The Commodity Outlook in China’s New Normal

While the emergence of China demand drove the commodity supercycle in the past decade, by the same token its “new normal” of slower growth has triggered a steep correction in everything from energy to hard commodities. Now as China’s economy rebalances towards being consumption-driven and commodity markets adjust to lower prices, there is still considerable uncertainty about the future.

To get a better idea of what these shifts mean for the commodity world, we sat down with Neil Beveridge, Senior Oil and Gas analyst at Bernstein Research in Hong Kong and Mihir Chandra, Head of Research Asia at SC Lowy in Hong Kong.

 

 

How much of a factor has China been in the correction in oil prices?

Neil Beveridge: Chinese demand and weak non-Opec supply were the key drivers when oil was in the $100 plus range. But the recent price correction has primarily been an issue of supply, not demand. Last year we saw the biggest increase in supply since the 1980s due to the new shale production in the United States. At the same time, compared to some industrial commodities, oil is much less dependent on Chinese demand, which accounts for just 10 percent of total world demand.

We still expect global oil demand to grow another 3-4 percent until the end of the decade, primarily driven by transportation demand. There is still a substantial growth opportunity driven by catch-up automobile demand; if you compare the car density to South Korea or Japan, China’s car fleet could easily treble.

 

In April China became the world’s biggest importer of oil for the first time. Is this a sign of renewed strength?

NB: There are two factors here, the first being the supply situation. We expect a decline in onshore domestic oil production in China in the region of 3-4 percent this year.  The other factor is policy driven, as China is using the fall in oil prices to shore up its energy security by replenishing its strategic oil reserves. These are still well below the International Energy Agency’s recommended level of 90 days emergency supply. China has just 250 million barrels, meaning it needs to add another 600 million barrels, which it will likely do at a rate of 300Mbpd for the next five to six years.

 

How do you see the outlook for oil prices after the rebound in the first half of the year?

NB:  We are definitely in a different pricing environment and nobody sees the price quickly going back up to $100 a barrel. The big question is how prices impact supply. At  $60-70 dollars a barrel there is a view that shale can still profitably operate but below that price, the rig count is still falling.  We have compared the recent correction to that of 1986, which led to a decade-long decline in oil prices and we do not expect a repeat this time around.

 

Given where we are with oil prices at $60 a barrel, are people now hedging?

NB: I think it depends on where you are – if you are downstream customers such as airlines or shipping, there is interest to hedge at these levels.  But for upstream companies (involved in production), the price is simply too low.

 

Turning to iron ore, it has really suffered from China’s slowdown if you look at price falls from $180 per ton in 2011 to below $50 this year – how do you see the market outlook?

Mihir Chandra:  Yes, iron ore is most exposed to China weakness as it accounts for approximately two-thirds of the seaborne market.

When you have such a high base of overall demand, who else can replace this if China slows down? To offset domestic weakness, last year China has increased its steel exports to a run rate of almost 100 million tons in year-to-date 2015. These export volumes are likely to face anti-dumping measures, meaning it is likely steel production will flat line or possibly fall in the near term.

The dominating factor, however, is the supply situation where there is a wall of supply of low cost iron ore. The top four producers –  Brazil’s Vale, BHP Billiton, Rio Tinto and Australian producer Fortescue Metals – control an estimated 75 percent of the seaborne market between them and are continuing to ramp up production. Between 2014- 17, their overall production is forecast to increase by an estimated 200 million tons.

Prices need to go lower to cut out supply but this is not happening as fast as it might.  Miners have been cutting costs and sweating assets harder to adapt to lower prices but also there is also so much cheap liquidity around which is helping to keep some distressed miners going.

 

What is the outlook for thermal coal, another commodity where China is a big player? 

MC:  China accounts for just under 20 percent of the seaborne market in thermal coal, which is a similar share to that of India. But as China has been moving coal power plants inland to curb pollution, this raises transport costs for seaborne coal so it is not competitive with domestic coal and imports are likely to decline.  It is more likely going forward that Indian demand will be the swing factor on prices. There, the government has taken some older coal licences back and re-auctioned them. We will have to see if this translates into greater domestic production, as the official target is to double coal production to 1.5 billion tons by 2020.

 

How is the outlook for other hard commodities?

MC:  Starting with copper, it is generally less sensitive to China’s slowdown. Unlike other metals such as steel, it is less exposed to real estate. It also has growth potential given its use in ultra-high voltage cables, even though it faces headwinds over the next couple of years due to anticipated supply growth.

 

Aluminium is more consumer driven, so it will do relatively better from a demand perspective although a huge inventory overhang and new capacity additions in China will keep prices subdued.  Overall zinc has the best supply/demand outlook as the market is still facing a supply shortfall.

 

How do you view the wider commodity landscape in the face of China’s slowdown and the end of the supercycle?

 

NB: I think by now, it is a bit passé to say it’s the end of the commodity supercycle.  I would say we are seeing a shift in what becomes important. Steel demand, iron ore maybe, but oil and gas have not peaked. And the outlook for natural gas looks particularly strong. It’s being called“the low carbon bridge to the future”.

 

How do you expect to see China’s influence on the global oil market develop? This year they have announced plans to launch a new crude oil futures contract, traded in Shanghai’s free trade zone.

 

NB:  Being the largest buyer in the oil market clearly gives a certain amount of influence. China would like to be a price maker, not taker. It becomes conceivable that they could have a benchmark and they have physical storage in place.  But it depends on liquidity given the lack of full convertibility of the currency on the capital account.

 

 

 

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