China Inc upsets supply-demand balance

11/06/2009 - 00:00

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ENTITIES controlled by the Chinese government are now taking major stakes in primary industries on a global scale that makes Enron's involvement in the US power industry look like child's play.

ENTITIES controlled by the Chinese government are now taking major stakes in primary industries on a global scale that makes Enron's involvement in the US power industry look like child's play.

This is a troubling new development in a world where China consumes between 25 and 30 per cent of virtually everything and has recently accounted for about 50 per cent of globally traded iron ore and copper.

Conventionally, the copper market involves companies, operating for the benefit of their shareholders, competing with one another in areas such as copper mining, smelting, metal trading, copper fabrication and final product manufacture. In modern China, alongside wholly state-owned enterprises, we have independent companies, listed on stock markets with shareholders outside of the central government, but the large players and even those corporatised groups involved are still controlled by central government edict.

In the 1990s, Enron famously controlled natural gas fields and coalmines, power generation capacity as well as the electricity delivery system and it made markets in the final product. The company was in a position to influence prices at every point along the way, and in defiance of the law, it did so.

Enron's commodity traders would buy call options against future power costs or sell puts at a high power price for the following day and then the company would shut down one of its generators so that the power price skyrocketed and its traders could make a killing, while customers were literally left in the dark.

Enron was able to make more money by not producing electricity than it did by delivering power to customers.

China Inc is now a global player in the world of copper mining. It has upstream influence in Asia, Africa and Australia, with operations in Zambia, Laos and Thailand, Afghanistan and Tibet, to name just a few. In addition, the Chinese central government has recently been buying large tonnages of copper metal.

While London Metals Exchange stockpiles fell from 530,000 tonnes to 312,000t during the past couple of months, the Chinese have been buying the metal. The copper price has responded, moving from $US1.35/lb to more than $US2.25/lb, despite the fact that industrial production throughout developed nations is contracting and inventories of finished goods continue to be run down.

On the supply side, while there has been some contraction of copper production where it is associated with other base metals, at a price of more than $US1.50/lb, most of the world's copper miners enjoy strong operating cash-flow surpluses, so there has been little motive to cut back production.

So where is all the copper going if it is not being consumed? The answer seems to be that the Chinese government has made a decision to stockpile copper at prices 35 to 50 per cent below the highs of 2007, as a way of ensuring that its industries will be well stocked when demand picks up, and also as a way of diversifying the exposure of its financial reserves to US dollar denominated bonds.

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The issue is that China Inc, as a major consumer and producer, is now in a position to influence the copper market in a way that has little to do with the fundamentals of supply and demand.

This influence goes well beyond the ability of individual mining corporations to control the market. Even large integrated copper players such as BHP Billiton and Rio Tinto cannot dominate the copper market.

Unlike the large copper miners, China is both a large consumer of copper and well as a major upstream player in the industry.

A high copper price might suit the Chinese government as it strives to achieve financial returns from its investments in global copper production assets, during a period of weak demand. Stockpiling metal at prices half those seen during 2006-07 can hold up the copper price to ensure that its mines are profitable while the government builds diversity into its financial reserves. When it stops stockpiling the metal, the price could plummet back below $US1.50/lb.

In a similar way, at some point a lower copper price might suit the interests of the Chinese government. This point might be if the government was to enter negotiations to buy a major stake in a large copper miner. A weaker copper price during the negotiations would reduce the value of the assets under consideration. While we must assume that China would not act in an anti-competitive way, or in a way that was designed to distort the market, the fact is that as a major player on all sides of the industry, it is in a position to do so.

This is why Australia's regulator is taking such a close look at the activities of Chinese companies in Australia's resource industry. The critical test for foreign investment is if a foreign owner would damage the long-term national interests of Australia.

I remember similar alarm during the 1970s and 1980s, as Japanese interests seemed to be buying everything in sight. Yet the Japanese were not acting as a group and the buyers did not control both sides of the market. Much of the Japanese investment during the 1980s ended up in Australian property, where the Japanese ultimately ended up losing as much as 80 per cent of their investments, when both the Australian dollar and property prices fell in a perfect storm for yen investors.

Australia's primary industry needs outside capital to develop domestic projects and it needs strong relationships with customers who can underpin projects with off-take agreements. There is, however, danger in giving up sovereignty over critical assets and entering into deals where profits can be transferred away from local entities by owners who control the value adding end-game and may, through sheer size, control the ultimate price of commodities.

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Another commodity that has been on the rise is oil. Despite high inventories of oil, even after severe production curtailment by Opec nations, the price of oil has doubled this year. Political and social affairs in Saudi Arabia, which is the world's largest swing producer of oil, continue to take alarming turns for the worse. A recent declaration of independence for a so called Republic of Eastern Arabia by a group representing Saudi Arabia's marginalised Shi'ite minority community shows just how frustrated this group, which numbers about 3.5 million, is becoming.

Shi'ites make up about 10 to 15 per cent of Saudi Arabia's total population of 25 million, but they are under-represented in positions of power and influence in that country, while their Sunni cousins continue as the favoured group in the kingdom for plumb jobs and prized university positions. Ageing Saudi leaders will be watching to see how far Iran's Shi'ite-led new leadership will move in support of the broader Arabian Shi'ite community. Iran is clearly seeking to expand its influence in the region, but will most likely play a low-key hand.

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Never mind spiralling capital costs for oilfield development and ever-present project delays, production of oil around the world has becoming ever more risky and more open to threats from social and political unrest. Venezuela's oil industry is being run into the ground, while sectarian strife continues to dog development of Nigeria's oil and gas projects.

The past 12 months of weak oil prices and chaotic capital markets has probably cost the world's oil industry about 2 million barrels per day of oil production development while a further 4 million barrels per day of project developments have been delayed. This loss is being masked by a massive fall in global oil consumption and by Opec's production cutbacks. Demand for oil will begin to recover through 2010, cutting inventories.

Non-Opec producers, who have been missing in action for the past 12 months, are unlikely to gear up for more drilling and project development until the oil price looks to be securely over $US80 to $US100 per barrel and Opec will quickly find that its swing production will drastically decline as it opens the tap to deliver more crude.

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n Peter Strachan is the author of subscription-based analyst brief StockAnalysis. Further information can be found at Stockanalysis.com.au.

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