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Global Commodity Strategy Summary (August 13, 2013)

Core Content Overview

BMO Research conducted a two-week site visit to China, focusing on the copper, iron ore, met coal, and aluminum sectors. The report outlines the current state of China's economy and its impact on global commodity markets, emphasizing slowing growth, policy shifts, and supply-demand dynamics.

Main Points

• Economic Growth: China's economic growth is expected to slow, with most analysts forecasting 7.0–7.5% GDP growth for H2/13. The government is promoting steady and sustainable growth, and significant rebounds are unlikely due to reduced reliance on massive government spending.
• Commodity Outlook: Global supply growth is expected to outpace demand over the medium term, leading to continued pressure on commodity prices.
• Policy Shifts: Financial and fiscal reforms are top priorities, followed by environmental and social reforms. The government is implementing "mini-stimulus" to support specific regions or sectors, but not major policy changes.
• Commodity Preferences: Copper remains a preferred commodity, despite challenges in the broader commodities complex. Iron ore is viewed more positively than met coal due to supply dynamics. Aluminum and steel industries are in overcapacity, with weak price forecasts.

Key Insights

Copper

• Demand and Supply: China accounts for 41% of global copper demand in 2012. Domestic mine supply is only 20% of total demand, with smelters relying heavily on imports.
• Supply Constraints: Smelters have limited captive concentrate supply (<20%), and are facing challenges in securing concentrate due to strict import regulations and complex grades.
• Market Dynamics: Physical premiums are at an all-time high, suggesting potential credit bubble concerns. Smelters are increasingly using copper as collateral for financing, which may not support real economic growth.
• Price Outlook: Global concentrate supply growth is expected to outpace demand, leading to slightly higher TC/RCs. BMO maintains its commodity price forecasts unchanged.

Iron Ore

• Import Dependency: China imports most of its iron ore, with domestic supply accounting for only 359Mt against a demand of 1,088Mt in 2012.
• Domestic Supply: Domestic miners prioritize security of supply and employment over profitability, and are expected to remain slightly profitable at current contract prices.
• Price Outlook: Prices are expected to remain flat but volatile due to high steel output, low inventories, and profit-seeking domestic miners. BMO estimates marginal production costs around US$135/t.
• Supply-Demand Balance: BMO forecasts a balanced market through 2014, with a potential 20% cut in production if prices fall below US$110/t.

Met Coal

• Self-Sufficiency: China is largely self-sufficient in coking coal, importing only 10% of its demand in 2012.
• Industry Concentration: A few state-owned companies control most of the production, leading to limited price competition.
• Price Outlook: Met coal prices are expected to be negative due to expanding rail capacity and increased domestic supply. Improved rail capacity could reduce price differentials between regions and between imported and domestic coal.
• Thermal Coal Impact: Thermal coal producers may lose the cost advantage of inland production as rail capacity improves.

Aluminum and Steel

• Overcapacity: The aluminum and steel industries are in significant overcapacity, with prices expected to remain weak.
• Policy and Reform: The government is focused on reducing overcapacity through consolidation and real reforms, but this will take time due to employment and social commitments.

Overhanging Uncertainty

• Credit Bubble Concerns: The copper market suggests potential credit bubble risks, with physical premiums at high levels and increased use of copper as collateral.
• Housing Market: The housing market is cooling, with government interventions. However, this is not yet a major concern for commodity prices.
• Fiscal Reforms: The government's debt audit is a positive step, but a significant increase in debt could lead to a perceived credit crisis, affecting commodity prices.

Conclusion

• Market Dynamics: Oversupply remains the overarching theme for most commodities, with headline data only temporarily affecting prices.
• Long-Term Outlook: BMO remains cautious about the outlook for aluminum and met coal, while copper is still a preferred metal.
• Policy Impact: While the government is moving toward reforms, the transition is gradual and unlikely to result in immediate changes to commodity prices.

Summary Highlights

• China's Economic Slowdown: Expected to continue, with no significant rebound anticipated.
• Commodity Demand: Slowing globally, with China accounting for 40–60% of metals consumption.
• Supply Challenges: Persistent overcapacity in steel, aluminum, and other sectors.
• Policy and Regulation: Central government is shifting focus to financial and environmental reforms, affecting commodity price dynamics.
• Copper Market: Key focus, with potential credit bubble risks and supply constraints.
• Iron Ore and Met Coal: Both face supply and demand challenges, with met coal outlook more negative.
• Price Volatility: Expected to continue due to low inventories and high production levels.

Additional Notes

• BMO Research has not changed commodity price forecasts based on the trip.
• Further details on commodity fundamentals can be found in "Commodity Canvas: Q3/13".