Every other resource story you come across nowadays seems to have its genesis in China. Of course, it's not difficult to appreciate why this is the case. After all, we've long since become accustomed to the litany of statistics: China, among other things, accounts for half of global steel production, is the chief recipient for Australian iron ore, Chilean copper and Saudi petroleum. Not only that, but within the space of just three years, it has moved from being a net exporter of thermal coal to the world's largest importer.
And that's to say nothing of the country's burgeoning food imports, or the uranium, cement, nickel and high-grade titanium required for the phased roll-out of another 245 nuclear reactors over the next 20 years. So, as we assess prospects for commodity markets, we need to do it in the context of China.
Rio Tinto gets on board the 'super-cycle'
The factors that have underpinned the rising demand for commodities from China and other emerging markets remain intact. You don't have to be an advocate of a commodities 'super-cycle' to appreciate that, despite astounding progress over the past 20 years, the world's chief emerging market has a long way to go, not only in terms of infrastructure development, but also in establishing a broad-based domestic consumer market (India is better placed than China in this regard).
Mining giant Rio Tinto provided an illustration of corporate faith in China's long-term industrial growth potential, when it recently announced that it intended to invest an additional $7bn per annum, chiefly in a bid to boost its iron ore production by 50 per cent over the next five years.
Supply/demand fundamentals outweigh near-term monetary risks
Commodity traders were spooked last month, albeit briefly, when China set out the latest in a succession of measures designed to squeeze the domestic money supply. Prices for copper, coking coal and iron ore oscillated around their 2008 highs earlier this year, but traders are now obviously wary of the effects that structural reforms could have on Chinese industrial demand.
China raised benchmark interest rates for the first time in three years in October. Citigroup recently predicted that at least half of the national constituents within the JP Morgan MSCI Emerging Markets Index will follow suit next year in a bid to stifle rising prices, although it's curious that economies such as those of Brazil and South Korea would want to risk measures that might inadvertently attract more inflows of so-called 'hot money', especially with so many silky new US greenbacks in circulation.
However, it should be noted that Chinese industry, because of its financial clout, has been both willing and able to rapidly stockpile raw materials as and when prices move in its favour.
Chinese imports of key industrial goods, such as copper and palladium, have borne little relationship to industrial output in recent months, which implies that Chinese companies are in a phase of de-stocking. Recent analysis from Barclays Capital demonstrates this trend: Chinese imports of refined copper inputs fell by around a third during October, but end-use increased by 8 per cent year on year. Crude oil imports also fell by around a third during October despite the fact that refinery output increased by 11 per cent. Of course, it is not possible to run down inventories indefinitely, so it may be the case that Chinese industry will be compelled to re-stock during the first quarter, regardless of concerns over domestic monetary policy.
The general point is this: China's determination to avoid creating (or perhaps exacerbating) unsustainable asset bubbles within the wider economy is just one of a number of factors that could conceivably put the lid on prices for base metals in the early part of next year; the European sovereign debt saga being another.
However, the simple long-term, supply/demand dynamic covering a range of commodities provides a compelling case for investment. Timing, as ever, remains the key. Bearing this in mind, here are some investment themes linked to China that we expect to form a backdrop to commodity markets next year.
Resource M&A activity to accelerate in 2011
Unlike finances within much of the public sector, corporate balance sheets, and particularly those of many larger resource companies, are in rude health at the moment. Many companies either paid-down debt, or conserved their cash resources in the wake of the global financial crisis. But now, as an element of risk appetite returns to the market, we have reached a point where many resource companies are more inclined to commit excess cash reserves towards expansion, rather than simply returning funds to shareholders through buy-backs.
For European resource stocks, the currency risk associated with holding high levels of cash reserves has become more acute due to the uncertainties surrounding EU sovereign debt.
Debt funding is also still problematic for most small and mid-cap resource companies, which is another key driver of M&A activity.
In general, the M&A intentions of western companies are still reactive to macroeconomic developments. If, for instance, major western economies were to slide back into recession during the first half of next year, we would witness a sharp contraction in UK deal activity. However, the main driver of M&A activity within the Asia-Pacific region is based primarily on the desire to secure raw materials, so it is conceivable that deal activity could still flourish within those markets.
Supply shortfalls predominate
While demand from emerging economies has underpinned the rise of commodity markets, these same economies are now exacerbating production shortfalls by either curtailing their own exports of raw materials, or introducing export duties. China recently courted controversy after it allegedly reduced exports of rare earth minerals to overseas markets, which is problematic given that it is the world’s only significant producer.
European industry has become ever more reliant on Russian energy exports, yet Russia has sharply cut back coal exports (and isn't above curtailing gas supplies to gain political leverage). Supply lines for raw materials have also tightened because certain Asian economies, most notably China, have increasingly been securing critical production inputs through bilateral agreements.
This is often achieved via sovereign wealth funds, with access to huge pools of foreign reserves. The practice is not only tightening the supply/demand ratio for certain commodities, but has also distorted pricing models. The spot price for uranium, for instance, while indicative, often bears little relationship to the actual trade price.
A skilled labour shortage is pushing up production inputs
Recent developments in the Australian iron ore industry have highlighted a structural problem that will continue to hamper production throughout the wider resource sector, but mining in particular. Skilled labour shortages, already a reality in the West Australian mining industry, is one of a number of factors that are leading to increases in exploration, extraction and production costs for raw materials.
Internal forecasts from Rio Tinto point to an 8.3 per cent average increase in input prices for its Western Australian interests next year, followed by a further 6.3 per cent in 2012. Given the fluidity of the modern labour market, it is relatively straightforward for skilled employees to find higher paid positions throughout the world, which is driving up wage costs. Low participation in the resource sector in the decades leading up to the 1990s has resulted in a dearth of suitably trained and experienced middle-management engineers. This is just as true for emerging economies, so labour shortages will persist for some time to come. If you've got a son or daughter pondering which discipline to follow at university, you could do worse than nudge them towards geology or mining engineering.
A tightening of monetary policy in China is likely to result in further volatility in commodity markets through the first quarter of next year. At some point, however, industrial inventories will need to be re-stocked, which underpins the case for key inputs, such as iron ore and copper. M&A activity will accelerate as China and other emerging economies seek to tie up future supplies of raw materials. We can also expect some margin erosion for mining majors as a result of a worsening labour shortage.
