Back in April 2014, the main reason why we said buying Glencore CDS is the best way to trade the upcoming Chinese credit-commodity crunch was because it was basically stacking leverage, with CDS being a massively levered way to short credit, upon leverage as Glencore had $1.2 billion of profit exposure to every 10% drop in copper, upon leverage, as copper is in turn levered to China's credit bubble, upon even more leverage, with Glencore's dirty not so little secret of $100 billion in counterparty exposure now revealed.
This combination of leverage upon leverage upon leverage upon leverage, coupled with the anticipated China "hard landing" catalyst, made long Glencore CDS (which were then trading near record tight levels) not only the best-performing trade of 2015, but as we expected, turned into the best way to trade China's economic slowdown and alleged hard-landing: alternatively, anyone who had shorted Chinese equities in anticipation of China's various bubbles bursting when the SHCOMP was at 2000 over a year ago, is now flipping burgers.
But another question has emerged in recent days: is copper truly the most levered way to bet on China? According to a new analysis by Goldman, copper is "only" the third most levered commodity to Chinese demand.
As the bank notes, in its latest bearish note on the commodity space (perhaps a reason in itself to buy commodities), beyond the obvious relationship that strong (weak) Chinese growth equals rising (falling) commodity prices, its "China Leverage Score (see Exhibit 1) attempts to provide a simple composite measure of which commodities are most exposed to China demand, by combining share in global demand (squared) plus net imports (as a share of global demand)."
While this provides a good “first glance”, going beyond a cursory look paints a much more complex picture for most commodities. Some of the less obvious facets of Chinese commodity demand are:
- Where China is an intensive consumer of a particular commodity, it tends to import that commodity in large amounts, even if it already has substantial domestic production capacity. This is because China plays a key role across value chains: China produces raw commodities (especially metal ores), refines imported and domestic raw commodities (in particular iron ore and coking coal into steel, and to a lesser extent crude oil into oil products), and also turns refined commodities into manufactured goods for export (in particular, petrochemicals, copper and aluminum).
- China has also made substantial strides towards metals independence over recent years thanks to new production technologies such as nickel pig iron (leading to a decline in leverage score for the most “leveraged” commodities). As such, China has become the largest exporter of refined metals such as aluminum and steel over recent years, despite also fulfilling robust domestic demand for these metals (by domestic investment projects and the export-led manufacturing sectors).
- A key drawback of this larger and more integrated role in commodity production is that lower commodity prices are now far less stimulative for China than they would have been several years ago. On net, lower oil prices are still very likely to provide a positive effect on Chinese oil demand and the overall economy. Yet, lower metal prices, other than copper, are likely to reinforce weakness in some of the key Chinese heavy industries centered on commodity production.
So for those seeking the next (massively levered) Glencore, by shorting those with most exposure to Iron, Nickel and Zinc (3 of the top 4 most levered commodities to China aside from copper), here is the place to start.