18 months ago we first brought the world's attention to the end of what has now been exposed as among the largest ponzi schemes in history - the Chinese Commodity Financing Deals (CCFDs) - pointing out how this meant commodities like copper were likely to come under pressure as firms liquidate what minimal holdings they had (and sell out futures hedges) to manage the risk of unwinds in these quasi-collateralized deals. Since then, copper prices have indeed plunged, as has global growth expectations and global bond yields as a realization that 'demand' implied by previous prices was entirely artificial. Now, as Goldman notes, the real world is catching up (or down) to the reality of mal-investment and how copper is set to drop notably further...
As Goldman Sach's Max Layton,
Metals and mining commodities – including the base and bulk commodities, steel and cement – are highly exposed to a slowdown in the Chinese property, with over 40% of Chinese demand for cement and copper in particular consumed in the construction sector. The recent slowdown in Chinese property sales, prices and early-cycle new starts has most impacted physical demand for (and sentiment towards) commodities exposed to the earlier stages of China’s construction cycle – steel and iron ore – which have underperformed commodities more exposed to latter stages of the construction cycle, such as copper. However, as the recent slowdown in new starts flows through to late-cycle, copper-intensive construction completions, we expect copper to come under further pressure.
Understanding the construction cycle and commodity demand
The property development timeline for a typical Chinese building (such as an apartment building) from new start to property completion takes around 18 to 24 months. An “early-cycle” construction phase can be characterized as a period with strong new starts, relatively weak completions, and falling inventories (associated with higher sales). Conversely, “late-cycle” construction phases are typically associated with weak new starts, relatively strong completions, and rising/and or high property inventories (associated with weak sales). The intensity of basic material consumption varies significantly across these phases: consumption of steel and steel-making raw material (such as iron ore and coking coal) tends to be strongest in the earlier stages, while copper tends to be consumed in the later stages.
Specifically, as much as c.61% of Chinese and c.25% of global copper consumption is related to Chinese housing and property activity. Of the c.61% of Chinese consumption that may be related to property, up to c.45-50% is directly associated with project completion (plumbing, wiring for lighting, local power infrastructure, telecom, etc.), and c.12% is associated with the actual property sale, when the property is fitted with copper-intensive consumer appliances and/or tiling intensive in mineral sands. The strong link between completions and copper demand owes to the fact that internal and external copper wiring (for connection to the grid) tends to be installed around project completion. There is strong empirical evidence for the relationship between completions strength and copper prices: using completions as the primary indicator of China’s copper demand, together with ex-China demand data, explains the vast bulk of variation in copper prices over the past decade.
Bad news for copper
In 2012/2013, the Chinese construction sector transitioned from an early-cycle construction phase to a late-cycle one, as completions surged following a wave of new stimulus-related construction post the Global Financial Crisis. Since then, the cycles have been relatively muted, with both new starts and completions growing sub-trend, for the most part. More specifically, the observed weak growth in new starts over the past two years has bearish medium-term implications for late-cycle copper-intensive construction completions. In our view, this weakness has not been priced in, as it has not flowed through to the physical market via higher inventories, and therefore supports our bearish copper view over the next year ($6,600/t and $6,200/t at 6- and 12-month horizons).
Double whammy (at the margin): commodity financing deals
In the past three years, China has increasingly employed complex commodity financing deals to import relatively low-cost US dollar funding, which in some cases has likely been used to fund property development. While the profitability of these financing deals has already fallen owing to lower Chinese interest rates, higher rates outside of China, and – in the case of copper – persistent LME backwardation, we expect a further gradual unwind in such deals over the course of 2015 as China opens up its capital account gradually over time. This broader reduction in financing deals, combined with an expected rise in US interest rates, could result in higher costs of funding for Chinese property developers, potentially further slowing property starts and property-related commodity consumption. At the same time, a further reduction in deals would reduce demand for copper imports into bonded warehouses in China (a key component of the financing transactions), potentially raising inventory visibility outside of China. This scenario would be a double whammy for copper, which is both highly exposed to the property sector and supported by low visible exchange stocks.