New Age of Commodities after China?

It is well known that China has had a great influence on global economy last decade, as one of the main emerging countries, leading industrial growth while the world succumbed into 2008 crisis. The impact of a sharp slowdown in Asian Giant all over the world is well understood since its GDP represents 16% of global wealth. The Chinese Central Bank has tried to stop this scenario, encouraging investment in the country, cutting interest rates but also trying to curb speculative bubble created by 90 million small investors who got leveraged in a continuous uptrend market.

Chinese GDP evolution (Source: World Bank)

Since early this year, expectations of increased growth, fuelled by the highly interventionist Chinese government, reached values beyond what was justified by economy fundamentals. Finally, bubble burst last July, when the first news of a sharper than expected economic slowdown were published. New reports from National Bureau of Statistics of China (NBS) showed GDP growth in the range of 7%. Doubts about the continuity of Central Bank support to investments increased among the highly leveraged investors.

The Chinese stock market breakdown in July shook global markets, jeopardising the ability of Chinese economy to resume its growth of previous years. The government undertook several initiatives in order to halt the economy fall, including successive devaluations of its currency, the yuan.

The slowdown in Chinese economy is leading to a drop in demand expectations of main commodities. China is the main buyer of raw materials, especially metals, but also cereals and fossil fuels such as oil and coal.

Standard & Poor’s Goldman Sachs Commodities Index, which measures changes in agricultural products, metals and energy prices that are traded on US futures, has suffered its biggest drop in the last 5 years, as you can see in the following chart:

Source: Bloomberg Business Markets

The combination of a global surplus in raw materials production and the expectations of a slowdown in Chinese demand is weakening prices, dragging them to their lows of last 6 years. In addition, the devaluation of yuan has also dealt a serious blow to imports of main raw materials, since most are valued in dollars, so a weaker yuan will increase the cost of imports for buyers in China.

Regarding the energy sector impact:

• Oil: The slowdown in Chinese economy has been one of the trigger factors of drop in oil prices since July, as China remains the world’s second largest crude consumer after the United States. Although the country has increased its refining capacity in recent years and demand forecasts published by IEA (International Energy Agency) predict an increase of 4.1% for 2016, expectations of a contraction in the economy have encouraged further fall in prices.

In Magnus we have followed how continuous news about Chinese demand have raised volatility in the market, causing daily movements of ± 5% to 10%, beyond what was required by market drivers.

Recently we read news that China would create its own oil derivative contracts, with the aim that yuan will become the main trade pattern in global commodities markets. If so, it could represent the third global benchmark in oil prices after Brent and WTI.

• Coal: Coal demand in China in 2014 fell by 2.3%, while consumption continued to represent 31.3% of global total. Coal prices, which are in their lows of the last 12 years, are not encouraging consumption because China is changing its environmental policy and its production model, from industrial to service sector.

China launched in November 2014 a plan to combat pollution, with a main measure of reducing coal-fired plants share in its energy mix (now it represents 70%) in support of other technologies such as natural gas, nuclear, wind, solar and hydro power. Coal production fell 2.6% in August from the same month last year, after the government ordered the closure of several plants to reduce pollution as part of World War II end commemorative events.

The slowdown of Chinese economy does nothing but increase the gap between global supply and demand. This situation especially worsens main exporters focused on Asian market, such as Australia, whose mining companies are suffering to keep going.

• Gas: Exporting countries that currently supply natural gas to the country will suffer the greatest impact ofdemand drop. These include Turkmenistan, Qatar and Australia. Some OPEC members (Iran and Kuwait) have begun to apply discounts on gas supplies next year to ensure Asian market share.

Compared with other commodities, China represents only 5.4% of world consumption of natural gas, so its impact is relatively minor. On the other hand, the decrease in coal consumption towards natural gas is keeping input levels.

China growth expectations will drive the evolution of many commodities, leading to new levels of market equilibrium prices. The impact on coal and oil, and indirectly on gas and electricity market, will be smaller in comparison.

In Europe, as net importers of raw materials, this scenario is beneficial to us. Regarding to energy, Europe will suffer the greatest impact by the influence in oil prices. While we depend on long-term contracts indexed to oil with producer countries (in Spain it represents approximately 50% of gas consumed), it will directly affect gas prices and, indirectly, electricity ones.

However, the slowdown of Chinese economy may end up dragging a recession of global growth at a time when much of the developed countries are trying to get out of its crisis. China must re-gain investors trust with a more balanced and robust growth. Henceforth we need to be aware of new Chinese government actions, but also to other policies such as the delayed possible US interest rates hike, whose consequences could pose an even greater challenge.

Susana Gómez | Energy Consultant