The lack of a clear improvement in DM apparent metal demand—the result of demand
rising from the trough and continued manufacturing destocking—compounded by a
seasonal slowdown in EM demand has led to a sell-off. We continue to expect that
the market would move meaningfully to the upside when the DM recovery continues
apace and the destock cycle finishes its course, or when China goes into the next
restocking season; both are expected in Q4.
A long-anticipated slowdown in Chinese imports and rapid build in copper inventory since
August have caused uncertainty about the sustainability of the strong emerging market
(EM) growth—the key driver of the rally for the most part of the year, and concerns about
the fragile developed market (DM) recovery—technically started in July. These factors
contributed to a pullback in prices across the base metals complex to the lower edge of
recent trading ranges formed since August. This volatile but range bound price action has
in our view reflected the nature of reaching the end of the recession - the trough in
economic activity – and the growing impatience of the market to see clear signs of
improving fundamentals in metals as well as other commodities, such as oil, where price
action has been similar (see Exhibits 1 and 2).
Despite these concerns, we maintain our positive outlook on prices, as we have not seen
any new information since our last publication that would prompt us to alter our view. In
fact, we expect the inventory to build in Q3 as China works through its stockpile and DM
demand is not yet strong enough to pick up the slack. An important fact to keep in mind is
that DM metal demand recovery is in line with the macroeconomic variables, which are
improving off a rather low base. On the positive side, US economic data continued to
surprise to the upside with August US IP rising 0.8% month-over-month and July’s IP
growth was revised up to 1% from 0.5%. Furthermore, recent economic and anecdotal
evidence in China reinforce our view that Chinese metal demand has been strong and will
likely remain so, discussed below as we answer the 10 most asked questions on China and
base metals. We remain most constructive on copper and view the recent pullback as a
copper buying opportunity.
Nonetheless, short-term volatility could remain high in a market that lacks a clear direction.
In China, expectations about continued credit tightening towards the end of the year have
resulted in lower liquidity as evidenced by the large decline in open positions on the
Shanghai Futures Exchange for base metals. Total open positions in aluminum, copper,
and zinc have come down between 15 to 25 percent since August with most of the decline
in liquidity concentrated in the nearby up to 3 month futures.
1. Did China import the large amount of metals for consumption or stockpiling? What
is the extent of stockpiling of metal in China?
The evidence continues to suggest that materials were stockpiled in the first half of the
year, but stockpiles were relatively contained as a majority of the metal imports were
consumed by metals-intensive end-use sectors. As we have emphasized in recent months,
growth rates in Chinese implied metals demand (domestic production + net imports) has
been broadly consistent with growth rates in metals-intensive industrial activity for most of
the metals. Specifically, this analysis suggests moderate stockpiling in copper with only
large stockpiling occurring in nickel (see Exhibits 3 and 4).
Although accurate reports for the non-government stockpiles do not exist, our inventory
indicator, which is the ratio of refined metal supply to production of copper semis,suggests
around 600 kt of copper was stockpiled in China during the first seven months of
2009 including the 250kt of SRB purchase. Given the annual consumption of copper in
China of about 6,000kt, 360kt of private sector stockpiling amounts to only about 6% of
annual consumption. Moreover, the preliminary August production and trade data suggest
a recent shift to destocking (see Exhibit 5).
For nickel, we estimate Chinese stockpiles in excess of 60kt based on stainless steel
production data. This stockpiling amounts to about 15% of total annual consumption and
is completely held in the non-government sector that is not strategic. As a result, these
supplies are likely to be pushed back into the market if prices are sufficiently compelling to
warrant profit-taking and/or expectations about future price increases diminish.
Anecdotal evidence from the region supports these estimates. Local physical traders’
estimates of copper stockpiling seem to range from 450kt to 550kt including the SRB
purchase, relatively consistent with our estimates. Further, we believe that bonded
warehouses hold about 100kt of the 360kt of copper that we calculate to be held in private
stocks, which has been corroborated by regional reports. The anecdotal evidence from
warehouse operators in the region also points towards significant builds in nickel.
Aluminum and zinc stand in sharp contrast to copper and nickel in that stockpiles reported
by warehouse operators have tended to be at more normal levels.
2. What are the signs of demand strength, if any?
We continue to believe that Chinese demand remains robust and will likely pick up further
in Q4 based on latest industrial production data and other gauges of economic activities.
Specifically, August industrial production growth came in at 12.3% year over year, up from
September 25, 2009 Commodities: Metals
Goldman Sachs Global Economics, Commodities and Strategy Research 8
10.8% in July, above the consensus forecast of 12.0%. Fixed asset investment (FAI) growth
inched up to 33.0% in the January-August period from 32.9% in the January to July period,
higher than consensus forecast of 32.5%. Nominal retail sales growth accelerated to 15.4%
year over year from 15.0% in July, again, above the market consensus of 15.3%.
Further, a potentially more reliable industrial activity indicator-- electricity generation- has
been rising steadily and rose over 9% in August, a typically slow month for industrial
activity (see Exhibit 6). Moreover, growth in metals-intensive sectors remained strong and
newly started residential floor space surged over 24% after bottoming in May, which
indicates strong future demand for metals (see Exhibit 7).
Anecdotal evidence from commercial players along the metal supply chain reinforces this
demand strength. Shipping companies have reported strong domestic shipping activities
and a labor shortage in Southern China, where traditionally export-oriented business is
located. Such a labor shortage could indicate an improvement in export orders that may
be reflected in the trade statistics in coming months. Fabricators in the region have seen
rising order books as consumer electronics manufacturers, benefiting from various
government stimulus programs, have sold out inventories and will need to restock soon.
Producers of copper wire and cable, and copper tubes have reported strong demand for
home electronics in 1H2009 and expect a pick up in demand for construction-related
materials for the balance of 2009.
3. Does the physical discount in China indicate sustained demand weakness?
The answer is it depends. The physical discount published daily by various local sources
only concerns a small segment of the physical market. The local spot physical market is
usually dominated by relatively small consumers or investors who buy spot. The large
users of metals tend to sign annual contracts with suppliers and import monthly according
to the contract. The premium is fixed for the year. During the year, when the large
producers find themselves short of metals for whatever reason, they can usually obtain
more metal from the suppliers based on a negotiated premium given the prevailing market
conditions without having to go to the local spot market. The estimated size of the spot
physical market is about 5,000 to 6,000 tons per month for copper and even smaller for
other metals.
However, Shanghai Future Exchange and LME registered brands almost never trade at a
discount in physical markets as the owners of the branded metals could always deliver to
the exchange and get the exchange price rather than taking a discount. Usually only the
local unregistered brands are quoted at a discount on the physical market.
Recent reports suggest that the local physical discount has widened to about Rmb 400 for
copper and to over Rmb 800 for nickel. However, it is our understanding that buyers
usually cannot buy a sizable amount from the sellers and often when the buyer makes an
inquiry, a new negotiation starts on the discount/premium. Not many transactions actually
take place at the quoted price.
On net, we tend to think that the local physical market only covers a small portion of the
players and is not representative enough to capture the overall balance between demand
and supply. Nonetheless, shifts in the physical premium/discount still reveal some
information about local demand/supply conditions. A case in point, on September 14 when
Shanghai copper sold off over 4%, the physical discount swung immediately to a premium,
indicating strong buying interest for copper on the price pull-back.
4. How does the Shanghai/LME arb affect LME price and inventory?
The Shanghai/LME trade has seasonality. Typically as the end use industries tend to
destock from March to end of summer and restock from October to March next year, the
demand pattern tends to gradually tighten domestic market from year end till next spring
and when domestic supply becomes insufficient, domestic price rises above that of the
LME creating the arbitrage between Shanghai/LME. Consequently, China tends to pull
metal from the LME during this period, tightening the global market, until the premium is
reversed. At that point – typically spring through early autumn, Shanghai traders may even
be induced to send metals back to the LME which, as was widely reported, occurred in
July and August of this year. Despite this general seasonality, the underlying strength of
demand may shorten or lengthen the arb window, which could last from a few days to a
couple of months as is the case in 2009
Given that the imports of metals in the first half of 2009 have partly gone into stockpile
therefore we expect the restocking in 2009/2010 will likely start later than usual probably in
the middle of Q4 when strong end demand pushes inventory towards a lower level.
5. If the arbitrage has closed, why does China continue to import metals?
Chinese metal users usually sign an annual supply contract with the metal producers at
the end of each calendar year—called the “mating season” in China. Most large fabricators
would secure their supply via long-term contract. It is estimated that about 150kt are
imported monthly on the annual contract regardless of the Shanghai/LME arbitrage opens
or not. Therefore, monthly imported refined copper should be at least the annual contract
amount. In months where the arbitrage is open, the imports will increase by the amount
traders are moving to benefit from the arbitrage. In other months, when the arbitrage is
large enough to move metal back to LME and demand is weak, the imports could be lower
than the monthly contract amount.
6. What does the August import tell about demand in China?
The preliminary August trade number has shown an expected further decline from the July
level given the arb has closed. As the detailed data breakdown will only be available later
in the month, a rough estimate suggests refined copper import was about 250kt, though a
decline from July but still higher than the long-term import amount of 150kt.
We view the August number positively as it could indicate stronger seasonally-adjusted
demand given that July and August are typical low-demand months. Further, as the
Shanghai/LME arb was closed, the numbers should largely reflect true demand from end
users. If we take 150kt as the base-line import figure, the extra 100kt could be another
indication of strong end-user demand, although the data may also be reflecting delayed
arrivals of metals booked when the arb was still profitable.
7. Why are the owners of the metals in warehouse not selling their metals given the
Shanghai/LME arbitrage (arb) has closed?
The stock in the bonded warehouses belongs to physical traders who tend to trade the arb
on a hedged basis—they simultaneously buy physical and sell future. The metals will only
be sold into the physical market if the physical premium rises above what the trader paid
for. Otherwise, the trader will roll the futures or sell back to LME depending on the arb
situation, unless the opportunity cost of holding the metal is not compensated by the
rolling. While the traders hold the metal in the warehouse, financing deals could be
arranged with some local banks on metals with certain warehouse warrants. Those
warrants will allow the traders to secure financing with only 10% haircut thereby
significantly reducing borrowing cost of the traders. This relatively cheap financing allows
the traders the ability to keep the metals in the warehouse while ascertaining the market
direction.
8. What is the impact of scrap on refined metal market?
In the first few months of 2009, a scrap shortage has affected most metals that rely on
scrap as a main source of supply for refined metals, especially copper - as China has
developed over the years a large secondary production capacity that relies on scrap - and
to a lesser extent aluminum and nickel. The shortage mainly resulted from two factors: a
slowdown in industrial production led to less “new scrap” and in China specifically, a
crack-down on the quality of the imported scrap by the Chinese government to ensure
certain environment standards as well as import-duty exemption standards were observed
by the importers. The crack-down led to hundreds of cargos with scrap quarantined
outside Guangzhou port, exacerbating the shortage.
The large amount of imports of refined metals in the first half of this year was partly a
result of the scrap shortage (see Exhibit 6 and Exhibit 7). Recently with the rally in copper
prices and economic recovery, scrap availability has improved and scrap imports have
been rising steadily suggesting future imports of refined metal will likely come down,
keeping everything else constant.
Nonetheless, we believe that scrap prices are a lagging indicator and feed back to refined
metal prices, not the other way around. In an economic slow down, scrap shortages are a
result of a decline in the refined metal price ensuing from a collapse in demand. The
shortage causes the scrap discount to refined metal prices to narrow, motivating
consumers to switch to refined metal and on the margin exert some upward pressure on
the refined metal price. When demand improves and industrial activities rebound, primary
metal prices rise and scrap availability improves, leading the scrap discount to widen
again. The scrap shortage tends to affect the discount of scrap price versus refined price
more directly.
9. A lot of the discussion concerns copper mainly, what about aluminum, zinc, and
nickel?
The Shanghai/LME arbitrage trade applies also to aluminum and zinc, but not to nickel,
which is not traded on the Shanghai Futures Exchange. Therefore, similar arguments can
be made about the pattern of imports. There has not been a large amount of stockpiling in
aluminum and zinc probably reflecting the fact that the local supply of both metals is very
abundant—traditionally China exports aluminum and imports a small amount of zinc.
Therefore, a rise in domestic demand tends to be met by local supply. In addition, the
liquidity for aluminum and zinc futures is not as high as it is for copper, as a few dominant
producers have the ability to control the physical market and overwhelm futures positions.
Consequently traders are generally more hesitant to take big positions in the these two
markets.
In general, the fundamental outlook for the three metals is not as strong as that for copper
in our view due to much larger excess production capacity. Restarts of aluminum smelters
are widely reported and zinc smelters are being brought online at a rapid speed. Local
production of Nickel Pig Iron—a low grade ferronickel technology invented by China about
3 years ago—has restarted. In addition, for nickel, there is a large investor stockpile to
contend with.
10. What is the greatest risk to our constructive base metal price forecasts?
The biggest risk to our positive outlook stems from an earlier than expected Chinese
tightening that risks derailing the recovery or a double-dip in the Chinese economy as the
impact from the stimulus program runs out. However, according to GS China economic
team’s analysis, the risk of either of these happening is very low.
As the economy recovers, our economists expect profitability of the private sector and
household income to improve quickly. Both are important determinants of future private
consumption and investment. The impact of the Chinese stimulus program is very visible
in a range of industries: infrastructure, transport, home electronics, industrial equipment,
and construction. These measures have jump-started the recovery and led to strong
increases in Chinese domestic demand. The latest data from the NBS has shown a
dramatic improvement in the profitability of large enterprises, while retail sales remain at
double-digit growth. The total amount of investment projects financed by private funding
has also risen suggesting a pick-up in private investment.
Therefore, our economists are not overly concerned that the economy will go into doubledip
once the impact from the stimulus program wanes as private sector consumption and
investment will likely pick up the slack by then. In the worst case scenario, given the
comfortable financial condition of the Chinese government, another round of stimulus can
not be ruled out.
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