 2008, down about 1% from the first batch of quotas issued in 2007. The ministry did not give the total amount of coke export quotas it intends to issue for 2008. In 2007, it issued 13.3 million tonnes of coke export quotas.
¦ It is no secret that China is trying to cut down on its coke exports, as the process to make coke from coking coal, called coking, is highly pollutant. In addition, China became a net importer of coking coal itself in 2007. To preserve domestic resources for long-term domestic use is apparently a sensible policy direction. This is why early this year, China increased its coke export tax again to 25% from 15%, effective January 1, 2008.
¦ Initially, the market believed the export quota would also be slashed in 2008. However, China’s efforts to curb coke exports prompted a series of protests from the Indian government. Less coking coal and coke from China has put India’s steel industry at a disadvantage, Kamal Nath, India’s Trade Minister said last week in Beijing; and he requested China relax its restrictions in recognition of India having lowered a proposed tax on its iron ore exports to China early in 2007.
¦ On the general coal side, Asian coal traders are closely watching the size of the export quota for coal in 2008. There was already some talk in the market that Beijing might cut coal export quotas again for 2008. The Chinese government reduced the total coal export quota for 2007 to 70 million tonnes from 80 million tonnes the year before.
DAP – Higher Sulphur Price Might Hurt Output
¦ Last week, we discussed China’s output and reserve of phosphate rock, a key input for the production of DAP. From the perspective of phosphate rock availability, China does have the ability to further grow its DAP output in the current high commodity price environment, in our opinion. However, the near-term output growth potential will probably be capped by the availability of another key input – sulphur.
¦ Since December 2007, China’s sulphur prices spiked to over RMB4,000/tonne. At some local markets, spot quotations topped RMB5,000/tonne last week. China is highly reliant on imports for sulphur. For 2007, we expect China’s total sulphur imports to be close to 10 million tonnes, up some 12% YOY. China’s imports now represent some 22% of world seaborne sulphur transactions. In contrast, China’s domestic production was only 1.2 million tonnes. Therefore, China’s import reliance on sulphur is close to 90%.
¦ China’s contract price for sulphur imports has reached US$505-US$510/tonne in 2008, almost double last year’s level. The spot import quotation has rallied to US$525-US$550/tonne in the last week. With such high import costs, we expect local sulphur prices to remain lofty. We heard that some DAP producers in Hubei and Sichuan provinces have reduced output due to high sulphur costs.
¦ Among the three major types of fertilizer, we marginally prefer DAP to potash and urea from a China perspective, mainly due to the introduction of an export tax on MAP and China’s shortage of sulphur. We maintain our neutral view on all three fertilizers.
Strategy – Looking Through Some Headwinds
¦ In this section, we address some of the near-term concerns for the market on the global raw materials sectors.
The Dropping Freight Rate
¦ Over the past few years, we have been using the Baltic Dry Index (Bloomberg ticker BDIY INDEX) as a concurrent indicator to illustrate the ongoing strength of China’s physical demand for seaborne raw materials. This index has been in a freefall over the past few weeks. Some clients are seeking our views on this – has China’s physical demand for raw materials dropped abruptly?
¦ To answer this question, we would first observe that, in recent weeks, the direction of the Baltic Dry Index has shown unusual divergence from the direction of physical commodity prices. In the past, freight rates and spot commodity prices in China usually go in the same direction, as they both benefit from strong commodity demand (or suffer from the same weakness, from time to time). Over the past few weeks, however, commodity prices remained at record levels in China, while freight prices have dropped.
¦ To a certain extent, there is “logic” to this recent divergence. For example, when iron ore prices reached a record high, some small steel mills in China could not afford it. These mills have been cutting output to reduce losses. As a result, seaborne iron ore demand might be compromised. This has actually happened in China. In the past two months, steel output growth stalled and iron ore inventory at ports increased. But the normal pricing mechanism is responding – steel prices have rallied due to stalled output and iron ore prices have stopped climbing and have begun to stabilize at record levels.
¦ Besides this “logic,” there are a few other factors that have exacerbated the drop in freight rates. Initially, freight rates for iron ore dropped after CVRD released a number of vessels due to a halt in operations at its Itaguai maritime terminal, while coal freight rates fell as a result of a 40% reduction in vessel queues at Newcastle. Later, logistical difficulties at the U.S. port of Baltimore and production issues in Venezuela also reduced vessel needs. Therefore, in our opinion, the initial freight rate weakness was triggered by supply disruptions rather than weaker demand.
¦ Over the past two weeks, the drop in freight rates accelerated, as the annual contract negotiation for iron ore drags on. Rumours have surfaced in the market that the suppliers (CVRD, BHP, and Rio Tinto) have proposed a contract price hike of over 70% and, as a result, China’s Baosteel “walked out” of the negotiation room. The deadlock has dampened sentiment on the freight market.
¦ In conclusion, we believe the recent drop in freight rates is a result of record high iron ore prices, supply disruptions, and ease of port congestions. It is not an indication of an abrupt demand slump.
The Reserve Ratio Hike
¦ Last week, the People’s Bank of China (PBOC), the Chinese central bank, hiked the bank reserve ratio for the first time in 2008, after 10 hikes in 2007. The ratio was increased by 50 bp to 15%.
¦ Obviously and understandably, this move added bearish sentiment to the market. That said, our investment theme for the raw materials sector (“comfortable for 1H/08; nervous for 2H/08”) remains unchanged, despite the recent selloff. In our opinion, the latest reserve ratio hike by the PBOC simply shows that the central bank wants to prevent a seasonal surge of bank lending, which has usually happened in the first quarter of each recent calendar year.
¦ We leave it to investors to make the trading call of when to buy the dip, but we reiterate that the recent selloff should be bought for a potential powerful tradable rally into 1H/08. We would note again that prices for key commodities, such as energy and steel, are very firm in local Chinese markets. The strong behaviour of physical commodity markets now tells a totally different story from the raw materials sectors’ behaviour on the stock market.
¦ We would also observe that, until last week, on a relative basis the key raw materials sectors, such as energy, steel, metals, gold, and fertilizers, had outperformed the broad markets (such as S&P 500) by a big margin during the recent selloff, particularly in the U.S. equity market. The final catch-up drop (or capitulation) of previously well-held sectors, such as energy and materials, might show that a near-term rebound is well in the cart, even for the broad market.
The U.S. Recession
¦ Will China survive the possible U.S. recession? This is a question we addressed in our China Outlook for 2008 two weeks ago. To repeat one simple point: if there were indeed a sharp slowdown in the global economy, the Chinese government could easily ramp up government spending in rural areas to shore up investment growth, cushioning the downside. The Chinese government has minimal fiscal deficit and sits on US$1.5 trillion in foreign exchange reserves. In the meantime, the infrastructure in rural China still needs major upgrading as it has been lagging badly versus the urban region. Under the slogan of “Reviving the New Socialist Countryside,” the Chinese government has both the monetary resources and the political will to significantly boost investment in rural China.
¦ At the end of this section, we would like to quote the recent remarks of Chinese Premier Wen Jiabao. Last week, state radio quoted Wen as saying, “There are many uncertainties influencing the world economy today. Global financial markets are unstable, oil prices remain high and agricultural products are also getting dearer… But I’m confident in telling you that China has made good preparations to face them. We will step up our efforts to restructure the economy and promote a shift in the economic growth model.” We shall see.
Economy – Price Controls
¦ As we reported last week, the Chinese government has introduced “temporary intervention” on prices for life essentials. Prices of diesel, gasoline, water, and electricity have been frozen at current levels “in the near term”.
¦ The government also stipulated that all major producers or processors of flour, rice, noodles, cooking oil, milk, and liquefied petroleum gas must apply to provincial or central governments for the go-ahead if they want to increase prices. Large wholesalers and retailers of these necessities should notify the authorities within 24 hours of any one-off price increase of more than 4%. They also need to give notification if they raise prices by 6% over a 10-day period or by 10% in a month.
¦ We note that this is the first time since 1993 that the Chinese government has intervened in the market pricing mechanism with such a heavy hand. The move has, understandably, generated a lot of skepticism and criticism in the market and we would like to offer the following observations:
¦ First, there is merit to the move. If successful, the move might lower inflation expectations. To a certain extent, inflation is self-fulfilling when the expectation for it is high. Cao Changqing, the pricing department’s head of National Development of Reform Commission (NDRC), said the temporary measures are intended to soothe fears and break the cycle of market behaviour, which he blamed in part for driving up inflation. “If a supplier anticipated further price rises, he would reduce sales and hold back his goods from the market,” Cao said. “And if a consumer anticipated further price rises, he would increase his purchases.” We would not dismiss this observation.
¦ However, we hope these measures will turn out to be temporary indeed. Otherwise, sustained price interference could result in eventual shortages and a potential black market. For example, readers of our Weekly could easily recall the shortage of diesel and gasoline in October and November 2007. The shortage was caused by the control of oil products prices. Refiners in China were (and still are) buying crude oil based on international prices but selling diesel and gasoline at regulated prices in China, which were about 25% below Asian benchmark prices. Facing negative refining margins, refiners had to cut output and a shortage crisis emerged in the market.
¦ Fortunately, at the end of the week, China’s government tried to reassure local companies by emphasizing the limited scope of the controls and promising they would be quickly removed once inflation moderates. “The temporary price intervention does not change companies’ autonomy in setting prices, is not a price freeze, and will not affect normal business operations,” the NDRC said in a statement. We would like to see the NDRC take these promises seriously.
News in Brief
Energy/Grain – Dry Season Came Too Early, Too Severe
¦ In middle and southern China, this year’s dry season came a month earlier than usual and water levels fell sooner than expected. China’s longest river, the Yangtze, is suffering from a severe drought this year with water levels in some areas falling to the lowest in 142 years. On January 8, the Yangtze water level at Hankou plunged to 13.98 metres (46 ft), the lowest since records began in 1866, the China Daily said on Thursday, quoting the Wuhan-based Changjiang Times.
¦ We observe that if the drought continues, hydro-based electricity generation might be impacted, increasing the country’s dependence on coal. In addition, the upcoming grain planting season might have to be delayed, leading to a shortened growing period and reducing crop yield.
Vehicle Sales – Up 21.84% YOY in 2007
¦ In 2007, China’s total vehicle sales were up 21.84% YOY to 8.79 million units. Car sales alone grew 21.68% YOY to 6.3 million units in 2007. (Back in 2006, car sales in China surged 30.02% to 5.18 million units, following a 21.4% rise in 2005.)
¦ We note that China’s strong vehicle and passenger car sales were not up from a small base – China was the second-largest auto market on the planet, only after the United States. In addition, China’s strong sales in 2007 were achieved in the context of shortages of diesel, gasoline, parking lots, etc.
Recap of Our Calls
¦ The sole purpose of our China strategy research is to answer one question: purely from a China perspective, should investors in the western world overweight, market weight, or underweight the global raw materials sectors? To this question, effective August 16, 2007, our answer is “overweight” (upgraded from “market weight”).
¦ We are now bullish on the coking coal, iron ore, copper, zinc, aluminum, molybdenum, oil, methanol, and hardwood pulp sectors. We are neutral on grains, ethylene, potash, DAP, urea, steel, and nickel. We are cautious on paper products on a relative basis from a China perspective. |
