How Is China Driving Down Commodities?

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Includes: BCM, CMD-OLD, CMDT, COMT, CSCB, CSCR, DBC, DDP, DEE, DJCI, DJP-OLD, DPU, DYY, FTGC, GCC, GSC, GSG, GSP, LSC, PDBC, RJI, SBV, UCD, UCI, USCI
by: Jeevan Parameswaran

Summary

China's slowdown and chronic oversupply has weighed on commodities.

China is impacting commodities on both sides - supply and demand.

Plenty of room for more inventory destocking.

Silver lining if a boost in China's consumption can feed into commodities demand.

As a net importer, China benefits from cheaper oil despite the lack of consumption boost.

Commodities right now are certainly the place not to be. Commodity markets today are characterized by a triple whammy of overcapacity, overleverage and low profitability. Prices have reflected as much, tanking across the board in the last year, with much of the blame attributed to China's slowdown as well as the supply glut.

China has proven to be one of (if not the) most important driver of commodities today. As China soared in the early 2000s on the back of rapid industrialization, so did commodities. Construction projects began rolling out to modernize infrastructure and urbanize, which drove demand for metals such as copper and steel. So began the new phase of the commodity supercycle.

From a higher level perspective though, the main (perhaps only) thing that drives the commodities market is supply and demand. Industrial commodities (steel, copper etc) are especially heavily driven on both sides by developments in China. If China slows down, it demands less and down goes commodity prices through the demand channel. If China exports more than is demanded by the market, an oversupply is created and prices go down through the supply channel. Commodities are currently suffering from both the demand and supply sides as weaker Chinese demand and oversupply drive down prices.

Supply and demand balances of commodities are therefore very sensitive to changes in Chinese growth and investment prospects. A Chinese slowdown combined with a depreciating renminbi have been the main culprits driving down commodity demand. In other words, get China right, get (bulk) commodities right.

Supply and Demand

Commodity prices are impacted by two sides of the same coin, namely, supply and demand. From a demand perspective, the lion's share of global commodity demand and production comes from China. The graph below shows just how dependent global commodities are on Chinese demand with almost 50% of aluminum, steel, nickel and zinc consumption coming from China. China's energy consumption is also on a rapid rise, most recently reaching a 12% share of crude oil consumption. China is actually the largest net importer of crude oil and the world's second largest oil consumer. With per capita consumption more than three times less than the US, expect its energy demand to rise long term. On the supply side, China is also the largest producer of many industrial metals. China has a 40-50% share of aluminum, coking coal, iron ore and zinc production and 35% of copper production.

China is certainly not helping commodity prices on the supply side as well, with record shipments of steel, oil products and aluminum. China still has so much excess capacity that it has to export in droves to compensate. Essentially, it is exporting deflation to the rest of the world and creating a major oversupply problem. Nine groups, including Eurofer and the American Iron and Steel Institute have estimated 700 million tons of excess capacity globally, with China contributing 425 million. The enforcement of antidumping tariffs should play a role in keeping supply under control for now and protecting margins.

The problem with the global commodity oversupply situation is that production changes slowly (barring disruptions). Developing mines and factories take time and once they are built, companies just can't afford to turn them off on a whim. Therefore, the overcapacity in China is really a long term problem and will take time to address.

With China transitioning into an entirely different type of growth engine (consumption driven), the lack of demand also looks to be a secular shift and will act as a double whammy to commodities in addition to the supply glut. Add to that the pressure on the yuan to devalue further and we have an even bleaker commodities outlook. If one yuan buys less now than before, imports fall due to decreased Chinese purchasing power and exports go up since they are now cheaper.

Inventories

In addition to supply flooding the commodities market, inventories continue to remain high with plenty of room for destocking. How quickly Chinese inventory destocking can occur will likely depend on the government's fiscal easing and its effectiveness in stimulating demand at the consumer level which should feed through to producers.

Attempts at production cartels through strategic stockpiling has also become an option for many producers. Since producers have the option of taking advantage of the stockpiles to sell their stock, the incentive to cheat does not make this a viable long term trend.

The Chinese Slowdown

The full impact of China's slowdown on commodities might have yet to be felt as the transition progresses. Typically, a move from investment led to consumption led growth leads to a halving of the growth rate. Thus far, Chinese growth has only slowed to 6.5%, lower than the 7+% figures it used to post, but certainly not a disaster.

How much will growth slow? We'll see but the answer lies in how much of the overcapacity can be absorbed or exported. Typical "old economy" industries such as manufacturing and infrastructure should continue to slow as China has passed its peak in the growth rate of construction of infrastructure and new homes.

However, as Andy Rothman from Matthews Asia points out, "factory wages were up 5% to 6% last year, reflecting a fairly tight labor market, and more than 10 million new homes were sold." So while growth and manufacturing turn sluggish, the traditional statistics typically used to gauge an economies' health - employment, income, inflation and consumer spending - should prove to be silver linings. Whether the overall growth picture can return to its old might will depend on how effectively the "new economy" i.e. services and consumption can offset the slowdown in the "old economy". And there is certainly evidence that the Chinese consumption story is emerging.

While the graph above shows a clear deceleration in income and consumption growth in China, it also shows is income growth stabilizing at around 7% and consumption around 10%. Another thing to keep in mind is that China is now growing off a far larger base than it used to. Hence, one could well argue a deceleration is only natural.

Consumption should receive a major boost going forward should the commodities slump continue as lower commodity prices filter through to consumer prices and higher purchasing power. Manufacturers should also benefit from the lower input costs. A boost in consumption could then feed into higher commodities demand which could buck the commodities downtrend down the road.

Industrial Production

If industrial production (a proxy for commodities demand) is anything to go by, the commodities outlook looks bleak. The graph below shows that much of the upside from global industrial production is actually still being driven by China.

Despite the bleak IP outlook, fiscal easing by the Chinese government could cushion global IP weakness. A surge in bank loans and tax breaks on autos have certainly contributed to recent M/M IP growth. Further easing in real estate could also be one to look out for. Short term however, the Chinese New Year period is typically slow for industrials and this should prove the case again.

As China moves into environmental damage control mode as well, expect weaker industrial demand to further stress the commodity market going forward. Energy sources such as thermal coal as well, could bear the brunt of a clean energy push.

Chinese Market Volatility

Falling Chinese equities do actually have a major impact on commodities, particularly metals such as iron ore. With the Chinese stock market selloff likely to continue, this could have a negative spillover effect on commodity prices through sentiment changes as well as the wealth effect.

As commodity markets are now very much financialized with the widespread trading of financial contracts such as derivatives, this has introduced an additional factor (market sentiment) to think about in addition to fundamental supply and demand drivers.

The Production Boom

While Chinese deceleration has certainly contributed its fair share to lower commodity prices, let's not ignore the role of a commodities production boom in the recent commodities downturn. From a supply perspective, one could say that the downturn has been cyclical. The same investment that fueled the commodity supercycle is now unwinding as supply exceeds demand. Iron ore and aluminum production for instance, has benefited tremendously as production has become much cheaper. Same story with oil, where new methods of extraction have dramatically shifted cost curves in favor of producers.

The current price environment is really unsustainable and undesirable for many producers, such that their assets may cease to be viable concerns. Eventually, something's got to give.

Presumably, one would look to a supply response kicking in first, as producers begin to exit due to growth pressures and capital shortfalls.

What about lower oil prices?

In theory, lower oil prices should boost growth as costs decrease and consumption picks up. In practice however, things tend not to work like they do in the textbooks. What we have seen in the US for instance, is gas prices falling but consumption not really picking up to compensate for lower oil revenues.

In this case, the 1st order effect of lower oil prices (lower oil revenue) has prevailed over the 2nd order effect (in this case, consumption). The lack of a consumption boost reflects the fact that lower commodity and oil prices are a symptom rather than a cause of the weakening global demand.

Globally as well, we have not seen much benefit from lower oil prices as global growth remains sluggish. As the world's largest net importer, China should reap most of the benefits of cheaper oil. The lower import bill has boosted China's trade surplus to $594.5bn last year, providing some offset to yuan pressure from capital outflows. According to Kenneth Courtis, former Asia vice chairman at Goldman Sachs Group, China stands to save $460bn from lower commodity prices with $320bn from cheaper oil.

Another key point to consider with regard to oil is its role as a leading indicator for commodities as a whole. Oil is currently experiencing strong supply growth and building stocks, which has led to its recent decline. As inventories begin to draw down towards mid 2016, we could see a rebound in oil prices (barring geopolitics, supply disruptions etc).

In a nutshell, weaker Chinese demand along with a chronic oversupply has created the current deflationary supply glut for commodities. This structural shift does not look to be reversing anytime soon. Low commodity prices could theoretically, incentivize buying activity from the Chinese, especially considering the commodity intensive nature of policy responses (infrastructure etc). However, we have yet to see commodities reach this inflection point. And with continued deleveraging in industrials and real estate, we may not see much relief anytime soon.

Eventually, the commodities world might just have to learn to live without demand from China.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.