CommentaryMarket Analysis

In 2011, the big challenge facing China involves moving ahead meaningfully to abandon its extreme economic stimulation policy without choking off the economy in the process. The housing market is a case in point.

Last year, Chinese banks had opened their lending floodgates wide to help stimulate the domestic economy, granting new loans worth a total of around 9,600 billion Renminbi. By way of comparison, the average new lending volume in the period between 2000 and 2009 came in at somewhere in the region of RMB 3,000 billion a year. Although the expansion in lending has indeed slowed this year, the volume of new loans granted will likely once again continue well above the long-term average of around RMB 8,000 billion. Various estimates still put next year’s lending at RMB 7,500 billion or more.

As we embark on a New Year, China has embarked on a new Five-Year Plan — interestingly, the emphasis has changed. Previous plans (and the current 11th is no exception) were focused on growth at all costs. Specifically, a doubling of GDP within a ten-year period no longer appears part of the new plan with the focus more on economic, social and ecological sustainability. Growth will still be rapid; indeed, will have to be rapid in order to satisfy the social criteria. Expectations remain high yet that growth could hit at ‘only’   7-8 percent rather than the unsustainable 10+ percent of recent years. There are so many factors driving inflationary pressures in China that Beijing has a major task in cooling the pressures without adversely impacting the growth throwing baby out with the bathwater, so to speak. Bank lending, interest rates and the exchange rate will all play a part, as will moves to curb certain industrial sectors such as high energy users and dissuade “unattractive exports” such as aluminum, viewed as   exporting energy. Even so, massive investment will still flow into infrastructure projects such as electrification and rail, and low-cost housing for the poor, all requiring large amounts of copper and steel. According to one report, the twelfth five-year plan requires the government to invest RMB 400 billion per year on average into power grid expansion.

The extent to which this balancing act achieves success will determine the ongoing growth China will enjoy. Almost certainly it will be lower than during the last five-year plan if for no other reason than a desperate need to control rising inflation — not just in China, but in the region. Even so, for the second-largest economy in the world, even 7-8 percent growth would make for a significant percentage of global growth and would ensure that China’s dominance in the metals markets continues.

–Stuart Burns

The People’s Bank of China raised its one-year base lending rate by 25 basis points to 5.81 percent the central bank’s second move in just over two months, according to a FT article as it sought to tame inflation.

Although the move had been anticipated for weeks, it serves as a reminder that Beijing’s earlier efforts to rein in inflationary activities by raising bank reserve ratios have failed to address the problem. “We expect more to come in 2011, forecasting another 75 basis points of rate hikes by the end of next year, Brian Jackson at RBC Capital Markets is quoted as saying, adding “Policymakers have work to do too, not only in China, but across the region, with more rate hikes also likely from India and Korea in the New Year.

Source: Allianz Insurance

The annual rate rose to 5.1 percent in November from 4.4 percent in October, and food is no longer the only area of concern, according to a different FT article. The campaign against inflation is broad, but obviously not working, the article says, to judge by the latest money supply figures. (Although down from a near 30 percent rate at the end of last year, M2 increased at a 19.5 percent annual rate in November, much too high for an economy growing at a 10 percent rate).

That Beijing’s attempts to rein in inflation have not been successful should come as no surprise; the economy is seriously skewed in favor of investment-led growth rather than consumption-led growth, yet while interest rates are (at base rate) now only 0.7 percentage points above the inflation rate, a case for investment in such a fast-growing economy is easy for corporations to make. As this graph from an Allianz Insurance report on China shows, China’s economy has been going in the wrong direction for decades with gross fixed capital investment exceeding domestic consumption for the last few years.

Source: Allianz Insurance

Real incomes have been kept low by an artificially depressed exchange rate, and only recently have incentives been introduced to promote domestic spending in the form of subsidies on cars and white goods, and easy bank credit for housing.

–Stuart Burns

The steel producers have not had the best of years; true capacity utilization has recovered a little after a surge of restocking in the first half came to an end.

Source: Dept of Commerce.

Since then, it has been bumping along at around 70 percent as producers have struggled with rising costs of scrap, coal, iron ore and natural gas, yet been largely unable to pass through increases to a lackluster market. That many have maintained profitability is a testament to how much they have learned in the last decade and what tight control they now have of their businesses. Better times are on the horizon, though, if a recent report by Credit Suisse is correct.

In a detailed report to clients the bank predicts the steel markets in North America and Europe to be on the cusp of a four-six quarter rally driven by rising raw material costs and improving demand. In and of themselves, rising raw material costs are not sufficient to drive prices higher as we have seen in the last. If demand is so weak that price rises do not stick, then the producer just gets squeezed; however, although the bank is predicting the next sustained upswing will not start until Q2 2011, early signs of rising scrap prices and Q1 finished steel price increases being accepted by the market suggest the bank is on to something.

Price forecasts courtesy of Credit Suisse and CRU

Many of the main drivers for increased demand, and, with it, the pricing power the mills are looking for, are beginning to show early signs of picking up. Auto sales have been on a steady road to recovery, as the following two graphs from CSM suggest.

After five years of falling home starts, Credit Suisse points to a rise in the pending home sales index as evidence that the construction industry could pick up next year.

In the past, there has been a strong correlation between the pending home sales index and new housing starts, but the false dawn of Q3 2009 and Q1 2010 have shaken belief that an uptick in one is a guarantee of an uptick in the other.

Finally, steel service-center inventory levels remain at historically low levels and while the rate of re-stocking for industries like construction will be slow at first, the rate of change will appear dramatic.

As a result, Credit Suisse is predicting a 12-18 month re-stock and demand-driven tightening of the market, resulting in higher steel prices and extended lead times. Consumers may do well to track some of the metrics the bank is using to make their predictions for early signs of confirmation. Where possible, early buy forwards may help to mitigate price rises expected in H2 2011 and H1 2012. Longer out, four t0 five years, the bank feels the low prices and shuttering of capacity since 2008 will result in a lack of investment in new capacity. Prices of more than US $1000 per metric ton will be needed to incentivize mills to make new investments. While Europe and the US need more steel mills like they need another recession today, the result may be in four to five years that imports play a significant, if not dominant, role in pricing and supply again.

–Stuart Burns

An intriguing article in CPO Agenda entitled “The return of make or buy” looks at the perennial question of whether it is better to manufacture all parts, components and materials in-house or whether the thinking of the last decade still holds true that everything should be outsourced that is not core competency. Of course, that phrase can be defined in any number of ways and often looks different depending on the industry in question. Steel makers, for example, have been vertically integrating into iron ore mining since the latter years of the last decade as the big three iron ore suppliers evolved to take a dominant position in the supply and pricing of iron ore. Prior to that the new wave of competition, Asian steel mills had relied almost totally on the seaborne iron ore market for supplies, but in the last few years both Asian and European players (like Corus) and global players (like ArcelorMittal) have been investing heavily in new mines and buying into existing junior miners to secure supply. Security of supply has become of paramount importance for any industry facing raw material supply issues, such as parts of the metals industry, of late.

In the article, Uwe Schulte, a former head of global procurement at Unilever and now owner of the Prosolvo consultancy, gives three examples of when a company might want to maintain its production facilities in-house:

  • where ensuring capacity ahead of competitors would otherwise come at an unfeasibly high price;
  • where there is the threat of a leakage of knowledge, particularly where this know-how is unpatented;
  • or, where the price-forming mechanism is not under their control, as with steel mills and iron ore. “If there’s high variability in demand and supply you’d probably want to own the assets, he is quoted as saying.

The financial crisis of 2008 has thrown some new dynamics into the mix, which for some companies have changed the desirability of outsourcing key products. Firstly, volumes are down for many industries; think of auto manufacturing in the US. Many auto suppliers have struggled to adjust to the reduced volumes post-2008 and there has been a rationalization in the supply base. Some OEMs in such situations are faced with making this decision: do we step in and rescue a key supplier, or let them go and seek new supply options? The article states results from a survey by CPO Agenda in November last year,   which revealed that 9 percent of CPOs had been forced to invest capital in a supplier’s business during the downturn to help ensure their survival, while 3.6 percent had acquired a failing and/or strategic supplier.

Secondly, although firms are well capitalized after good profits during the last decade, new capital can be difficult to secure and investing in internal manufacturing sometimes comes second to cash flow considerations.

Thirdly, the supply base has suffered capacity reductions, making previously secure supply chains vulnerable to supply shortages — the European aluminum large bar and plate markets are a case in point. A combination of capacity closures in established markets like the UK and more buoyant domestic markets in producers’ home markets, like Russia, have conspired to result in a very tight physical market this year in Europe. While it is impractical for OEMs to buy extrusion or rolling mills, we have seen OEMs developing strategic relationships which have resulted in investment and technology transfers in return for exclusive or guaranteed supply relationships such as Boeing’s collaboration with Russia’s titanium producer VSMPO.

How much further this process has to run remains to be seen and certainly the effect is greater for some industries than others, but at least the one-way traffic of outsource manufacturing to emerging markets is showing a return flow in the new normal we are living through and where supply-chain specialists have never had such a crucial role in manufacturers’ range of competencies as they do today.

–Stuart Burns

We have been hearing a lot of cheery news about GM this year, not least its IPO and successful fund raising, the launch of the Volt and a return to profitability, even on what is a historically low level of sales. So it is interesting to read an alternative viewpoint by Edward Niedermeyer, editor of the Web site The Truth About Cars espoused in a NY Times article.

The article takes GM in particular to task, but ropes in Chrysler and Ford in its criticisms on a number of fronts, not least for failing to live up to President Obama’s hype at the time of the bailout that Detroit was turning its back on gas-guzzling trucks and SUVs and would become the world leader in fuel efficient transport, meaning smaller engine petrol cars or hybrids. Taking General Motors as an example, the NYT states sales of actual cars this year have fallen by nearly 6 percent compared with last year’s already anemic numbers, while light trucks (which include pickup trucks, SUVs, minivans and crossovers) are up by more than 16 percent. Nor is fuel efficiency making big gains: according to the EPA, the Big Three are among four of the lowest average fleet fuel economy ratings among front line manufacturers, and none achieves the industry average of 22.5 mpg. But to what extent are GM, Chrysler or Ford at fault for this? They all produce a range of cars and light trucks in response to what the market demands. With some justification, critics could argue that Detroit’s offerings in the small- to medium car market are not as attractive as those from European or Japanese manufacturers, leaving the Big Three with sales only in larger vehicles. Even hybrid sales have been disappointing — a quarter of all the hybrids built by Detroit has been bought by federal agencies, graphically underlining the public’s attitude toward models like the Volt compared to Toyota’s Prius, for example.

As if GM’s lack of small car development was not enough, the company stands accused of further misdemeanors. As a result of poor demand for the manufacturers’ product range, all the Detroit car makers were guilty to varying degrees of stockpiling or over-production, then offering large cash discounts to move that stock, and an excessive reliance on discounted fleet sales, all of which led directly to poor brand identity and low residuals. It would appear from the article that GM and Chrysler are relying on the same tactics, reporting production as if they were sales, building inventory GM now has three months worth of sales sitting in lots and falling back on fleet sales to shift cars (32 percent of the Big Three’s October sales were to the fleet operators.)

This has not passed the markets by. Trading today at around $33.50-34, GM’s stock price has yet to reach the $36 a share it reached on its first day of trading last month, in spite of the wider market rising from 11,000 to 11,400. Does this matter so long as GM is trading somewhat profitably? Yes, to have a viable long-term future the company needs an attractive product range that can compete across a broad spectrum of the market. It needs to operate sound business practices, not adopt the tactics that got it into bankruptcy in the first place. For suppliers, for workers, and for the taxpayers that bailed them out, GM and Chrysler need to do more than just divest themselves of bad working practices and accumulated responsibilities — they need to transform themselves into modern automotive manufacturers. It sounds as if they may have some way to go.

–Stuart Burns

A Reuters article this week supports comments elsewhere that demand from auto makers in emerging markets and investor interest in new exchange-traded products in base metals are likely to drive lead prices higher next year. Lead, now around $2,450 a ton, will rise to above $2,500 a ton on average, with some analysts saying it may even cross the $2,700 mark.   Demand for lead is steadier than for most other base metals, the article says, as about 40 to 50 percent is for replacement batteries, making it very resilient to ups and downs in new car sales. China’s auto sector and rebounding production in Europe and North America have boosted demand for batteries this year.

However, as scrappage schemes in Europe fade out, attention is focused on economies such as China, India and Brazil.

Vehicle sales in China could exceed 17 million units this year, Reuters quotes Deutsche Bank, who sees that rising to some 20 million in 2011.

Source: Kitco

Meanwhile, the International Lead Zinc Study Group (ILZSG) announced this week that the global lead market was in surplus by 51,000 tons in the first ten months of the year. Intriguingly, while producers’ stocks fell to 139,000 tons in October from 142,000 tons in September, up only slightly on end-2009 stocks of 135,000 tons, the LME has gone in the opposite direction. LME lead stocks are at a 10.1/2 year-high and, at above 200,000 tons, are about five times higher than two years ago.

Source: Kitco

As China fears and risk appetite waned, the rising stock position for lead, as with aluminum, meant lead’s rebound in price was not as dramatic as, say, copper, for which falling stocks are a clear sign of a tightening physical market.

The consultancy CHR Metals sees the lead market tipping into a very modest deficit next year, as Chinese consumption remains robust. Others such as BNP Paribas say the 90,000-ton surplus will remain next year and a deficit will not develop until 2012. China is both the biggest consumer and the biggest producer; demand may slow next year if credit tightening and interest rate hikes cool demand as Beijing hopes. Meanwhile, although production this year has been hit by power cutbacks, next year there should be sufficient power available from the New Year and production is expected to rise, according to state research firm Antaike, causing a surplus in the domestic market. The lead price has not responded to the general bullishness surrounding copper and like some of the other metals has struggled to make return to fall highs. One positive development could be the launch of the SHFE lead contract in the second half of next year which, according to Societe Generale, could promote arbitrage activity between London and Shanghai to lead’s benefit. The bank is forecasting $2,775 per ton next year.

Much will depend on risk appetite among investors, GDP growth and particularly auto/e-bike sales in both emerging and developed markets. On balance, we don’t see the fundamentals supporting lead at $2,775 per ton and feel $2,600 is probably the top end for the first half as supply will continue to outstrip demand, but with so much uncertainty around, a narrow 90,000-ton surplus could evaporate quite quickly, in which case the current $2,450-per-ton prices may look good come the summer of 2011.

–Stuart Burns

We’ve all read about the tenuous relationship between US importers and Chinese exporters that colors anti-dumping news, with the requisite lists of duties and suspensions that are in line for metal products. But a new concern lurks behind the dumping dispatches; one that may come into play pretty heavily in future US-China trade — some may argue it already has — especially in terms of affecting US exports.

The debate over certain elements of intellectual property rights (IPR), a contentious issue here in the States, has now spilled over into the macroeconomic forum between the US and China. It’s long been known that Chinese pirating of copyrighted works, for example, is commonplace, but this is the first time that a federal-level investigation will try to put a quantitative stamp on the extent to which IPR infringements in China can devastate US business there. This comes from one of two reports, released by the US International Trade Commission (USITC).

China has been robustly advancing “indigenous innovation policies, which the US sees as undermining its firms’ business opportunities in China’s economy. “This “web of policies” often embedded in government procurement, technical standards, anti-monopoly, and tax regulations may make it difficult for foreign companies to compete on a level playing field in China, the USITC’s news release states. The graph and table below show the extent of China’s involvement at every stage of the supply chain.

Source: USITC

The first report found that the extremely weak or even non-existent enforcement of IPR leads to “widespread infringement upon “U.S. firms’ copyrights, trademarks, patents, and trade secrets in China. (The second report, a more quantitative analysis of the effect of IPR infringement on US jobs will come out in May 2011.) For metals companies doing business with China, this can certainly cause harm beyond simple exports the firm’s brand image, for example, or proprietary information, even if not explicitly shared, may become easily compromised. (Manufacturing equipment or processes are also targets.) As we’ve seen through the WikiLeaks cables, the Chinese have few qualms when it comes to hacking US corporations’ databases. Who’s to say this doesn’t extend into IPR?

Reuters intelligence in the Business Standard pointed to a recent report by PwC that said “the urgent need to protect intellectual property has forced 92 per cent of surveyed companies operating in China to plan budget increases on information security in the next 12 months. Chinese firms and the government have been under fire for either forcing companies to hand over patents and designs (or simply stealing them) when it comes to products such as high-speed trains, auto designs, mobile phones and wind turbines. The International Intellectual Property Alliance estimates US trade losses due to piracy in China of at least $3.5 billion in 2009, according to the article. For context, that is nearly the total value of the US aluminum extrusions market.

–Taras Berezowsky

The WTO Secretariat reported that the first half of 2010 saw a 29 percent decrease in anti-dumping initiations of investigations, as well as a sizable decrease in new measures applied, when compared to the same period in 2009.

With the spate of activity in dumping cases between China, the EU and the US since that time period, however, the decrease feels, well, moot.

India reported the most initiations with 17, the EU came in second with eight, while the US reported only two. India was also tops in reporting the applications of new measures with 17, the US came in with five, while the EU submitted two.  (The members to the Committee on Anti-Dumping Practices provide this data from their semi-annual reports.)

China is the top target once again for investigations, leading with 23 new initiations. Ahh, now that’s more like it.

The world’s second-largest economy is batting .500, to use a wholly American cliché, in its two highest-profile anti-dumping cases recently. The WTO rejected China’s claim against the US that the Obama administration’s tariff impositions on light vehicle tires violated rules. Nearly a week earlier, the WTO ruled in favor of the People’s Republic by striking down the EU’s policy to impose a 63% to 87% tariff on Chinese-made steel fasteners the first case China won against the EU.

What concerns us, however, is that industrial metals are still at the center of most cases (the base metals sector accounted for the greatest percentage of new initiations and new measures applied, according to the WTO report). The US imposed new duties on oil country tubular goods stainless alloy products used for drillpipe, casing pipe and tubular applications in the petrol industry and prestressed concrete steel wire strand from China in the first half of 2010. The USW has also taken the lead in pushing for investigation of Chinese imports of aluminum extrusion, Dustin Ensinger writes. According to the union, China controlled 8 percent of that market in 2007, which jumped to 20 percent in 2009. Over that same time, prices of the Chinese imports fell 30 to 50 percent. (Our own Stuart Burns analyzed what this means for the aluminum market back in November.)

With China’s economy growing proportionally much faster to that of the US, their government is ostensibly acting as though they can afford to get away with these types of practices. By taking advantage of the slumping western economy for their gain, they know that slaps on the wrist from the WTO will have minimal effect. It doesn’t look like China will forced to stop their rumbling econo-machine anytime soon; with pressure to feed demand both in their own domestic sphere, and in keeping up exports to meet internal quotas and fuel their GDP, the WTO at times seems nothing more than a minor roadblock.

–Taras Berezowsky

An intriguing if slightly scary article appeared on Mineweb last week, summarizing a number of earlier interviews and comments by gold market commentators and investment gurus concerning the degree to which gold on deposit in bank vaults actually exists. Or, as the article explains, doesn’t. Confusing? Yes, well, the situation is more than a little confusing, but I will try to explain.

Unlike paper money, which we have always accepted, does not physically sit in bank vaults — following your deposit, it’s instantly recycled into loans and payments by your bank. We have always understood that for those of us fortunate enough to hold physical gold (this author not included), when we deposit our precious bars in a bank’s vault for safekeeping, and the bank starts billing us for storage charges, that gold is sitting safe in their vaults for our eventual return. Secure and instantly available when we want it? Well, maybe not. Anecdotal evidence quoted by Jim Ricards, Snr. MD of Market Intelligence, and James Turk, founder of Gold Money, relayed stories of clients with physical gold and silver in Swiss banks who had to fight for one and two months, respectively, to secure the physical return of their gold and silver holdings. The conclusion in both cases: the banks were no longer holding the physical metal, even though they were continuing to charge the owner for storage.

The article also quotes GATA in saying it has long been known that the amount of gold and silver traded every day on the markets far exceeds the amount actually in existence, and that if everyone demanded simultaneous delivery it would be impossible. That should not come as any surprise; the same ounce can be bought and sold many times in a day representing dozens of ounces when in fact it is the same ounce going around. In addition, many trades are swaps, hedges and other transactions requiring financial delivery, not physical. Nevertheless, the point is probably a fair one that we trade gold and silver as if ever trade was physically backed, with no risk on non-delivery priced in and yet in most cases there is a counter-party risk which like a sub-prime mortgage gets passed around, until one day it doesn’t. As the volume of physical gold taken up by sovereign states like China and by physically backed funds like ETFs has rapidly risen in recent years, it raises doubts about how much metal is actually available for prompt delivery in the market place.

If these stories of bank non-delivery were isolated cases, they could be dismissed as exceptions. But Resourceinvestor ran an article by James Turk   providing empirical evidence supporting the view that we have already entered a period of severe and growing physical tightness in gold supply — and he points to the forward price curve to prove it. The London Bullion Market Association (LBMA) forward price curve is normally in contango, meaning the forward gold price is higher than the spot price. The difference is a reflection of the cost of finance and storage of gold for the intervening months. If the spot price is higher than the forward price, the market is said to be in backwardation and is usually the case if spot demand exceeds supply, creating pressure for buyers to pay excessive premiums to secure prompt delivery.

Source: Resource Investor

As these graphs show, both the gold and silver markets have been in backwardation. This degree of backwardation has not been seen since the LBMA databases started in 1989. The fact that 12-month gold is also trending towards backwardation shows the situation is intensifying, says James Turk.

The situation is even worse for silver, where six-month silver has been in backwardation since June 2.

Source: Resource Investor

The likely result, says the committed gold bull Mr. Turk, is rising prices and although we cannot see any justification for a further bull run on gold, we have to agree. One likely solution to a short-term shortage is higher prices forcing more recycling and demand destruction as jewelry and industrial use is hit. Whether that will be enough to counteract rising fund buying, though, remains to be seen. One thing is for sure: it looks like an unpleasant set of opposing forces playing out in the gold market and could be the harbinger of further volatility.

–Stuart Burns

We don’t really want to beat the whole ‘base metals ETF’ thing to death much more than the next guy (rare earths coverage, anyone?), but it seems fitting to do sort of a “wrap-up post on how last Friday’s opening of copper, tin and nickel ETPs by ETF Securities went. At least, we can gauge analysts’ reactions to the opening and their expectations for the 2011 aluminum, zinc and lead offerings.

Can the initial trading activity and sentiment tell us anything about the health of future base metal stocks and supply? With a couple trading days behind us, leaving the dust to settle a bit, here are some indicators and viewpoints on where prices especially those for copper are headed.

As a partial answer to a question I posed in my last post on this topic, Deutsche Bank said back in October that physically backed copper ETPs could hold 300,000 to 400,000 metric tons of metal, according to a Reuters article. “That compares with stocks of about 350,000 tonnes in London Metal Exchange warehouses now, the article continued. Meaning, the amount tied up in ETFs will about equal what’s now available, exacerbating the supply tightness rather than alleviating it.

“The next couple of weeks will be very interesting to see what the level of interest is, said David Wilson, analyst at Societe Generale, quoted in the article. “You do wonder if investors may wait until the bigger players’ products are launched. Two of those bigger players are JP Morgan and Black Rock Asset Management, whose ETP launches are reportedly in the works.

Copper is clearly hotter right now than the other two base metals. The nickel ETP was unchanged from the open, and the tin ETP was left untraded on Friday, according to Reuters. In a Q&A published by Reuters’ Metals Insider, Luvata’s head of metals for Europe and Asia, Ian Scarlett, expressed concern for copper especially. “We’re in a period in which availability is challenged, he said. “Anything that ties up physical metal and restricts end users from using copper is unhealthy.

Kevin Norrish, the managing director of commodities research at Barclays Capital, provides a helpful line of reasoning from the investors’ viewpoint in a Financial Times article:

“In current copper market conditions, investors get a return boost from the futures market as it has gone into backwardation, meaning new contracts cost less than expiring contracts. Investors buying into the physically backed product will not enjoy that uplift. It is a contradiction at the heart of the new products that their existence could lead to tighter market conditions, resulting in ongoing backwardation, to the benefit of investors in futures, Norrish says. On the other hand, if spot market prices go down, and futures markets go into contango (new contracts cost more than expiring ones), investors in physical products will still lose out because the cost of warehousing will go up (because the fee is per ton of metal).

Ultimately, Norrish says in the article: “You can’t argue that physical market investment doesn’t have an impact on price.

–Taras Berezowsky

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