China takes metal reins

Say goodbye to metal price extremes ... China is in control.

Summary: China has effectively taken control of key segments of the metal supply chain, with its high percentage of global consumption enabling it to smooth out price movements by matching its demand with supply. Furthermore, with Hong Kong taking ownership of the London Metals Exchange, China is rewriting the rules around the warehousing of metals.
Key take-out: The huge influence of China on the metals market could make it difficult for mining companies to raise exploration and development funds as the potential for windfall profits will be eliminated.
Key beneficiaries: General investors. Category: Commodities.

Investors hoping for a return of the China-driven mining boom sometime in the next few years will be disappointed, because China’s role in the minerals world has changed from customer to market controller.

The difference is profound and reflects the success of efforts by the Chinese Government to eliminate extreme raw material price movements, either up or down.

What China wants is a supply chain that delivers a consistent flow of minerals and metals at consistent prices, which benefit its manufacturing sector.

The switch from “demand creator to market controller” has been identified by analysts at the French bank, Natixis, and forms the basis of its latest Metals Review. The heading on that report tells the story: “It’s nice to be in control”.

What the Natixis team has examined is the rise of Chinese demand for a number of metals, to the point where the country accounts for around 40% of global consumption.

China takes control

It is that high level of consumption, comprising imported materials and minerals produced inside China, which is enabling China to start dictating prices.

During a period of heavy buying in the six-years up to 2011 China was the key price driver, and the major cause of price spikes and price slumps in metals such as copper, nickel and zinc.

“China’s influence on base (industrial) metal prices was heavily pro-cyclical, exacerbating rallies and compounding slumps between 2005 and 2011,” Natixis said.

“Throughout this period Chinese authorities looked forward to a time when their country’s influence on base metal prices might become more of a moderating factor than a destabilising factor.

“Since 2011, this desire has gradually turned into reality.”

In other words, China has reached a point where it is able to match its demand for metals with supply, effectively smoothing out prices.

If the Natixis theory is correct, it represents a double-edged sword for Australian mining companies and investors.

On the one hand the extreme price peaks in some commodities, such as rare earths and nickel, could become a memory, making it difficult for mining companies to raise exploration and development funds because the potential for windfall profits has been eliminated.

On the other hand, an assured price structure will eliminate the high levels of risk associated with mining.

From mining to manufacturing

It might be stretching the point, but a future where a single country is able to exert control over demand and supply could reduce mining to a form of manufacturing.

Cash flows could be more assured, and success would go to the miner with the best management and lowest costs rather than the company which makes a lucky strike, or is able to ride a price spike despite incompetent management.

The way China will achieve its price-smoothing objective is by regulating production in its own mines, and turning them on and off as required – a step that only a command-economy with an all-powerful central government can do.

“Across a number of the base metals, Chinese spare capacity is now sufficient to help regulate extremes in supply and demand,” Natixis said.

“In zinc, in particular, responses by Chinese producers to price signals are clearly helping to equalise supply and demand.

“In lead, accumulation of stocks at Shanghai Futures Exchange warehouses helped reduce the effect that a potential deficit might have upon market prices.

“In copper, destocking and restocking by the Chinese copper industry has clearly helped to moderate price swings over the past two years.

“In aluminium, however, Chinese excess capacity remains more of a curse than a blessing and authorities must gain control of this surplus before it does significant damage to the global industry.”

The Natixis theory of China exerting its influence as a buyer of imported metals and producer of its own supplies to dictate prices extends a step further, with China now able to influence how the world’s premier metal trading bourse, the London Metal Exchange, sets its rules.

Last year, Hong Kong Exchange & Clearing (now trading as HKEx) bought the LME from London institutions and investors.

“This ownership (of the LME) should help facilitate China’s new moderating influence over base metal prices,” Natixis said.

“HKEx is clearly keen to expand within mainland China, and to this end it has offered to sacrifice warehousing rules in order to obtain permission to open warehouses in Chinese free-trade zones.”

New warehouse rules

The warehouse rules of the LME have been a contentious issue between investment banks and metal consumers.

Banks, such as Goldman Sachs and J.P. Morgan, had acquired LME-licensed metal storage warehouses in order to stockpile metal as part of an arbitrage play, which works well during a period of low official interest rates.

Rather than put cash on deposit for an effective zero return (or worse), clients of the banks would buy copper, zinc, aluminium, or some other metal and stockpile it in a bank-owned warehouse in the expectation that the price of the metal would rise in the future.

The banks, as owners of LME-licensed warehouses, generated storage fees. But the deals also meant that metal was effectively being withheld from the market and it could take up to a year for orders from metal consumers, such as carmakers, to be delivered.

HKEx, as the new owner of the LME, is changing the warehouse rules so they better suit metal consumers – and given China’s appetite for 40% of the world’s base metals, that means new rules that suit China.

Moderate price moves

It is not certain that the Natixis theory of China morphing from its role as the primary creator of metal demand into a global moderating influence on the metal market is valid and will only be proved (or disproved) by future prices trends.

However, it is interesting to look at some base-metal price graphs to see how extreme highs and extreme lows have been smoothed out in recent years.

Zinc, for example, has rarely gone below US80c a pound in the past three years, and rarely gone above $US1/lb. Copper over the past six months has been trading between the tramlines of $US3.05/lb and $US3.40/lb, and lead has rarely moved below US80c/lb or above $US1/lb for the past two years.

If the Natixis theory holds water, moderate prices are the future because they suit China, though perhaps not mining companies.