It Is Not About the Dragon Alone
The energy story has changed since the race for oil market share began in the summer of 2014, just after the signing of the natural gas deal between Russia and China. As the oil price plummeted, China's oil demand grew 6.4 per cent or 694 kb/d (kilobarrels per day) in 2015 according to the IEA (International Energy Agency.)
Since then, China's economy has slowed with sliding GDP growth and manufacturing PMI; its currency has been devalued and its stock market volatility has driven down markets globally. These issues have reduced China's power as a consumer, and now, India has the highest oil demand growth in the world. However, overall IEA demand growth estimates for 2016 have remained the same, so it is hard to argue the oil price spike is coming from demand, especially Chinese demand.
On the other hand, it can be argued that the falling US inventories and weakness in dollar are supporting oil more today. OPEC has the ability to be the swing producer given its large market share, spare capacity, low production costs and capability of acting alone or in a cartel; however, US inventories need to be low for it to matter. The production coordination of US shale producers is difficult since there are many suppliers aiming to produce as much oil profitably as possible. Although inventories in the US are sitting at seasonally high levels, declines are now being reported by the EIA (Energy Information Administration,) that again, are the key to bringing power back to OPEC as a swing producer to control oil price.
More immediately, the falling US dollar is boosting commodity prices. Brent and WTI crude oil are two of the most sensitive commodities to the falling dollar where for every 1 per cent drop in the dollar over the past 10 years, Brent has increased 4.5 per cent and WTI gained 4.3 per cent. Other commodities that benefit greatly from a falling dollar are corn and wheat that rise 5.3 per cent and 4.8 per cent, but the commodities that benefit most are from industrial metals. Lead, nickel, copper, zinc and aluminium rise 7.2, 6.1, 5.3, 5 and 2.2 per cent, respectively.
While Chinese demand growth in construction and automobile manufacturing supports industrial metal prices, the demand in many cases is not strong enough to be the main reason for price rise. Over the long term, there is a lack of correlation between Chinese GDP growth and metals that demonstrate other forces are at work - even for copper, the one most well-known for its Chinese economic influence. Using year-on-year data since 1978, the correlation of copper to Chinese GDP growth is only 0.21, and is actually the lowest of all the industrial metals. The most correlated metal is zinc, but the relationship is still weak at only about 0.28.
Besides the tailwind of a weakening dollar for metals, there are noticeable shortages that have appeared. March was the first month the industrial metals sector was in backwardation (as measured by the roll yield in the indices) since September 2015. Within the sector, there have been recent shortages in industrial metals like lead, copper and aluminium. While copper has more shortages than excess inventories throughout history, its roll yield has grown (measuring a shortage) 60 per cent in the first quarter. Also, lead showed a shortage in February for the first time since November 2012, but now is a seasonally weak time for lead as the winter demand for replacement automobile batteries slows. However, the support for aluminium could be more persistent from stockpiling and tax policies. It is very rare to see shortages in aluminium. There have only been 10 months in 10 years with a positive roll and it seems to be driving the whole sector.
Zinc has gained more than gold this year and is the best performer in the sector, up 20.5 per cent in 2016. Its excess is half of what it was in October. Supply cuts and mine closures have boosted returns, and stockpiles are the lowest in more than six years.
Nickel hasn't seen a shortage since 2011, despite its huge price spike in 2014 of more than 50 per cent. The suppliers are producing relentlessly to try to squeeze out marginal producers for market share - much like what is happening in the oil market. Except the role of China is flipped where nickel producers want to squeeze it out. Yet China is the oil customer everyone wants.
So, the story isn't as simple as "Chinese demand growth boosts copper (or industrial metals)." While the demand growth may help, the dollar and supply side are the more important factors for the sector. If the demand grows at the same time the supply is disrupted and the dollar is weak, it may be a best case scenario for the industrial metals.
The writer is global head of commodities and real assets at the S&P Dow Jones Indices
