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As we warned last week, stockpiles of iron-ore have reached record levels in China as end-demand slumps but, as Bloomberg notes, this is potentially creating massive dislocations in other markets. Record imports of iron ore and copper, driven by traders who use them as loan collateral, risk repeating the vicious cycle of repayment difficulties and falling prices already seen in the steel-trading market. A stunning 40 percent of the iron ore at China’s ports are part of finance deals (having replaced copper after China’s last shadow-banking crackdown) and with the glut, prices drop (driving down the value of collateral on loans) and “borrowers, forced by their bankers to repay loans or to top up collateral, will have to sell the metals, sinking market prices even further and begetting a vicious cycle.”
As we noted last week, Bloomberg reports China’s record imports of iron ore and copper, driven by traders who use them as loan collateral, risk repeating the vicious cycle of repayment difficulties and falling prices already seen in the steel-trading market.
Iron Ore stockpiles ar record highs…
But Lenders seeking repayment are finding irregularities, including the same pile of materials used as collateral for multiple borrowings, China International Capital Corp. said.
Xiao Jiashou, known as the “steel-trading king” in Shanghai, had his assets frozen as China Minsheng Banking Corp. sues for money owed.
About 40 percent of the iron ore at China’s ports are part of finance deals, Mysteel Research estimates.
“The risk comes when metal prices fall by a large magnitude within a short time, driving down the value of the collateral,” Yang Changhua, a researcher with Beijing Antaike Information Development Co., said in a Feb. 19 interview. “Borrowers, forced by their bankers to repay loans or to top up collateral, will have to sell the metals, sinking market prices even further and begetting a vicious cycle.”
And those prices are tumbling:
Steel reinforcement-bar futures in Shanghai have fallen 19 percent in the past year, while iron ore delivered to China’s Tianjin port dropped 22 percent
And non-performing loans are therefore – exploding (as we noted here)…
Traders began having trouble repaying loans when steel prices in China slumped 38 percent in the seven months through August 2012 as the economy slowed. In the southern city of Foshan alone, local banks have given 100 billion yuan in credit to steel traders, Caijing magazine reported this week, citing a local banker it didn’t name. Loans to the sector helped drive non-performing loans in Yunnan province to 5.86 percent as of November 2013…
At China Citic Bank Corp., bad assets surged from 2011 to 2013 mainly because of non-performing loans to the steel-trade industry, Moneyweek magazine reported on Feb. 17, citing bank President Zhu Xiaohuang. The lender said on Dec. 12 that it plans to write off 5.2 billion yuan of bad debt for 2013.
At least a third of China’s 200,000 steel-trading firms will collapse as part of the credit crisis which started at the end of 2011, the official Xinhua news agency said Feb. 7, citing industry estimates. Nanjing Iron & Steel Co. said last month its 2018 bonds may stop trading due to losses.
But no matter how much the PBOC cracks down, only one thing matters:
“Those cash-starved steel mills or trading firms don’t care whether steel or iron-ore prices are falling,” said Zhang Jizhou, a trader at Ningbo Future Import & Export Co. “Their priority is to get cash flow so they can survive.”
So the shadow-banking system filled the gap as prime lenders disappeared…
Which means, howevere well intended, the PBOC is exacerbating the situation that many have drawn ugly comaprisons to the subprime-lending bubble in the US.
Simply put, the ‘clever’ people in China – having had their copper financind taken away, have shifted to steel – as the following diagram explains (just replace Copper warrants with Iron Ore…)
Which will end just as disastrously… unless of course, China once again unleashes the ghost cities building spree. Which it inevitably will: after all it has become all too clear that not one nation – neither Developing nor Emerging – will dare deviate from the current status quo course of unsustainable, superglued house of cards “muddle-through” until external, and internal, instability finally forces events into a world where everyone now has their head in the proverbial sand.
The big question is then, does China re-ignite huge inflation in an attempt to save its vicious-circle-facing economy or does the “pig in the python” get expelled first as fast-money carry leaves en masse and crushes collateral values…
It may not be one of the core three (somewhat) realistic and accurate econometric indicators of China’s economy (which as a reminder according to premier Li Keqiang are electricity consumption, rail cargo volume and bank lending), but when it comes to getting a sense of capacity bottlenecks in China’s fixed investment pipeline – be it in ghost cities or the latest skyscraper building spree – nothing is quite as handy as commodity, and particularly iron ore (if not copper, which as we have explained before has a far more “monetary/letter of credit” function in China’s markets), stockpiles at China’s major ports. The logic is simple: no stockpiles means end demand by steelmakers is brisk and there is no inventory build up which in turns keep Australia, Brazil and other emerging markets happy. Alternatively, large stockpiles indicates something is very wrong with final demand, and hence, the overall economy.
One look at the chart below, which shows how much iron ore has been stockpiled at China’s 34 major ports (spoiler alert: it just hit an all time high), should explain at which of these two extremes China currently finds itself.
Here is what happened as explained by Market News:
Weak demand from steelmakers saw iron ore stockpiles at major ports hitting record highs, according to data from industry website umetal.com. Iron ore inventory at China’s 34 major ports jumped 4.56 million tons last week to 100.86 million tons as of February 14, the 2nd time it has surpassed the 100 million-ton level and matching the record of 2012. Iron ore imports were also at a record high in January, at 86.83 million tons, as steel traders boosted imports to bet on rising steel prices this year. But data from the China Iron and Steel Association showed crude steel output falling around 2% m/m in January. Average steel prices fell 0.79% last week, according to data compiled by mysteel.com.
There is another, more finely spun, explanation: monetary financing, or in other words, when it comes to China’s peculiar “generally accepted collateral”, iron is the new copper. Bloomberg explains:
Iron ore stockpiles in China, the world’s biggest buyer, climbed to a record as traders increased imports to use the steel-making raw material as collateral for credit and domestic demand remained weak.
“Imports kept piling up at ports as more cargoes are being hauled in for trade-financing deals,” Gao Bo, chief iron ore analyst at Mysteel.com, a researcher in Shanghai, said by phone from Beijing today.
While this may suggest end demand has not completely imploded, it does bring up a different set of complications: steel mill funding difficulties – perhaps the most sore topic in China nowadays.
Steel mills and trading firms in China are contending with increasing difficulty in getting funding, said Mysteel’s Gao.
“The funding situation in the steel industry was getting worse last month,” he said.
The weighted average lending rate in China was 7.2 percent in December, up from 6.22 percent a year earlier, central bank data released earlier this month show. In December, 63.4 percent of loans had interest rates above benchmarks, up from 59.7 percent a year earlier, according to the central bank.
However one spins it though, there is no denying that in addition to its on again, off again infautation with tapering and deleveraging, which usually continues right until the moment yet another shadow bank has to be bailed out, construction in China has slammed on the brakes:
Stockpiles of steel products also rose as construction activity remained weak after the Lunar New Year holidays, Gao said. Traders’ stockpiles of rebar, a building material, jumped by 65 percent this year to 8.55 million tons last week, according to Shanghai Steelhome.
One thing is certain – the biggest loser, as iron prices are set to tumble, will be Australia
Prices may average $119 a ton this quarter, $110 in second quarter and drop to $100 in the final period of this year, Goldman Sachs analysts led by Christian Lelong said in the Feb. 11 report.
Mine supply of iron ore reached a record over the fourth quarter of 2013, “with the natural destination being China,” Macquarie Group Ltd. said in a Feb. 13 report. “With inventory build being evidenced on the back of higher imports, this will act as a buffer to buyers in the coming months,” it said.
China’s shipments from Australia’s Port Hedland, the largest ore-export terminal, rose 27 percent to 23.3 million tons last month. Increased supply from Australia, the top ore shipper, may push the global seaborne surplus to 94.2 million tons this year from 9.1 million tons in 2013, UBS AG estimates.
Rio Tinto Group (RIO), the world’s second-biggest exporter, said last month that output rose 7 percent to 55.5 million tons last quarter from 52 million tons a year earlier. Fortescue Metals Group Ltd. is boosting capacity to 155 million tons by the end of March.
And speaking of Australian iron miners, it was in late summer of 2012 when Chinese iron ore stockpiles were once again in the 100 million ton range, when iron prices crashed so bad, that Fortescue was on insolvency watch. Should the current episode of collapsing Chinese end demand persist and construction freeze persist, it may be time to short to FMGAU bonds once again.
Unless of course, China once again unleashes the ghost cities building spree. Which it inevitably will: after all it has become all too clear that not one nation – neither Developing nor Emerging – will dare deviate from the current status quo course of unsustainable, superglued house of cards “muddle-through” until external, and internal, instability finally forces events into a world where everyone now has their head in the proverbial sand.
Something has bothered me of late: why is the price of crude oil still elevated? Other commodities have taken a battering since 2011. Gold, copper and iron ore – all are way down off their peaks. But oil has seemingly defied gravity. And that’s despite increased supply from shale oil in the U.S., still soft demand particularly in the developed world and declining rates of inflation growth across the globe.
What gives? Well, shale oil proponents will say falling oil prices are just a matter of time. And that the boom in shale oil will reduce U.S. reliance on foreign oil, leading to cheaper local oil, which will free up household budgets and spur consumption as well as the broader economy. Perhaps … though I’d have thought all of that would be already reflected in prices.
On the other side, you have “peak oil” supporters who suggest high oil prices are perfectly natural when oil production has peaked, or at least the good stuff has disappeared. Yet the boom in U.S. shale oil appears to put at least a partial dent in this thesis.
There may be a better explanation, however. It comes from UK sell-side analyst, Tim Morgan, in an important new book called Life After Growth. In it, he suggests that the era of cheap energy is over. That the new unconventional forms of oil are far less efficient than old ones, meaning they require significant amounts of energy to produce. In effect, the energy production versus energy cost of extraction equation is rapidly deteriorating.
Morgan goes a step further though. He says cheap energy has been central to the extraordinary economic growth generated since the Industrial Revolution. And without that cheap energy, future growth will be permanently impaired.
It’s a bold view that’s solidified my own thinking that higher energy prices are here to stay. And the link between cheap energy and economic growth is fascinating and worth exploring further today. Particularly given the implications for the world’s fastest-growing and most energy-intensive region, Asia.
Real vs money economy
First off, a thank you to Bob Moriarty of 321gold for tipping me off to Morgan’s work in this well-written article. Morgan’s book is worth getting but if you want the skinny version, you can find it here.
Morgan begins his book outlining four key challenges facing economies today:
- The biggest debt bubble in history
- A disastrous experiment with globalisation
- The massaging of data to the point where economic trends are obscured
- The approach of an energy-returns cliff edge
The first three points aren’t telling us much new so we’re going to focus on the final one.
Here, Morgan makes a key distinction between what he terms the money economy and the real economy. He suggests economists around the world have got it all wrong by focusing on money as the key driver of economies.
Instead, money is the language rather than the substance of the real economy. The real economy is a surplus energy equation, not a monetary one, and economic growth as well as the increase in population since 1750 has resulted from the harnessing of ever-greater quantities of energy.
In fact, society and economies began when agriculture created surplus energy. Before agriculture, in the hunter-gatherer era, there was an energy balance where the energy which people derived from food was largely equivalent to the energy that they expended in finding the food.
Agriculture changed that equation. It allowed for the creation of surplus energy. In essence, three people could be supported by the labor of two people, allowing one person to engage in non-subsistence activities. This person could make better agricultural tools, build bridges for better infrastructure and so on. In economic parlance, this person didn’t have to concentrate on products for immediate consumption but rather the creation of capital goods. The surplus energy equation allowed for that.
The second key development was the invention of the heat engine by Scottish engineer James Watts in 1769, although a more efficient version was produced later in 1799. This invention allowed society to access vast energy resources contained in oil, natural gas, coal and so forth. In other words, the industrial revolution allowed the harnessing of more energy to apply vast leverage to the economy.
In sum, the modern economy is the story of how society overcame the limitations of the energy equation. Or as Morgan puts it: “…all goods and services on which money can be spent are the products of energy inputs, either past, present or future.”
The creation of surplus energy during the Industrial Revolution and subsequent explosion in economic and population growth isn’t an accident. They’re tied at the hip.
Understanding the distinction between the money economy and the real economy can also help us better understand debt. Debt is a claim on future energy. The ability of indebted governments to meet their debt commitments will partially depend on whether the real (energy) economy is large enough to make this possible.
Era of cheap energy is over
Morgan goes on to say that the era of surplus energy, which has driven economic growth since 1750, is over. The key isn’t to be found in the theories of “peak oil” proponents and the potential for absolute declines in oil reserves. Instead, it’s to be found in the relationship between the energy extracted versus the energy consumed in the extraction process, also known as the Energy Return on Energy Invested (EROEI) equation.
The equation maths aren’t difficult to understand. If the EROEI is 10:1, it means that 10 units are extracted for every 1 unit invested in the extraction process.
From 1750-1950, the EROEI of oil discoveries was very high. For instance, discoveries in the 1930s had 100:1 EROEIs. That ratio declined to 30:1 by the 1970s. Today, that ratio is at about 17:1 with few recent discoveries above 10:1.
Morgan’s research suggests that going from EROEIs of 80:1 to 20:1 isn’t disruptive. But once the ratio gets below 15:1, energy becomes a lot more expensive. He suggests the ratio will decline to 11:1 by 2020 and the cost of energy will increase by 50% as a consequence.
Non-conventional sources of oil will provide little respite. Shale oil and gas have EROEIs of 5:1 while tar sands and biofuels are even lower at 3:1. In other words, policymakers who pin their hopes on shale oil reducing energy prices are seriously deluded.
And further technological breakthroughs to better locate and extract oil are unlikely to help either. That’s because technology uses energy rather than creates it. It won’t change the energy equation.
While some unconventional sources offer hope, such as concentrated solar power, they won’t be enough to offset surplus energy turning to a more balanced equation.
Oeuvre to growth tool
If the real economy is energy and the days of surplus energy are coming to an end, then so too is economic growth, according to Morgan. In his own words:
“…the economy, as we have known it for more than two centuries, will cease to be viable at some point within the next ten or so years unless, of course, some way is found to reverse the trend.”
This terribly pessimistic conclusion requires some further explanation. Morgan explains the link between energy and the economy thus. If your EROEI sharply declines, it means more energy is needed for extraction purposes and less energy is available to the economy. Ultimately, this results in the cost of energy rising as a proportion of GDP, leaving less value for other things. Put another way, with the leverage from surplus energy diminished, there’s less energy available for discretionary uses.
Now I don’t have total buy-in to Morgan’s thesis. It certainly solidifies my thinking that the era of cheap energy is indeed over. It provides a unique and compelling way to think about this. And the proof is seemingly all around us. It explains the high oil prices and the surge in agriculture prices (agriculture relies on energy inputs).
You can’t help but being more bullish on energy and agriculture plays in the long-term. Oil drillers for one as they’re more reliant on increased work than the price of oil. Also, the likes of fertiliser companies given agriculture land is tapped out, making an increase in output essential and thereby requiring greater quantities of fertiliser.
Morgan thinks inflation is on the way given a squeezed energy base with still escalating monetary bases. Regular readers will know that I am a deflationist over the next few years. But nothing is certain in this world and Morgan’s arguments on this front have some credibility.
As for whether this spells the end of a glorious 250 year period of economic growth, well, I’m not so sure. The link between energy and economies is compelling. But whether we’re at a tipping point where surplus energy disappears is a guess. I’m convinced that we’re coming up against resource constraints that will inhibit economic growth. To say that we’re imminently coming to the end of economic growth requires further evidence, in humble opinion.
Impact on Asia
Asia has been the largest demand driver for energy over the past decade. The region’s net oil imports total 17 million barrels of oil a day. China is now the largest net oil importer, having recently overtaken the U.S.. Other large net oil importers in Asia include India and Indonesia. Obviously, higher oil prices would be detrimental to these net importing countries.
It may be somewhat offset by agricultural prices staying higher for longer. China and India are agricultural powerhouses. And the impact of agriculture on their economies is still profound (agriculture accounts for 14% of Indian GDP and 10% of China).
On the other hand, higher agricultural prices mean higher food prices. And given lower incomes in Asia, the proportion of household budgets dedicated to purchasing food is much higher than the developed world. Therefore higher food prices has a larger impact on many Asian countries. Witness periodic recent protests on this issue in Indonesia, Thailand and India. So net-net, higher energy prices would still be a large negative for Asia.
Turning to resource constraints potentially inhibiting future economic growth: given Asia has the world’s strongest GDP growth, it would be disproportionately hit if this scenario is right. The past decade may represent a peak in the region’s economic output. Whether there’s sharp drop or gradual fade is impossible to forecast.
These are but a few of the potential implications for Asia.
AC Speed Read
– The real economy is a surplus energy equation, or the harnessing of ever-greater quantities of energy.
– That equation has deteriorated to such an extent that one can now declare the era of cheap energy over.
– If the economy is energy and cheap energy is gone, future economic growth will be inhibited.
– Consequently, higher energy and agricultural prices can be expected in the long-term.
– The impact on Asian growth may be disproportionately large.
This post was originally published at Asia Confidential: