September 19, 2012Commoditiesby Michael Pettis

Could a Commodity Market Crash be Imminent?: Michael Pettis
Could a Commodity Market Crash be Imminent?: Michael Pettis

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The first article came on Tuesday from Bloomberg:

Cotton consumption in China, the world’s largest user, may shrink 11 percent this year as a deteriorating economy hurts demand and causes a buildup in commodities, according to Weiqiao Textile Co.

…Coal inventories at Qinhuangdao port rose to 9.33 million tons on June 17, the highest since 2008, data from the China Coal Transport and Distribution Association showed. Stockpiles were at 6.69 million tons as of Aug. 19. While steel-product stockpiles at the nation’s 26 major markets have dropped for five months as the end of July, they’re still 19 percent higher this year, according to the China Iron & Steel Association.

Commodity-related companies have flagged their concern. Noble Group Ltd. (NOBL), Asia’s biggest listed commodity supplier, expects a tough environment for the next 12 to 24 months, Chief Executive Officer Yusuf Alireza said yesterday. Vale SA (VALE5), the world’s largest iron-ore producer, said this month that China’s so-called golden years are gone as economic growth slows.

The article in Tuesday’s Financial Times talks about excess inventory of a wide variety of products and refers to an earlier article, from July, that claims that China’s coal inventory is up 50 percent from last year:

Memories of the London Olympics are already beginning to fade. Li Ning, a Chinese sportswear maker, had better hope that they last a while longer. Like thousands of Chinese companies from property developers to car manufacturers, Li Ning is sitting on a mountain of unsold products. Whether they can whittle down these bulging inventories is the single most important question facing corporate China and arguably the economy as a whole.

…The problems of Li Ning and the sportswear industry are just the tip of the iceberg in China. Across virtually all corporate sectors, inventories are excessive. The stock of unsold homes is the most worrying, because property plays such a dominant role in the economy. Vanke, the country’s biggest developer, estimates that it would take about 10 months to absorb all the unsold homes in China, which is reasonably quick. The snag is that this figure doesn’t count the millions of homes that have been sold but are sitting empty.

Then there is the auto sector. Car sales have been remarkably resilient despite the economic slowdown. But manufacturers have been more bullish than consumers. The inventory index (inventories divided by sales) was 1.98 at the end of June, according to industry data. More than 1.5 is seen as critically high.

The unsold mountains of electronics and white goods are also looking Himalayan in scale. Over the past week, the country’s main retailers descended into a price war. It began when online retailer vowed that it would sell home appliances at a zero profit margin. 

The commodities sector is also dealing with a huge inventory overhang, most graphically in the piles of coal that have built up at ports across the country.

In an article one day later from the South China Morning Post, the concern is about copper:

At first glance, China’s copper demand is soaring. According to Ross Strachan, commodities analyst at independent research house Capital Economics, if you add domestic production of refined copper to China’s imports and changes to official stockpiles, then it appears that copper consumption leapt 22 per cent in the first seven months of 2012 compared with the same period last year.

But if you look at the volume of copper products actually turned out by China’s factories – pipes for air conditioners, windings for electrical transformers, foil for circuit boards and the like – then output was flat in July compared with a year earlier (see the second chart).  Weak output makes sense. Together, manufacturing industries, home appliances and the construction sector accounted for half of China’s copper consumption last year.

With economic growth now slowing and property investment weak, demand is bound to be soft. Analysts at Credit Suisse expect China’s copper usage to grow by just 2 per cent this year and 1 per cent in 2013, in contrast to the 26 per cent growth seen at the height of China’s stimulus effort in 2009.

This gaping discrepancy between apparent demand and actual consumption implies there has been a massive build-up in unreported stocks of refined copper held in bonded warehouses and elsewhere.

Strachan at Capital economics believes these stockpiles have climbed by 900,000 tonnes since the middle of last year. Standard Chartered puts the total amount held in bonded warehouses at 600,000 tonnes, together with another 400,000 held elsewhere.

To put these figures into perspective, the LME’s worldwide network of warehouses reports copper stocks of just 231,000 tonnes.  In other words, China is sitting on a huge overhang of refined copper.

This partly reflects state corporations’ efforts to build strategic reserves of the metal. But it is also the result of massive speculation in copper. The details of the trade are complex. But in a nutshell, companies buy copper on margin, then use the metal as collateral to obtain low-cost loans, using the proceeds to bet on higher-yielding assets.

Not just the raw stuff

And just one day later I saw this article in Bloomberg:

Rubber is poised to drop as sustained supplies from Southeast Asia and falling demand from China’s tiremakers push stockpiles to match their record at Qingdao port, the main shipment hub, an industry executive said. Futures fell for the first time in four days.

Inventories in the bonded zone, where traders store deliveries before paying duties, will probably climb to 250,000 metric tons by end-August from 240,000 tons last week, Li Xiangou, chairman at the Qingdao International Rubber Exchange Market, said in an Aug. 17 interview. China accounts for 33 percent of global demand and tires represent 70 percent of natural-rubber consumption in the country. Reserves last reached 250,000 tons in mid-January, he said.

The article goes on to quote one Chinese rubber trader as saying “Many Chinese tire makers are mired in high inventories of end-products right now.”

I can easily cite many more articles, but as this short roundup suggests, finding articles about huge stockpiles in China is a pretty easy game to play. This shouldn’t come as a surprise and indeed I have been discussing this for the past three or four years. When financing costs are low or even negative in any economy, there is a tendency to accumulate inventory since it is not only easy to finance but, thanks to low or negative financing costs, it can also be extremely profitable. If prices just keep up with inflation, inventory earns a profit, and the greater the pile, the greater the profit.

In addition in the past decade as China’s trade relationship with the rest of the world has expanded and as China’s economy has grown, most Chinese businesses have only experienced rising prices – both for commodities and many kinds of goods. As a result firms that tended to hold high inventory have outperformed firms that haven’t.

This has created a selection process that favors accumulation. Companies that prefer to hold more, rather than less, inventory of commodities and goods in which commodities are a high cost component have outperformed their rivals, and so the whole market has moved towards a preference for stockpiling, much in the same way that, according to Hyman Minsky, periods of stable or rising asset prices force the financial system into taking on excessive risk. Since overstocking has always been a winning strategy until very recently, it is a pretty safe bet to assume that Chinese traders, speculators, end-users and investors have a built-in prejudice towards being long or longer inventory.

The overstocking problem in part has also had to do with financing constraints. In late 2010 and early 2011 in this newsletter I wrote often about commodity inventory financing as a popular tactic among Chinese businesses and banks aimed at getting around regulatory constraints on lending.

By importing commodities that were funded through trade financing and then using inventory receipts to borrow domestically, banks and borrowers could get around lending restrictions. We have never been able to figure out exactly how much of this was going on, but there was plenty of anecdotal evidence to suggest that this was a pretty wide-spread scheme and it involved a variety of commodities – copper, most famously, but also soy, magnesium, cotton, rubber and several others.

Finally, I should add that in China there is, more than in any other country I know, a sense that physical ownership of commodities or of commodity producing facilities creates substantial intangible benefits. This may be a legacy of Maoist perceptions of self-sufficiency, or it may have to do with a history of unstable political and monetary arrangements, but whatever the reason Chinese are often obsessed with the need for physical control of commodities.

The result has been a tendency to hold much larger commodity inventories than can be justified by business needs and risk management concerns. By the way, when economists try to calculate the amount of unsold inventory of commodities they typically focus on the raw commodity, but it is important to remember that inventories of finished goods are also forms of raw inventory.

An empty apartment, for example, contains lots of copper wiring, and although it is extremely unlikely that the copper will ever be melted down and sold, it nonetheless has the same price effect as unsold copper inventory. Why? Because an empty apartment today is one less apartment that will be built tomorrow to fill real demand, and so it represents a reduction in the future amount of copper that will be purchased to make copper wire. The same is true of other finished goods.

Click to continue reading… What about demand?

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