Commentary

The China Non-Ferrous Association announced this week that leading Chinese aluminum smelters intend to axe 2.4 million metric tons of capacity in the next couple of months.

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Nearly all the world’s net gain in production capacity has come from China this year and, while estimates vary, a portion of the industry, even in China, is certainly losing money at current prices.

That is the case in the rest of the world, too, with UC Rusal and Alcoa, Inc. both contemplating further closures. Inside China, the growth of new smelter capacity has been in the northwest, often based on captive, low-cost coal deposits for power generation and utilizing the latest smelter technology that, combined with large economies of scale, has made these Chinese smelters some of the lowest cost of production in the world.

aluminumingots_500

The aluminum surplus, and a weak economy at home, have finally forced Chinese smelters to cut production.

Older Production Goes Offline

It would make sense, then, that as prices have fallen firms would close the higher cost older smelters on the east coast and concentrate production at the lowest cost. This year some of this older capacity has already been cut. China Merchants Futures put overall closures so far this year at more than 1.8 mmt, while a trader at a state-owned smelter estimated nearly 2 mmt had already been cut according to press reports.

Will these cuts be enough to bring the market in China into balance and stem the flow of exports? Whether primary posing as semi-finished product or real semi-finished product China’s exports have the same effect, they displace western production and depress global prices.

“If the cuts reach about 5 mmt, it would have some impact (on prices),” said Xu Hongping, an analyst at China Merchants is quoted by the Times of India as saying. State-backed research firm Antaike, estimates production will be at 31.9 mmt and demand 30.6 mmt. But this was before the current stock-market turmoil and growing evidence the Chinese economy could have slowed further.

More Capacity Being Added Despite Surplus

If the Chinese aluminum market were static the above would make encouraging reading but the reality is even as possibly millions of tons of capacity are being closed, millions more are still being added. Estimates vary but by some counts almost 3.8 mmt of new smelting capacity will be added in China this year, while a further 4.2 mt of smelter capacity is forecast for 2016. For this 2016 capacity to be achieved these projects must be well on the way to being completed and as such are not projects that will simply be shelved due to a low current price.

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While any capacity closures are to be welcomed, we shouldn’t assume they will have a major impact. As fast as old capacity is closed, new capacity is being added and if the economy slows as much as some reports suggest consumption could falter too.

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After the market tumult of last week, many expected things to calm down and that China’s stock market would finally calibrate to the new, devalued yuan/renminbi while equity markets elsewhere would bounce back from Friday’s big sell. Heck, maybe even the beleaguered commodity markets might recover some of their losses, right?

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Wrong. Oil reentered a bear market on Tuesday extending the previous day’s losses, when Brent crude — the international benchmark — recorded its biggest one-day sell-off since February. After dropping more than 6% on Monday, Brent fell a further 2% in the next trading session to $55.40 a barrel. It is down more than a fifth from its year-high of $69.63 a barrel reached during intraday trading in May.

Not the Oil That Made Jed Clampett Rich

Not such a good time for oil companies but, at the very least, gas prices are down here in the US and costs for everything from construction to automobile production is down, too, right, so we must be on to step three, profit, right? Oh no, not even close. Construction material prices are down, but new construction spending isn’t exactly picking up, either. Not here and not in China, where lack of demand has led lead and zinc to five-year lows.

Jedclampett

Jed Clampett made $9.5 billion in oil and gas. That likely would not have happened with today’s prices.

Incidentally, Forbes estimated Jed’s net worth at $9.5 billion, 4th on its “Fictional 15″ list. That’s more than weapons tycoon Tony Stark (#6). Not bad for wealth based entirely on oil and gas discovered while hunting possums.

A Rebound in Stocks… Of Sorts

The Dow Jones Industrial Average has been back in positive territory, though, saving our collective retirements and paring the losses we saw last week. The Dow gained 369 points yesterday, alone, curbing the big losses from Friday and Monday. It’ll surely last, right? Ummm, no promises. While our own Stuart Burns acknowledged the rebound in western markets, he also cautioned that aftershocks from China’s economic crisis could be forthcoming.

“With (Chinese) GDP growth widely believed to be lower than the official government number of 7% it is hard to see how domestic consumption can pick up as households lick their wounds,” Burns wrote.

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So, in short, expect more volatility as China spares the rod of economic depression while spoiling the child with purposely devalued currency.

What Does This Mean for US Buyers?

Expect to pay less for Chinese steel. We know, it’s already dirt cheap as foreign imports were up 5% in July. The job of policing foreign dumping into the US market just got tougher.

 

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Stock markets around the world have rebounded after Monday’s dramatic falls, even so pension and investments funds have been severely depleted even after the bounce back.

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In China, though, where it all started, the market has continued to fall, down another 7.6%. When the Shanghai Market last “corrected,” Beijing stepped in with a $400 billion fund to buy stocks, ordered state-owned companies to buy shares, banned large shareholders from selling and even launched a criminal investigations into short sellers in a desperate effort to prop up the market.

Chinese Stocks Still Falling

Clearly, although that bought a temporary calm it has not lasted and the market went into free fall again this week. Tellingly, Beijing has not stepped in this time, acknowledging that even China does not have the funds to turn global equity markets. Li Jiange, vice chairman of state-owned investment company Central Huijin is quoted by the Washington Post as saying “The trade volume of the market can reach 2 trillion yuan ($300 billion) a day, which means if it collapsed no one could save it,” adding “The issues of the market should be handled by the market itself.”

US dollar vs. RMB

Beijing’s way out involves producing in yuan and selling in dollars.

This time, the Peoples Bank of China have simply cut interest rates, for the fifth time in nine months, by a quarter percent to 4.6%. It also cut its one year deposit rate to 1.75% in a vain attempt to bolster the economy, and reduced banks reserve requirements in another attempt to get them to lend more.

Further to Fall

The rout in shares, though, is not just fear the economy is slowing, it is a growing realization that the market was deeply in bubble territory and the game was up. After rising 140% it is still even after the massive falls some 35% higher than it was a year ago and many doubt the bottom has been reached.

Beijing is putting a brave face on it, trying to show calm and, as usual, blaming foreigners for the falls. But the reality is many millions of retail investors have been burned. Some very badly. With GDP growth widely believed to be lower than the official government number of 7% it is hard to see how domestic consumption can pick up as households lick their wounds.

What This Means for Metals Buyers

The pressure will be on Beijing to do all it can to support export industries as a source of some growth, even though it runs counter to the long-term strategy of rebalancing the economy toward domestic consumption. As with the move earlier this month to weaken the currency, Beijing has shown it is willing to bend its own rules as needs dictate and losing face over allowing the economy to slow down too much is a good enough need.

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Reining back excess exports of steel, aluminum and other metals may, therefore, be too big an ask in Beijing’s opinion, and the flow of such metals could continue unabated for some time.

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Well for one thing it means our retirement funds will likely be worth less, at least in the short to medium term. On the plus side, our mortgage will likely stay cheaper for longer and metal prices will remain lower for longer.

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Why? well if the Fed was worrying about a China slowdown in July, they must be in full-on panic mode by now. If the Federal Reserve was to raise rates next month, to stave off the possibility of inflation picking up next year, it would strengthen the dollar, making imports more attractive and making life tougher for US exporters.

China’s Deep Slowdown

The collapse of stock markets around the world has been precipitated by fears of a China slowdown becoming far deeper and more prolonged than previously thought – although why this appears to be such a surprise to investors today compared to 2-3 weeks or even 2-3 months ago I fail to see, the writing has been on the wall all year.

Traders in London

The signs that China’s economy could lose steam were there, but it still caused global stock market panic.

However, as the herd mentality sets in all those stop orders get hit and the fancy algorithms cut in selling stocks and becoming self-fulfilling as they drive prices down. Hedge funds have been aggressively shorting the market, not just for stocks but for commodities too. It would be a brave man who bet any pause was the start of a bounce back, markets could have a lot further to fall.

Back to the Fed and China: weaker demand from China will mean lower demand for commodities. For a few commodities, China has become a net exporter but across the board the world’s largest consumer is reversing what was once a one-way bet on demand.

Lower prices feeding into the US market will keep inflation low and may even put the US into a deflationary situation for a short while. Does the Fed really want to be increasing interest rates against that backdrop? No. September’s long-anticipated rate hike isn’t going to happen, indeed even one before November seems very unlikely now.

What Does This Mean for Metal Buyers?

Commodity bulls, if any exist, will say producers are operating below the cost of production and that can’t last, sooner or later capacity will close and prices will rise.

In part, they are right. 17% Of copper mines are producing at a loss according to the Financial Times, but with producers aggressively doing all they can to move down the cost curve it could be some time before enough capacity is closed to impact prices.

The situation is worse for aluminum. Chinese producers are still bringing new capacity on stream and with state-of-the-art technology they have some of the lowest production costs in the world. There is no prospect of a recovery in aluminum prices anytime soon even though demand has continued to rise robustly.

What Does This Mean for Oil Users?

Nor are oil prices likely to rise unless OPEC has a dramatic change of policy. China has been a bigger contributor to oil demand growth than any other nation in the past decade, so any slowdown in the Chinese economy may spell bad news for crude consumption the FT opines. Saudi Arabia, Iraq, Russia and others are pumping oil like its going out of fashion – which, in a way, it is. Just as significantly, though, the US shale industry has been more resilient than expected, and is now on the brink of potentially exporting, adding to global supply.

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All in all, a rise in Fed rates seems about as unlikely as a rise in commodity prices. This would all be good news if it wasn’t for the fact that what’s driving both is a fear of a global slump, and that would most certainly not be good for anyone.

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RBC Capital Markets recently released updated forecasts for the gold and silver markets. Conventional wisdom says that safety plays such as precious metals outperform during periods of stock market weakness, but, as we’ve pointed out before, general commodity weakness is dragging down even traditional hedges such as precious metals along with their base metal cousins.

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With the market volatility of the last few days, one might think that silver and gold would see a rebound as investors, at least initially, abandon stocks and put their money into something reliable such as hard currency. Gold and silver are up, but the outlook for the precious cousins is still, at best, mixed.

Could gold's hedging value by renewed by falling stock values?

Could gold’s hedging value by renewed by falling stock values?

In the report, analyst Stephen Walker lowered his price targets for both gold and silver through 2018. RBC reduced its Q4 2015 forecast for gold from $1,300 an ounce to $1,150/ounce, a 12% reduction. For silver, RBC scaled back its Q4 2015 forecast by 15%, from $18/ounce to $15.25/ounce.

RBC believes that a Federal Reserve interest rate hike in a weak inflationary environment will pressure gold and silver prices. That hike got a little less likely, at least in the near term, in the last few days as the global stock market plunge happened. Cheaper imports from China mean lower prices and deflationary pressure in the US.

All of the precious metals we track on the MetalMiner Indx were up after Friday’s market selloff and gold held firm in a tight range on Monday in London, trading above $1,155 per ounce as China’s markets continued to plummet.

According to data gathered by Commodity Futures Trading Commission, last Tuesday the COMEX gold futures and options net position of managed money turned bullish for the first time in five weeks. Silver’s net position of managed money also was bullish last week after seven bearish weeks. Treasury bonds, another safe haven, saw their yields fall, as well. The 10-year Treasury yield fell below 2% for the first time in nearly four months and traded 7.8 basis points down on the day at 1.976%, its lowest point since April 28.

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It is too early to tell if gold and silver will see their hedge appeal restored, but the conversation has significantly changed when it comes to interest rate hikes and weary investors may see silver and gold in a different light, depending on how long China’s market rout continues.

 

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The Architecture Billings Index (ABI), an indicator of demand for design services, is showing strong markets for nearly all US nonresidential project types.

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An economic indicator of construction activity, the ABI reflects an approximate nine to twelve month lead time between architecture billings and construction spending. The American Institute of Architects (AIA) reported the July ABI score was 54.7, down a point from a mark of 55.7 in June.

This score still reflects an increase in design services (any score above 50 indicates an increase in billings). The new projects inquiry index was 63.7, up slightly from a reading of 63.4 the previous month.

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“On top of what has been a flurry of design activity in recent months, some architects are reporting a break in the logjam created by clients placing projects on hold for indefinite periods, which bodes well for business conditions in the months ahead,” said AIA Chief Economist Kermit Baker, Hon. AIA, PhD. “There is some uneasiness in the design community that rapid growth in construction costs could escalate beyond development capital and municipal budgets, which could trigger some contraction in the marketplace down the road.”

Key July ABI Highlights

  • Regional averages: Midwest (58.2), South (55.7), West (53.8) Northeast (53.5)
  • Sector index breakdown: institutional (57.3), mixed practice (56.8), commercial / industrial (53.4) multi-family residential (49.8)
  • Project inquiries index: 63.7
  • Design contracts index: 54.5

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The answer as you can imagine is not a simple one, it will impact prices in a number of ways and different commodities will be impacted in different ways.

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So far, it has been seen as a bearish development mostly for macro reasons – that Beijing felt the need to allow the currency, the yuan/renminbi, to fall to bolster export industries, particularly manufacturing. It is certainly true that real GDP growth is slowing and is probably already under 7%.

aluminumingots_500

Oversupply of aluminum could get worse with a devalued renminbi.

Worse, most of the sub-indexes in China’s General Manufacturing Purchasing Managers’ Index have weakened this month, with output, new orders, new export orders and employment all deteriorating. Up to now, the employment prospects for China’s 10 million new entrants each year had held up well, but some indicators show the job market is weakening according to the Financial Times.

Woeful PMI Numbers

The paper reported the Caixin China General Manufacturing PMI, dropped to 47.1 in the first three weeks of August, down from 47.8 in July, sending domestic stock markets plunging by as much as 5.6% in the course of the day. Nor is it just indexes falling. Growth in investment and manufacturing has slowed to its weakest level in more than a decade, while there are growing signs that consumption is struggling to pick up the slack.

This year sales of smartphones in China have started to fall for the first time, the FT reports. Meanwhile, car sales fell 3.4% in June against the year before, the first decline since early 2013, in addition retail sales grew by close to their slowest pace in a decade last month, leading some to hope Beijing will announce some form of stimulus soon.

Seen against this backdrop the decision to weaken the renminbi and help those exporters makes good sense from Beijing’s perspective and you may think an uptick in China’s manufacturing sector would be good for metals prices, but that may not be the case.

Production Vs. Consumption

China may be the world’s largest consumer of many metals, but for some metals it is also the world’s biggest producer. A weaker currency raises the cost of imported raw materials, making domestically produced resources more attractive. For China, it could mean a boost for coal, iron ore and aluminum production. Unfortunately, these are all commodities in which the world is already in oversupply.

More competitive exports of these items will only drive down global prices further. According to another FT report, China accounts for more than half of the world’s production of aluminum and steel and over 70% of thermal and metallurgical coal.

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As the FT observes, aluminum prices hit their lowest level in six years this week, while coal futures are at a 12-year low. A weaker currency effect, therefore, could temporarily send prices even lower as supply keeps growing. Even where China is a net importer, a weaker currency, as the falling renminbi is, will boost substitution of imported commodities to the benefit of domestic producers further increasing global supplies.

So contrary to a weaker renminbi being a boost for export-dependent manufacturers, and hence metals demand, it is entirely possible oversupply in many metals will be exacerbated rather than reduced.

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Following our recent article on the seaborne iron ore market, some may assume the landlocked domestic contract supply market for iron ore and pellets is immune from the volatility found in Asia.

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To some extent that’s true, there isn’t a spot or futures market in the same way as we see in Asia, but the market is far from immune to global prices and prices have fallen in North America as they have elsewhere.

That makes Essar Steel’s decision to proceed with the massive $1.9 billion development of North America’s richest iron ore deposit across 150 kilometers of Minnesota’s Mesabi Iron Range particularly brave in today’s market.

Source FT

Source: Financial Times

Essar Steel is said by the Financial Times to be ramping up construction on a $1.9 billion mining and processing facility, with a planned completion in the second quarter of 2016. It will be one of the largest construction projects in North America by capital expenditure according to the paper and Essar hopes to produce 7 million metric tons annually of high-grade iron ore pellets for 70-80 years from the resource.

Why Iron Ore? Why Now?

With Iron ore prices plunging you may ask what would possess them to embark on such a venture, but Essar would say they expect the price to come back and indeed have made much of their expectation that the US will see rising steel demand, particularly for the high-grade steel used in automobiles and advanced manufacturing.

Madhu Vuppuluri, chief executive of Essar Steel is quoted as saying “Due to the infrastructure revival that is likely to take place here in North America, the US and Canadian steel industry will remain robust moving forward.”

In 2013, the American Society of Civil Engineers estimated that $3.6 trillion in investment was needed by 2020 to return US infrastructure to its optimal state but whether any of that expenditure will be made is another matter. Robust state is also an interesting turn of phrase. North American steel producers would be more likely to say they are in a pitched battle against a flood of imports. US steel mills have had to lay off workers as cheap imports have undermined domestic production.

Source: FT

Source: FT

Imports have stabilized. If averaged over the first half of the year, they are up some months and down others, but in a falling market the percentage they take is probably less of an issue than the depressing impact they have on domestic prices.

Expanding From a Position of Weakness

Essar is not exactly in a rock steady place financially, either. their Canadian steelmaking operation recently emerged from bankruptcy protection and their Indian parent has had to sell a 49% stake in its main oil refinery to Russia’s Rosneft to pay down debt.

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Such a project, though, will be measured over the longer term. The price has time to recover before pellets are ready for delivery later next year but, as the FT concluded in a closing comment from Tony Barrett an economics professor at the College of St Scholastica in Duluth, Minnesota and an expert on the local mining industry, who said “Essar couldn’t have timed this worse. You just have to ask yourself, ‘is this going to make money over the next 30 years?’”

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China’s currency, the yuan/renminbi, fell further this week after the International Monetary Fund dealt a setback to the currency’s role on the global stage.

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The IMF pushed back the date that the yuan would be added to the IMF’s basket of reserve currencies, known as the Special Drawing Right currencies. Originally scheduled to become a reserve currency at the end of December, the yuan will now have to wait until at least September 30, 2016.

yuan2dollars_550

Yuan to dollars over the last four years. Graph: Marketwatch.

The IMF said in a release that the postponement would allow “the continued smooth functioning of SDR-related operations and responds to feedback from SDR users on the desirability of avoiding changes in the basket at the end of the calendar year.”

Could it be possible that the IMF is having its own reservations about using the yuan/renminbi as a reserve currency after the big government devaluation last week? The international banking institution would certainly have good reason.

Banks Trading Dollars for Yuan

On Thursday, China’s central bank, defying market sentiment, set the daily reference rate for the yuan, or “fix,” stronger than in previous days at 6.3915 per US dollar. That’s 0.08% stronger than the level set a day earlier.

In early trade the currency fell. Traders cited large, state-owned banks selling US dollars, which sent the yuan sharply stronger midday and 30 minutes before it closed.

US dollar vs. RMB

Cheaper Chinese imports dragging down inflation could mean a stronger dollar.

“It is hard to have a high degree of conviction in anticipating the increasingly fitful reactions of the Chinese policy makers, and by extension the near-term direction of the [yuan],” analysts from Goldman Sachs wrote in a note earlier this week.

IMF Fires Still Burning

I’ll say.

Being recognized as a reserve currency would have been a symbolic win for China’s currency and for the central bank’s policy makers on the global stage, but with the currency now purposely devalued to its lowest point in three years and construction demand for metals and other commodities in China still falling, perhaps the last two weeks have been a wake up call to the IMF.

Or Not.

Maybe they really did plan this all along. The IMF has other problems, after all, with Greek Prime Minister Alexis Tsipras stepping down and calling for new elections there, a situation that could bring Greece’s debt woes back onto the IMF’s front burner.

Adjusting to a Possible Reserve Yuan

In its release, the IMF stated that “the extension (to naming another currency to SDR status) would also allow users sufficient lead time to adjust in the event that a decision were to be taken to add a new currency to the SDR basket.”

This adjustment period might be as good for users of the yuan as it is for the IMF, as the Chinese economy will have more than a year to recover by the time it’s eligible to join the SDR basket.

It is certainly riskier today to invest in yuan/renminbi assets than it was just last week. Still, the lower costs of these investments will, no doubt, open up investment opportunities in bonds and, if the economy gets back on track, Chinese construction.

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Here in the US, the Federal Reserve is still taking a cautious approach to raising interest rates and a weaker yuan/renminbi will mean even cheaper Chinese goods flowing into US ports creating another reason for the Fed to hold off on raising rates in the short-term. Beijing’s move could actually slow US inflation.

The yuan’s loss, could be the dollar’s gain.

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Just when iron ore miners thought sentiment couldn’t get much worse, Goldman Sachs Group comes out with a report predicting iron ore prices will tumble by 30% over the next 18 months according to a Bloomberg article this week.

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The bank is saying the rebound seen over the last five weeks is merely a blip and that normal business will shortly resume.

Source: FT

Source: Financial Times

Supply growth is set to continue, the report states, but, and this is crucial, China has reached peak steel and from now on steel production will only contract in China.

More Inventory Than Necessary

As shipments pick up from Australia, Brazil and India, the seaborne market will become awash with inventory and prices will be further driven down. Iron ore is seen by Goldman as averaging $49 a ton this quarter, and $48 in the final three months of 2015. Before falling further next year to $46 in the first quarter and $44 the following quarter. With little or no market discipline, the bank suggests 2016 will see average prices around $44 per ton. In the words of the report’s authors “the summer of 2015 is the calm before the storm.”

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Steel consumers can, therefore, expect mills’ raw material prices to continue to weaken as seaborne prices gradually knock on to contract prices elsewhere. With demand lackluster and too much finished steel chasing too few orders, even as markets like North America and Europe show encouraging signs of GDP growth, steel prices will have little to support them this year and next. Good news for consumers, tough times for producers working with low-capacity utilization and stronger domestic currencies sucking in imports.

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