China accounts for about 40% of global commodity demand, rising to almost 60% in the case of iron ore. In 2010/11, China will account for about 50% of global GDP growth, against 20-25%% for most of the last decade. A sharp slowdown in China’s construction boom in H2 looks inevitable as further policy measures finally reverse soaring property inflation, which is threatening to generate destabilizing social tensions and with investment property accounting for up to 20% of all construction activity, the feed through to commodity demand will be substantial. China's GDP growth looks set to slow down from 11.9% in Q1 to maybe 8% annualized by Q4.
The long-term bull story for commodities is well known; rising per-capita consumption in rapidly urbanizing emerging markets collides with a relatively inelastic supply response to surging prices, as decades of resource sector underinvestment have created bottlenecks throughout the supply chain. Exacerbating this scenario is the rising marginal cost of incremental supply for many key commodities from oil to copper. That’s the secular trend, but the cyclical one will oscillate it around it, driven by the near-term economic outlook (particularly in China), industry supply disruptions and the ebb and flow of speculative interest.
Chinese demand is most significant in base metals. In 2010 about 80% of new demand for lead, 50% of incremental demand for aluminum and zinc and 35% of additional oil demand will come from China, giving any negative policy shock a geared impact on prices despite a modest rebound in OECD demand. It’s striking how strong in volume and price terms commodities have become in China's trade. For instance, five key commodities including copper, oil and iron ore accounted for about US$25 billion or about 20% of China's March import tally. Oil and oil products alone accounted for over US$14 billion. That commodity share at about 20% has been pretty constant in recent months. Crude oil import volumes have climbed 39% y/y in Q1 2010 reflecting still high refinery runs in China and filling of the petroleum reserve, now completed until an expansion scheme comes on stream in late 2011.
On the metals side, the greatest increases were in copper and aluminum scrap whose volumes rose 34% and 100% y/y in Q1. Commodity orders tend to be stronger in March/April as infrastructure projects start up and stock piling begins. In fact, the volume of China's commodity imports has been falling since mid-2009 as prices rise and domestic credit conditions peaked. Metal import volumes in aggregate have slowed from the mid-2009 pace. Chinese public infrastructure projects, consumer electronics subsidies and rebounding auto sales will once again lead global demand for copper, but the inability to crack down on overcapacity in several heavy industries, especially aluminum, will add to the global supply glut in several commodity markets.
Overall, industrial commodity markets had become a very complacent and crowded trade as a ‘reflation trade’ in Q1, highly correlated with other risk assets, in an echo of early 2008, and the current correction is both overdue and healthy. The global macro picture remains robust for 2010, particularly in the US, despite the spike in financial market risks aversion and fears of euro zone sovereign debt contagion. Chinese growth peaked in Q1 and is likely to slow to about 8% annualized by Q4 as the property boom is finally reined in. The impact on commodity demand will be exacerbated by destocking from stockpiles accumulated in 2009 and capacity rationalization, particularly in excessive aluminum and steel production and exposure to the latter should be avoided (including by extension nickel). Fundamental ‘fair value’ for crude is around current marginal production costs at $70-75/barrel, and for copper at $2.70-3.00/lb. New CFTC restrictions on speculative positions in US futures markets are a downside risk, supply disruptions (including an active Gulf hurricane season) an upside one.
Palladium remains well supported by auto catalyst demand and tight supply, and should test $700/ounce in H2 and outperform platinum from here, although both are better underpinned by fundamentals than gold, while attracting speculative interest from a low base. Oil prices near the bottom of their likely range for 2010 at just sub $70, but US natural gas prices may be the real upside surprise in H2, particularly if depletion rates for shale fields prove higher than anticipated as drilling activity subsides. Uranium remains an interesting long-term story for a mid decade supply squeeze.
Grains may remain subdued in 2010 (with the possible exception of corn) on USDA projected oversupply, but agriculture remains the most interesting commodities story structurally and is probably now where the energy market was a decade ago in terms of complacency and bearish sentiment.
Rising per capita EM calorie and protein consumption threatens to eventually do for food markets what urbanization and motorization has done for the industrial metals and energy. Overall, despite the current correction in popular exchange traded commodities, input price inflation will continue to be a real issue for investors longer term, with minor commodities from rubber to cotton being squeezed to multi-year highs by a fundamentally tight global supply/demand balance, and the current correction to commodity markets should prove temporary for most.
