Material Matters: China, Base Metals, Gold, Iron Ore and Coal

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 – Slowing China to cap upside for industrial metals
 – Australian iron ore exports strong
 – Gold price and ETF holdings disconnect
 – Conditions becoming more conducive in tin and nickel?
 – Thermal coal's fundamentals improving

By Chris Shaw

Given China's importance for global commodity prices Standard Bank has looked at upcoming data for that economy and noted real economic indicators point to slower growth.

As the bank notes, freight volumes in China for June showed a significant drop in both month-on-month and year-on-year terms. Declining volumes are bearish for industrial commodities as it signals weak underlying real demand.

As well, Standard Bank notes in many cases the underlying economic weakness or strength indicated by freight volumes typically impacts on commodity prices for more than a month. This suggests the June data offers a good indicator for commodity demand and prices into August.

The latest data is consistent with Standard Bank's view the upside for industrial commodities remains capped.

One market where data is improving is Australian iron ore exports, as Commonwealth Bank notes for June exports grew by 14.4% in year-on-year terms and by 0.9% in month-on-month terms. The 41.6 million tonnes exported for the month was the second highest level ever recorded.

The strong Australian export volumes into an already slowing seaborne market is likely to have the dual effect of reducing iron ore prices and pricing out more expensive Chinese mine supply. Assuming expansion plans of Australian producers such as Fortescue ((FMG)) and BHP Billiton ((BHP)) go ahead, Australia's iron ore export volumes will continue to rise. CBA expects this will weigh on prices, especially if Chinese demand remains muted. 

Turning to gold, CBA notes since August of 2008 the volume of gold held in Exchange Traded Funds or ETFs has been highly correlated with the gold price. This correlation has broken down since February of this year, as over that time the gold price has fallen by more than 7% against a marginal increase in gold ETF holdings.

While this disconnect increases downside risks to the gold price if large scale liquidation of gold ETF holdings occur, CBA suggests the potential for central bank stimulus measures could prove enough to keep gold prices firm. 

It has taken six months of consecutively weaker prices but Indonesian tin producers have finally reacted, Standard Bank noting around half of the 28 smelters in the Banka-Belitung province have shut. As well, PT Timah has announced it will curb spot sales of the metal and stockpile any material not already committed to term contracts.

In Standard Bank's view the reaction in Indonesia is not surprising, as tin producers in the country have tended to react to a weak pricing environment more quickly than producers of other industrial metals.

Looking forward, Standard Bank's view is the market may be approaching a more sustained rally in both premia and prices. LME inventories of tin are at their lowest level for this time of the year since 2008, having seen drawdowns rather than the traditional seasonal increases.

This leaves the market likely to head into the final quarter of 2012 with less exchange inventory than normal, which could act as a boost for prices. For Standard Bank, the next couple of months will be the key for LME inventory trends and implications for tin prices. 

As with tin, nickel prices have also weakened in recent months as ample supply and ongoing macroeconomic concerns have impacted on the market. The news is not all bad in Macquarie's view, as from a cost perspective there are some positives for the metal.

As Macquarie notes, at current prices more than 30% of the supply curve is losing money, whereas other commodities continue to trade at or above the 90% percentile of the cost curve.

Nickel generally has bigger price volatility than other LME commodities given a relatively small market size and sharper changes in supply and demand balances from the impact of the stainless steel cycle and nickel pig iron production.

Big swings in Chinese supply and demand play a major role, as Macquarie notes China accounts for around 45% of global nickel demand and around 25% of global supply. The falls in nickel prices in recent months have, since June, seen big cuts in Chinese nickel pig iron production. Macquarie estimates more than 50% of Chinese production has been switched off since the peak levels of the March quarter this year.

On the demand side, Macquarie suggests nickel should see some improvement in the second half of 2012 thanks to new stainless steel capacity additions and an improving economic cycle. When added to an easing in the market surplus thanks to the supply cuts experienced in China, Macquarie is now more positive on nickel's outlook in coming months. 

Turning to coal, Macquarie suggests fundamentals in the thermal coal market are also improving as prices appear to have found a more stable level. This has been achieved via supply-side adjustments, mainly in China, and through domestic shipment cuts.

This means thermal coal inventories are starting to decline from recent highs, though Macquarie cautions prices need to maintain current levels for a couple of months to keep new supply offline. This would allow stocks to return to more normal levels.

Assuming stocks to return to more normal levels, Macquarie expects some incremental supply would be incentivised back into the market. This should support Chinese domestic prices, so underpinning the international price floor.

What should also support is prices is reports of some Indonesian output being taken off-line, while Macquarie suggests at current Asian price levels even some US, Russian and Australian material will be out of the money. 

There is little evidence to date of any Australian volumes being taken out of the market, something Macquarie suggests is not a great surprise given the amount of material being solid at the current US$115.25 per tonne contract level.

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