Classical Supply Curves
The supply curves, of course, are positively sloped – the higher the price of copper, for example, the more copper will be produced and sold. The slopes of the curves, furthermore, are very sensitive to existing production capacity, and Minack lists curves for several points in time as production capacity changes. As one would expect, when demand for copper is less than production capacity the curves slope gently upwards, implying that small increases in copper prices correspond to very large increases in copper supply.
But this curve slopes gently upwards only up to a point, representing the limits of normal production capacity, after which the slope of the curve is almost vertical. Beyond this point – of maximum capacity – no matter how high the price of copper, in the short term supply cannot be substantially increased. Or to put it another way, beyond that point small increases in demand translate into large increases in price.
In 2001, according to Minack’s numbers, this transition point for copper was roughly 12 million tons, above which it would be extremely difficult for copper producers to supply demand except at extremely high prices. There was some improvement in capacity during this time but not much. By 2004 this same inflection point had increased only slightly, to roughly 13 million tons. This, as Minack pointed out, reinforces the argument that copper producers were not expecting any significant increase in demand and so had not prepared for it.
But by 2004-5 it was increasingly evident that demand was rising quickly. Copper producers responded, and thanks to increased investment in countries like Peru and Chile, among others, production capacity surged. By 2018 the inflection point is projected to be at roughly 21 million tons, suggesting that between 2004 and 2018 an enormous amount of additional copper production has become or is going to become available. In his July 17 “Down Under” note, Minack goes on to say:
What’s notable, in my view, is the forecast increase in supply versus the actual supply increases seen over the past decade. For copper, the increase in global supply in each of the next seven years will be roughly equal to the increase in supply over the decade to 2011. Consequently, it would require a material acceleration in demand to keep prices at current levels in the face of this supply increase.
The same story is more or less true for iron ore, although the expansion is supply has been more dramatic. In 2006, according to Minack’s numbers, the inflection point was at roughly 900 million tons, above which iron ore producers would have difficulty supplying demand. By 2011 it was at 1,300 million tons and by 2014 and 2020 it is expected to be1,900 million and 2,600 million tons respectively. In just over ten years, in other words, production capacity will have nearly tripled. This is a lot of iron that has to be absorbed by someone.
The supply considerations are exacerbated by the amount of stockpiling taking place in China. I won’t rehash all my arguments from earlier newsletters about stockpiling but it is enough, I think, simply to list some of the articles I found in my daily readings last week.
Stockpiling
The first article came on Tuesday from Bloomberg:
Cotton consumption in China, the world’s largest user, may shrink 11 percent this year as a deteriorating economy hurts demand and causes a buildup in commodities, according to Weiqiao Textile Co.
…Coal inventories at Qinhuangdao port rose to 9.33 million tons on June 17, the highest since 2008, data from the China Coal Transport and Distribution Association showed. Stockpiles were at 6.69 million tons as of Aug. 19. While steel-product stockpiles at the nation’s 26 major markets have dropped for five months as the end of July, they’re still 19 percent higher this year, according to the China Iron & Steel Association.
Commodity-related companies have flagged their concern. Noble Group Ltd. (NOBL), Asia’s biggest listed commodity supplier, expects a tough environment for the next 12 to 24 months, Chief Executive Officer Yusuf Alireza said yesterday. Vale SA (VALE5), the world’s largest iron-ore producer, said this month that China’s so-called golden years are gone as economic growth slows.
The article in Tuesday’s Financial Times talks about excess inventory of a wide variety of products and refers to an earlier article, from July, that claims that China’s coal inventory is up 50% from last year:
Memories of the London Olympics are already beginning to fade. Li Ning, a Chinese sportswear maker, had better hope that they last a while longer. Like thousands of Chinese companies from property developers to car manufacturers, Li Ning is sitting on a mountain of unsold products. Whether they can whittle down these bulging inventories is the single most important question facing corporate China and arguably the economy as a whole.
…The problems of Li Ning and the sportswear industry are just the tip of the iceberg in China. Across virtually all corporate sectors, inventories are excessive. The stock of unsold homes is the most worrying, because property plays such a dominant role in the economy. Vanke, the country’s biggest developer, estimates that it would take about 10 months to absorb all the unsold homes in China, which is reasonably quick. The snag is that this figure doesn’t count the millions of homes that have been sold but are sitting empty.
Then there is the auto sector. Car sales have been remarkably resilient despite the economic slowdown. But manufacturers have been more bullish than consumers. The inventory index (inventories divided by sales) was 1.98 at the end of June, according to industry data. More than 1.5 is seen as critically high.
The unsold mountains of electronics and white goods are also looking Himalayan in scale. Over the past week, the country’s main retailers descended into a price war. It began when online retailer 360buy.com vowed that it would sell home appliances at a zero profit margin.
The commodities sector is also dealing with a huge inventory overhang, most graphically in the piles of coal that have built up at ports across the country.
In an article one day later from the South China Morning Post, the concern is about copper:
At first glance, China’s copper demand is soaring. According to Ross Strachan, commodities analyst at independent research house Capital Economics, if you add domestic production of refined copper to China’s imports and changes to official stockpiles, then it appears that copper consumption leapt 22 per cent in the first seven months of 2012 compared with the same period last year.
But if you look at the volume of copper products actually turned out by China’s factories – pipes for air conditioners, windings for electrical transformers, foil for circuit boards and the like – then output was flat in July compared with a year earlier (see the second chart). Weak output makes sense. Together, manufacturing industries, home appliances and the construction sector accounted for half of China’s copper consumption last year.
With economic growth now slowing and property investment weak, demand is bound to be soft. Analysts at Credit Suisse expect China’s copper usage to grow by just 2 per cent this year and 1 per cent in 2013, in contrast to the 26 per cent growth seen at the height of China’s stimulus effort in 2009.
This gaping discrepancy between apparent demand and actual consumption implies there has been a massive build-up in unreported stocks of refined copper held in bonded warehouses and elsewhere.
Strachan at Capital economics believes these stockpiles have climbed by 900,000 tonnes since the middle of last year. Standard Chartered puts the total amount held in bonded warehouses at 600,000 tonnes, together with another 400,000 held elsewhere.
To put these figures into perspective, the LME’s worldwide network of warehouses reports copper stocks of just 231,000 tonnes. In other words, China is sitting on a huge overhang of refined copper.
This partly reflects state corporations’ efforts to build strategic reserves of the metal. But it is also the result of massive speculation in copper. The details of the trade are complex. But in a nutshell, companies buy copper on margin, then use the metal as collateral to obtain low-cost loans, using the proceeds to bet on higher-yielding assets.