CHINA AND COMMODITIES : CHICKEN OR THE EGG ? / SEEKING ALPHA ( RECOMMENDED READING )

China and Commodities: Chicken or the Egg?

by: Hard Assets Investor

August 14, 2009

By Daniel Harrison

It's hard to find two asset classes that have risen more this year than commodities and Chinese equities. The Shanghai Composite Index, which tracks China's leading exchange, has risen 65%, while the prices of raw materials used to build the infrastructure of the world's fastest-growing economy have followed suit. Iron ore and crude oil have more than doubled, to around $110 a ton and $70 a barrel, respectively, while steel prices are up over 30%. Copper, aluminum and zinc have all fared similarly.

Returns have been especially big for companies taking advantage both of commodity production and Chinese consumption. CNOOC, China's largest oil producer, is up 45%, while Wuhan Iron and Steel has leaped 109%. China Coal Energy has surged a whopping 111%.

But in the past week, prices in Chinese shares have eased by around 10%, and many commentators have begun predicting a correction in local markets. That raises a big macroeconomic question: If A-shares fall further, what will happen to commodity prices?

Strong China, Strong Commodities

While some argue that the recovering global economy offers enough demand to offset any temporary weakness in mainland China, many are still betting big on cheaper energy and metal prices.

Jackson Wong, vice president of Investment Management at Tanrich Securities in Hong Kong, told Hard Assets Investor that a further 15% correction in Chinese mainland equity prices could occur within the next quarter. That, he says, will spill over to commodity prices.

"I do think that a correction in Chinese markets will trigger a pullback in commodities," he said. "When A-shares are moving up, people are thinking that the Chinese economy is growing faster, as it consumes more oil, copper or other industrial raw materials. There is definitely a strong relationship."

Wong adds that in the third quarter, oil could bottom out at $55 a barrel, but after that, China will enter a third bull market phase that should push prices higher again. His is a popular theory right now in Hong Kong: Chinese equities may be currently overvalued, but they'll only ease back for a little while before resuming their upward charge.

Yoji Takeda, who manages $1 billion of Asian equities for RBC Investment Management in Hong Kong, told Hard Assets Investor that he expects a very temporary weakness in both A-share and commodity prices in general. Although a high correlation exists between the two markets, he explains, so far there has been little overspill in the selling of mainland equities and metal prices. Therefore, market gains don't matter as much as China's economic growth, which is due to come in at 7.7% this year.

"The A-share market is already down 10% in the last few days, but base metal prices haven't moved at all," said Takeda. "So long as the Chinese economy is strong, commodity prices will stay strong."

For the moment, however, China's white-hot economy and pent-up demand for commodities shows little sign of cooling. In July, crude steel production in China jumped 13%, rising to 50.7 million metric tons, and although iron ore output fell 7.7% on the month, imports rose to a new record of 58 million tons. On Wednesday, the International Energy Agency said it expects Chinese oil demand to rise 2.8% this year to 8.1 million barrels a day-only to rise again in 2010 to 8.4 million barrels.

Deliberate Deleveraging

Still, looking forward, some uncertainty persists, and gaps have begun to appear in the perennial growth story. Circulating on the mainland are rumors of private stockpiling of oil by gas stations and small-business owners. The reason for the hoarding, according to the IEA, is speculation that Beijing could lift the price caps imposed during harder times at the start of the year.

If price caps are lifted - or even eased - that would be bad news for downstream refiners, such as Sinopec Shanghai Petrochemical, which has risen 85% in value so far this year. On the other hand, PetroChina and CNOOC, up less than half that year-to-date, could still benefit.

The Chinese government is also committed to dramatically reducing interbank lending in the second quarter. China Construction Bank, the country's second-largest lender by market value, maintains that it will cut back loans by up to 70% in the rest of this year. A round of deliberate de-leveraging in the Chinese economy is significant, because for many market watchers, loose domestic monetary policy is exactly what kept the economy booming - and by association, commodities prices rallying.

Some evidence in the commodity markets suggests the de-leveraging might already be starting to take effect. In July, China's copper imports fell for the first time in six months, to 406,612 tons, representing a drop of 15% on the month. Perhaps not coincidentally, new lending by Chinese banks plunged 77% that month as well.

"The main driver here is the huge liquidity created by the huge new loans issued by commercial banks," Cheng Weiqing, director of trading at Beijing Citic Securities, told Hard Assets Investor. He points out that the average price-to-earnings ratio on the mainland right now is 29, and that "earnings estimations are very high compared to the rest of the world."

But even if there is a correction in the Chinese economy, and less liquidity to go around, supply constraints relative to China's "still-growing" status could keep some commodity prices rising nevertheless.

On Wednesday, China's largest electricity provider, Huaneng Power, admitted as much in a statement along with the announcement of its second-quarter earnings. Although the company beat expectations by a surprise profit of 5.8% last quarter, Huaneng also cautioned that "for the second half of 2009, there are still risks of a tight coal supply. ... Coal supply and the price of coal could present new problems and challenges."

How to Play China Now

Should a squeeze in the coal supply emerge, one way for investors to benefit would be to buy the recently launched Market Vectors Coal ETF (NYSE Arca: KOL). That position could act as a hedge alongside an equal position in the Market Vectors Steel ETF (NYSE Arca: SLX), while positioning investors for another sharp upward surge in Chinese growth and sudden loosening of monetary policy.

Perhaps surprisingly, precious metals garner the least attention from Chinese investors these days, as many market participants say the assets are only loosely correlated with the economy's growth. That implies the Market Vectors Gold Miners ETF (NYSE Arca: GDX) and the SPDR Gold Trust (NYSE Arca: GLD) may be better shielded from potential downturns in the Chinese economy than other metals ETFs. It also helps explain why large Chinese gold miners, such as Zhaojin Mining, have in recent months under-performed both Hong Kong's Hang Seng Index and the Shanghai Composite Index - as well as their hard asset mining peers.

"China is not the big concept country when it comes to gold," said Citic's Cheng. "Other factors have more influence in the gold price, such as the U.S. currency. I don't think Chinese consumption is related very closely to the gold price at all."