The news out of the middle kingdom remains impressive..

China Update from China Commodities Weekly

China Commodities Weekly for the Weeks of October 5-16, 2009

Macro – Post-Holiday Market and Data

September Macro Data Supportive

■ On the monetary side, growth of China’s broad M2 money supply accelerated to 29.3% YOY year-to-September, up from 28.5% year-to-August. Chinese banks extended RMB516.7 billion in new local currency loans in September, up from RMB410.4 billion in August, and higher than market expectations of RMB300 billion to RMB400 billion.

■ On the trade side, exports in September fell 15.2% YOY, beating economists’ consensus of 21%, while imports fell just 3.5% YOY, well short of expectations of a 15.3% decline. We note that the improvement in the external demand for Chinese goods is an encouraging development both for the Chinese economy and the world economy. In fact, in some major export hubs, some major industrial bases, and some big cities, a general labour shortage has manifested itself, which is, in our opinion, a result of stronger export order flows and still-strong general construction activities.

■ Separately, official data shows that China’s monthly car sales topped one million units for the first time ever last month. In September, China’s car sales surged 83.6% YOY to 1.02 million units. In the same period, China’s total vehicle sales grew 77.88% YOY to 1.33 million units (see Exhibit 1). Both car sales and total vehicle sales were at record highs in China and up about 17%-19% MOM.

September Commodities Imports Very Strong

■ In September, iron ore arrivals set a new monthly record of 64.6 million tonnes, up 30% MOM; and copper (unwrought and semis) imports jumped 23% MOM to 399,052 tonnes, reversing a two-month sequential drop. We note that before the data release, both iron ore and copper imports were expected to drop on a MOM basis, so the actual imports data were surprising on the high side and supportive for our bullish view on both commodities. We also note that in the first two weeks of October, Chinese spot purchase of iron ore remained active, as spot vessel bookings to China by Australian and Brazilian iron ore exporters are reported to be steadily strong.

■ Last month, crude imports rose 14% YOY to 17.2 million tonnes or 4.197 million barrels per day (bpd), but eased from peak rates in the previous few months, which have boosted domestic crude stocks to record highs. Back in August, Chinese crude imports were 4.36 million bpd, and in July Chinese crude imports set a record high of 4.64 million bpd. On the products side, we calculated that China’s net product imports fell 55% MOM and 35% YOY in September, as Sinopec and PetroChina shipped more refined fuels overseas to thin domestic inventories.

Post-Holiday Market Behaviour

■ After the October “Golden Week” holiday, an eight-day-long holiday from October 1 to October 8, the initial direction of Chinese local commodities markets is disappointing for the bulls. Steel prices continued to slip (Exhibit 2) and sentiment was hurt by the sluggish home sales in the Golden Week (see next section). Average rebar price and hot rolled sheet prices dropped 2%-3% versus the levels seen on September 28. Iron ore and coke prices were largely flat. On the base metals side, although the local market rose sharply to catch up to the strong move on the LME in the holiday week, the Shanghai market still

underperformed the LME market. On the chemicals market, ethylene and methanol prices were flat to lower. The only bright spot is the coal price, which inched higher post-holiday at Qinghuandao port by about RMB5-RMB10/tonne.

■ We note that the sluggish performance in Chinese commodities markets is more a result of amply supply driven by record levels of imports and output than any visible slowdown in demand. In addition to the strong copper and iron ore imports discussed above, we note that in September,

Chinese steel output was likely to set another record, according to the China Iron and Steel Association. Because of high output, local steel inventory surpassed the previous peak in March and now reached the highest level this year.

Consumer Behaviour During Golden Week

■ Consumer behaviour during the Golden Week holiday is considered a very good barometer of Chinese consumer confidence for the rest of the year. Initial data showed that sales were very strong during the past Golden Week for almost everything, except for home sales.

■ During the eight-day-long national holiday, nation-wide retail sales were up 18% YOY to RMB570 billion. Sales were particularly strong in the area of home appliances, electronic devices, communication devices, jewellery, and autos. Car sales were up about 71.7% YOY in key sampling markets. Quite a few models were reportedly sold out.

■ The first week of October has been known as the “Golden Week of the Year” for home sales in the past several years. But sales in this year’s Golden Week were disappointing, at least in first-tier cities. In major cities such as Beijing, Guangzhou, and Nanjing, home sales were

down significantly (over 30% YOY) on both a sequential and YOY basis.

■ We note that the downtrend in home sales, which started in September, has been accompanied by a spike in home prices. This unique combination made industry insiders divided on how to interpret the sales slowdown. The pessimistic view is that the pent-up demand accumulated in the previous sales downturn has been released and exhausted in the past eight months, and now the sharply higher housing prices are beginning to inhibit demand. The optimists believe that the slowdown in sales has occurred simply because existing inventory has drawn down to very low levels after months of supercharged sales and, as a result, developers are raising prices sharply to curb the pace of sales to maintain a minimum inventory. Optimists also tend to point out that the slower home sales were only visible in first-tier cities, but in second-tier cities, home sales are still accelerating. After talking to our local contacts, we believe that both views have merit, but the optimists’ opinion has more. We will be more comfortable with the optimistic view if we find September construction data continues to surge. Indeed, if the developers are worrying about inventory levels, as they have said they do, then they should begin to accelerate home construction. And home construction levels are what really matters for Chinese raw materials demand. September construction data is due in the next few days.

Overall Comments

■ The September trade and monetary data and the post-holiday market and consumer behaviours support our investment stance of “less bullish but definitely not bearish.” In essence, the underlying Chinese economy remains sound, and the recovery is intact. That said, the Chinese economy is still not strong enough to support/digest the record high output and import levels for key commodities so far this year. Inventory levels for key commodities are now on the high side and the local markets are comfortably supplied, and as a result, commodities prices are under slight pressure in China.

■ To make us more bullish on the raw materials sectors from a China perspective, we have to see home construction to continue to pick up strongly and Chinese steel prices begin to rally. As we have noted many times, government-supported infrastructure construction has been the key driver of Chinese raw materials demand so far this year. Ideally, if home construction can pick up strongly after months of strong home sales, Chinese raw materials demand will then have a second leg. This is why we have refused to change our overweight call for the raw materials sectors despite high commodity inventories and sluggish spot market prices in China.

Grain – Stockpiling to Continue

Reserve Level High

■ The actual level of China’s grain reserves nearly matches reported levels, China’s top state planning body said late last week, giving the conclusion of a four-month investigation into grain stocks at state warehouses. By the end of March, state-owned warehouses held grain reserves totalling 225.4 million tonnes, which was 99.7% of the reported level, the National Development and Reform Commission (NDRC) said. China launched a nation-wide check on its grain silos in April after some grain experts and local media cast doubt on the level of local reserves, saying many warehouses falsify booked numbers and keep stocks lower than

stated, or empty.

■ We note that the disclosed stock number, at 225.4 million tonnes, which did not include weekly sales by the government in the past five months, was larger than an earlier figure of between 150 million and 200 million tonnes announced by Premier Wen Jiabao last year.

■ The NDRC also said in its statement that half of the stocks came from last year’s harvest. China has stockpiled the highest-ever quantity of grains, including rice, wheat, corn, and soybeans, since late last year to help boost farmers’ incomes after a record harvest of 528.5 million tonnes and weak demand from processors and feed mills.

Stockpiling to Continue

■ For this year’s harvest, Singrain, the government buying agency, said it had bought 2.677 million tonnes of early rice and 39.99 million tonnes of wheat by September 25. Although purchases of corn and soybeans have not started for this year’s harvest, the central government just pledged earlier this week to extend its soybean and corn stockpiling scheme to this year’s new crop. The new crop harvest is due to begin within weeks.

■ Traders said the government was likely to offer prices higher than last year, when the government bought more than 6 million tonnes of soybeans at RMB3,700 per tonne and 36 million tonnes of corn at RMB1,500 per tonne for state reserves.

■ We note that the government stockpiling is a double-edged sword for global grain prices. In a year of bumper harvests, like this year, the stockpiling will keep the local Chinese price high and offer a support for global pricing from a China perspective. However, high grain reserves in China will prevent any sudden spike in Chinese imports in years of disaster and crop losses. Essentially, this is what the government reserve strives to achieve.

News in Brief

Iron Ore – Tougher Import Rules

■ China will soon introduce new rules to regulate imports of iron ore and will seek a greatersay in its pricing. Under the new rules, trading houses will not be allowed to import iron oreunless they hold firm orders from local steel companies, said Deng Qilin, chairman of China Iron & Steel Association. The move is aimed at preventing speculative imports by trading houses. Changes to existing import rules are being examined by the ministries of industry and commerce as well as the State Council, the country’s cabinet, he said.

■ Deng also said CISA, which represents a majority of big state-owned steel makers in China, will lead the next round of price negotiations and will push for a “China-specific price” to replace the old system of uniform pricing for all buyers. “China is the biggest buyer. We want to set a China-specific price for all (iron ore) miners … Why should the biggest buyer follow the others?” he asked.

■ Speaking at the World Steel Forum in Beijing on Monday, China’s Industry Minister, Li Yizhong, said the current 112 licensed iron ore importers were far too many, but didn’t offer details on how the government planned to reduce the number.

Steel – Baosteel Cut November Prices

■ China’s Baosteel has cut prices for its major steel products by 9%-13% for November sales versus the October tag. The largest steelmaker in China will cut the price of its major hot rolled steel coil by RMB400 per tonne to RMB3,942 per tonne, while reducing its major cold-rolled coil price by RMB700 per tonne to RMB4,676 per tonne.

Steel – Efforts to Reduce Capacity

■ Frustrated in previous attempts to consolidate its fragmented steel industry, China is working on a new way to promote mergers and reduce capacity, possibly giving a boost to other global steel companies.

■ Under a plan being worked out, steelmakers’ national tax bills would decline by year-end, with some of that money instead going to regional taxes. That would soften the blow of mill closures by giving regional governments additional tax revenue to stimulate their economies and help find jobs for displaced steelworkers. The lower tax burden would also leave steelmakers with more cash for acquisitions.

■ China has hundreds of steel mills, many of them small and inefficient. But the central government’s desire to close small plants and consolidate the industry has been stymied at the regional level. Local government officials have resisted the potential loss of jobs and tax revenue. Steelmakers, meanwhile, have been kept in check by riots protesting planned plant closures.

Re-Cap of Our Calls

■ Essentially, we are making four calls in our China Commodities Weekly: economic trends in China, our overall sector call, our individual commodity sector views, and our calls for the contract negotiations for certain commodities. We re-cap our calls as follows:

■ Economic trends: There are three intertwined trends for the Chinese economy – seasonal (the current and next few months), cyclical (the current and next few years), and secular (the current and next few decades). We are currently a seasonal bull, a cyclical bear, and a secular bull.

■ Overall sector call: Our overall sector call is to answer one question: purely from a China perspective, should investors in the Western world be overweight, market weight, or underweight in the global raw materials and energy sectors as a whole? To this question, our current answer is overweight.

■ Individual commodity sectors: On individual commodity sectors, we are now positive onthe copper, steel, iron ore, coking coal, uranium, molybdenum, corn, DAP, and hardwood pulp sectors. We are neutral on aluminum, zinc, nickel, thermal coal, potash, urea, wheat, soybean, methanol, ethylene, and crude oil. We are cautious on paper products. Please note that our positive, neutral, or cautious views on individual commodity sectors are all on a relative basis from a China perspective.

■ Views on annual contract negotiations: We are looking for a 7.5% rise in the 2010 annual iron ore contract. We expect the 2010 benchmark Australian hard coking coal price to settle at US$160/tonne, up from US$129/tonne in 2009. We expect the 2010 China potash contract price to drop US$181/tonne from its 2008 level, to US$395/tonne FOB.