Commodity price declines point to demand problems in China

A sobering article from Reuters points to potential credit problems with commodity buyers in China. It seems some middlemen have in the past been taking speculative inventory with the goal of earning more than the usual spread. As demand slowed, these buyers are having trouble raising cash to meet their obligations. They typically relied on rapid sales to their customers to purchase new inventory - but that does not seem as easy these days.

Reuters: - Chinese buyers are deferring or have defaulted on coal and iron ore deliveries following a drop in prices, traders said, providing more evidence that a slowdown in the world's second-largest economy is hitting its appetite for commodities.

China is the world's biggest consumer of iron ore, coal and other base metals, but recent data has shown the economy cooling more quickly than expected, with industrial output growth slowing sharply in April and fixed asset investment, a key driver of the economy, hitting its lowest in nearly a decade.

Coal and iron ore prices could fall further before recovering towards the tail end of the second quarter, traders say, sparking more defaults or deferred deliveries.

"There are a few distressed cargoes but no one is gung-ho enough to take them. Chinese utilities aren't buying because they have a lot of coal and traders are also afraid of getting burnt. It's very bearish now," said a trader.

The defaults come on the heels of a slump in global thermal coal benchmark prices to two-year lows and increases the prospect of an even steeper fall unless China revives buying to absorb the global coal surplus as exporters ramp up production.

Anecdotal evidence also suggests that wholesalers are cutting coal inventories in a number of ports. Spot prices for coking coal have indeed been dropping.

China Foundry Coke Domestic Spot Price Shanghai (Bloomberg)

These events may be an indication of a demand slowdown in China that is far sharper than anticipated - driven primarily by reduced infrastructure investment (discussed here). A more aggressive stimulus program from the government may be on the way shortly.

SoberLook.com

Why high gas prices at the pump? The answer is BICS

Here is a simple question: where is the growth in crude oil consumption coming from? According to Barclays Capital it's driven by four nations. They are Brazil, India, China, and somewhat surprisingly (and yes, we are talking about demand growth) Saudi Arabia, the so called BICS nations.

Barclays Capital: The reason for bringing together Brazil, India, China and Saudi Arabia is that once one has disaggregated global oil demand into BICS and non-BICS, it becomes clear which element is the key to predicting global oil demand. If you get BICS right, you have normally got the shape of the whole picture right. By contrast, if you get the US, EU or OECD right, you quite often can still miss the big picture. Perhaps the focus should be shifting to getting a better handle on BICS.

Last year BICS generated all the growth in global demand for oil. Given the economic malaise in the developed world, this year we expect the same. So the next time someone asks why people in the US and the EU pay such high gasoline prices all of a sudden, the answer is simple - BICS.

Demand growth in mb/day (Source: Barclays Research)

SoberLook.com

According to Credit Suisse, the global commodity demand has peaked

Credit Suisse is calling for the peak in global commodity demand due to their projections on China. The firm's argument focuses not just on China's slowdown but also on the shift in the nation's mix of growth sources. China is rebalancing its economy by moving away from export and infrastructure economy toward domestic demand, with a focus on household consumption. It's unclear just how successful they will be in that transition and how quickly they would be able to achieve it, but the nation's central planning will be steering the country in that direction. Such a transformation will in turn reduce China's demand for natural resources.

Credit Suisse: As the economy shifts its growth engines away from infrastructure, construction and exports toward consumption, especially service consumption, the propensity of demand for commodities is bound to decline. Getting a massage simply does not use as much steel as building an airport.

People often don't appreciate just how much of the commodity demand has been coming from China.

Credit Suisse: China had a massive surge in its demand for commodities over the past decade, fuelled by its housing boom and infrastructure investment boom. From 2000 to 2010, China’s imports (in value terms) of iron ore surged by 42.5 times, thermal coal 248 times and copper 16.2 times. During the same period, its production (in quantity terms) for aluminium jumped by 441.8%, cement 219.5% and steel 396.0%. It is the biggest consumer in virtually all commodity categories in the world. China was the key factor behind the global commodity supercycle, in our view.

The chart below is a bit dated but it makes the point. When it comes to commodities, China has been in the driver's seat.

Source: CS

A combination of reduced monetary stimulus and slowing GDP growth is expected to moderate China's demand for commodities. The chart below shows the long-term GDP growth projections for China.

Source: CS

But beyond just the slowing growth, China's focus on infrastructure and exports required unsustainable amounts of natural resources for every point of GDP growth. With the structural shift in sources of GDP growth, these requirements should decline. Credit Suisse believes we have reached the peak for global commodity demand on the back of China's economic shift.

Credit Suisse: In 2011, it took 71 million tones of steel for one percentage point of GDP growth – that is unheard of in the world’s modern history. We project that the ratio should moderate to 30-40 million tones for every percentage point of GDP growth by 2020. There will be cyclical ups and downs, which may affect China’s demand for commodities and commodity prices, but we think China’s supercycle for commodities is behind us.

SoberLook.com

Upside risks to crude oil prices

Other than the geopolitical concerns pushing up crude oil prices (in particular Brent crude), we may be seeing much tighter supply conditions going forward. OPEC spare capacity is approaching tight levels not seen since 2008 when crude prices were approaching the $150/b levels.

OPEC spare capacity and global oil demand (source: Barclays Capital)

The non-OPEC production has been on the decline in the UK, Norway, and China. Major forecasts for the 2012 supply growth are all materially lower than they were in 2011. With spare capacity tight, any slight disruption or a possibility of a disruption could push Brent prices higher, widening the Brent-WTI spread. The risks in crude oil in general are now to the upside.

SoberLook.com

Speculating on oil? Go for it.

A nice write-up R S Eckaus discusses the oil price bubble that we've experienced last summer and may be experiencing now. He disputes the argument that we have this tremendous new demand from China as well as some other justifications for oil price being where it is. As we discussed earlier (Oil price will stall on fundamentals), we've had some real demand destruction due to this financial crisis. Some of that destruction is also driven by substantial increases in production and delivery capabilities of liquefied natural gas (LNG) around the world. The Russians wanted to diversify from pumping gas to Europe via the Ukraine (Ukrainians can get a bit "restless" at times) as well as sell their natural gas to other markets. So they are completing some LNG capability, while consumers like China and the US have been building de-liquefaction capacity to diversify from oil. With natural gas prices at current levels, energy users are shifting wherever they can away from oil.

With all this, the IEA finally admitted that the demand will be lower than what thay have been predicting all along. They are now in line with the Credit Suisse forecast of under 90 million barrels per day by 2013.

So why are oil prices on the rise given such demand destruction? Eckaus argues it's speculation. Then what , if anything, can be done about it? Some would argue speculation in oil should be prohibited. Well, that could become a slippery slope. If you buy a piece of land as an investment, that's speculation. Should that be prohibited also? How about buying gold? What about the largest speculative bubble of all, the stock market?

Also, speculating on oil is generally done via futures, unless you own an oil storage facility. That means that eventually you will either have to sell your futures contract or someone will deliver you physical oil in Cushing, Oklahoma and make you pay for it. Plus being long oil futures is expensive because the curve is quite steep, making contracts worth less as time goes on (negative carry). That means that it's not the "fast money" that is doing all the buying but some more strategic players who store oil or hold it in tankers. Controlling or prohibiting that would be ridiculous - we would all be standing in lines to buy government issued gasoline. Socialism anyone?

So oil speculation can definitely hurt the consumer and corporations, but controlling trading is not the answer. It is no more productive than controlling speculation in the housing market that ended up hurting everyone - you just can't legislate whether people can buy or sell homes and at what price. The answer is to prove to the market that diversification away from oil is possible and it works. That will be the most effective way to burst the bubble.

Oil price will stall on fundamentals

Oil prices are not going back to the levels of last summer. The prices are capped. The latest numbers from Credit Suisse show why. The financial crisis has created permanent destruction of demand growth. The expectation now is 1% growth in demand per year. Two contributors to this are:

1. Faster gasification in Asia (as Asian nations begin to use liquefied natural gas)
2. Greater auto efficiency in the US. Sensitivity to high gas prices is extreme, given all the pain the US consumers have experienced. Fuel efficiency is here to stay.

From Credit Suisse


Given that the demand by 2015 is expected to be 90 million barrels per day (MBD), this new need for oil can be easily met by cheaper forms of production, in effect capping the price.

The graph below from Credit Suisse shows where oil price needs to be to achieve a 16% return on capital investing in new sources of supply, vs. the amount of new supply available from these sources. To get to 90 MBD can be done with the more traditional projects that are profitable even when oil is under $70 per barrel (and certainly under $100).