6_macquarie commodities comment

Please refer to the important disclosures and analyst certification on inside back cover of this document, or on our

website www.macquarie.com.au/disclosures.

GLOBAL

LME cash price

% change

US$/tonne day on day

Aluminium 1,682 0.8

Copper 6,489 0.7

Lead 2,053 0.3

Nickel 16,070 1.6

Tin 22,825 -0.7

Zinc 1,944 0.0

Cobalt 30,877 3.4

Molybdenum 22,000 0.0

Other prices

% change

day on day

Gold (US$/oz) 1,336 0.7

Silver (US$/oz) 20.55 1.9

Platinum (US$/oz) 1,439 0.2

Palladium (US$/oz) 789 4.6

Oil WTI 100.33 0.0

USD:EUR exchange rate 1.380 0.1

AUD:USD exchange rate 0.910 0.5

LME/COMEX stocks

Tonnes Change

Aluminium 5,414,875 -10,100

LME copper 265,700 -2,150

Comex copper 12,321 811

Lead 200,700 0

Nickel 283,578 144

Tin 9,430 185

Zinc 780,075 -5,275

Source: LME, Comex, Nymex, SHFE, Metal Bulletin, Reuters, LBMA, Macquarie Research, March 2014

Articles of the week

Chinas urbanisation path

JFY contract: Preparing for the lowest thermal

coal settlement in five years

Shanghai gold premium (discount) or London

gold discount (premium)?

Zinc rally faces China headwinds

Analyst(s) Macquarie Capital Securities Limited Angela Bi +86 21 2412 9086 [email protected] Graeme Train +86 21 2412 9035 [email protected] Chen Shao +86 21 2412 9041 [email protected] Macquarie Capital (Europe) Limited Colin Hamilton +44 20 3037 4061 [email protected] Jim Lennon Senior Commodities Consultant +44 20 3037 4271 [email protected] Matthew Turner +44 20 3037 4340 [email protected] Stefan Ljubisavljevic +44 20 3037 4247 [email protected]

24 March 2014

Commodities Comment Macquarie Copper Survey: demand starting to emerge Macquaries proprietary copper survey for March reveals recovering demand

for copper in China, with green shoots evident from major end-users including

the construction and power sectors. Having been destocking for quite a while,

some fabricators are planning to buy more copper from the market as they

have received increasing orders and because prices have stabilised at lower

levels following the sell off. However, tight financing conditions affecting the

industry should dampen consumers purchasing capability for copper, at least

until we see a full recovery in orders from the State Grid.

Latest news

Palladium gained 4.6% to its highest since August 2011 as traders

anticipated strong demand from the launch of two new palladium ETFs next

week (see yesterdays Commodities Comment for more details). Nickel

added 1.6%.

Steel inventory held by traders in China fell sharply this week, down 2.4%

WoW according to data from Mysteel. Since peaking four weeks ago, trader

stocks have fallen 5%, the fastest pace of destocking since 2010. Given that

prices have been falling over the same period, the destock perhaps looks

more like a trader liquidation than a demand driven drawdown, although rebar

prices in China did stabilise this week, rising 0.16%WoW to RMB 3120/t. In

US$ terms however, prices still fell 0.3% to $433/t highlighting that the recent

depreciation of the RMB will help sure up Chinas competitiveness in the steel

export market.

China released full February commodity trade data on Friday. As per the

preliminary data, refined copper imports were 28% higher than in February

2013 at 279kt, but down sequentially from the 397kt recorded in January.

Blister imports were also up 29% YoY to 53kt, while copper scrap fell 18% YoY

to 249kt. The strength in copper concentrate imports continued, rising 12.5%

YoY to 764kt gross weight, helped by a 44% YoY rise in imports from Chile.

Chinese refined zinc imports also remained strong, up 92% YoY to 39kt,

while tin imports dropped 78% YoY to 261t as the impact of semi-processed

material from Myanmar and a closed arbitrage into China reduced demand.

Nickel ore imports totalled 3.6 million tonnes, with 3 million of these from

Indonesia despite the export ban from 12th January. In our view there is

nothing untoward here, as the volumes suggests only a half month of imports

and a 4 week shipping time from Indonesia including time waiting to unload at

busy Chinese ports is commonplace. We expect further falls in March.

The Q2 met coal contract negotiations dont look set to conclude anytime

soon, with Platts reporting BMA (BHP Billiton-Mitsubishi Alliance) are refusing

to offer a fixed price following the recent price fall to ~$107/t FOB Australia for

hard coking coal. We would expect offers from other producers at ~120-125/t

for Q2, down from $143/t in the current quarter. This would put increasing

pressure on US exports and semi-soft coal from Australia to cut output.

Macquarie Research Commodities Comment

24 March 2014 2

Macquarie Copper Survey: demand starting to emerge

Macquaries proprietary copper survey for March reveals recovering demand for copper in China,

with green shoots evident from major end-users including the construction and power sectors.

Having been destocking for quite a while, some fabricators are planning to buy more copper from

the market as they have received increasing orders and because prices have stabilised at lower

levels following the sell off. However, tight financing conditions affecting the industry should

dampen consumers purchasing capability for copper, at least until we see a full recovery in orders

from the State Grid.

There have been some supply disruptions recently, although these are more likely to slow the

growth of refined copper production than actually reduce supply. Given smelters are delivering

more copper to bonded warehouse, we are anticipating a run down in domestic inventory that

should support the domestic price relative to LME and thus improve the import arbitrage ratio

(although it may not be enough to support prices in absolute terms).

Green shoots emerging from end-users

Contrary to the ongoing headwinds facing the Chinese economy and the property sector in

particular, green shoots have emerged from end-use sectors. Our latest copper survey suggests

there has been a recovery in orders from most of the end-use sectors, with the only exception

white goods. There may be seasonality at work here intuitively, March should be better than

February due to CNY although this wasnt obvious in the data a year ago.

Interestingly, the recovery of demand from the construction sector looks healthier than what might

be inferred from the reports of ongoing difficulties in that industry. Our own channel checks with

major cable producers who supply the low-voltage power cable to real estate projects support the

findings of the survey. They have received a 10%MoM rise in orders from property developers in

April, although the YoY growth is less than 5%YoY for many of them.

Moreover, orders from the power industry also showed a pickup for the upcoming months. Some

cable producers are planning to raise their capacity utilization from sub-60% in March to over 80%

in April as they will work to fulfil the delivery of some orders to the State Grid. The second round of

tendering by the State Grid in 2H13 specified the delivery period as April 2014 for some grid

projects; meanwhile, we are hearing increasing orders from provincial grid companies in some

Eastern regions since late March. Certainly orders from grid companies are not yet in full swing,

but we are expecting more orders to come as we approach the traditional peak season of the

summer months, especially when there are some positive signals from the central government

recently with regards to the construction of key investment projects.

Fig 1 Demand has awakened after the longer CNY holiday

Fig 2 Orders from end-use sectors have started picking up

Source: Macquarie China Copper Survey, March 2014 Source: Macquarie China Copper Survey, March 2014

0

10

20

30

40

50

60

70

80

90

100

Jun-1

2

Jul-12

Aug

-12

Sep

-12

Oct-

12

No

v-1

2

Dec-1

2

Jan-1

3

Feb

-13

Mar-

13

Ap

r-13

May-1

3

Jun-1

3

Jul-13

Aug

-13

Sep

-13

Oct-

13

No

v-1

3

Dec-1

3

Jan-1

4

Feb

-14

Mar-

14

Have sales increased or decreased over the last month?

Total

Large Fabricators (>200ktpa)

Medium Fabricators (100-200ktpa)

Small Fabricators (


24 March 2014 3

The only disappointment, though well within our expectation, comes from the white goods sector

whose orders are expected to decline in the months to come. Some major air-conditioner

manufacturers plan a 5% MoM cut in their production for April after a strong production period in

March and the resultant building of inventory of finished air-conditioner units. Inventory is now

equivalent to two-to-three months of sales versus a normal level of one-to-two months of sales.

However, this fits the seasonality as they are naturally tailoring air-conditioner production for

subsequent months from a production peak in March.

Given the above, we are expecting a sequential improvement for copper demand in the traditional

peak seasons of 1H, although the same YoY strength will not be observed in 2Q14 when

compared with 2Q13.

Fabricators have been destocking

Another important reading from the survey is that fabricators have been destocking their inventory

of raw materials (refined copper) as well as finished copper semis since the Chinese New Year

(CNY) to date. They had increased their inventory of refined copper modestly before the CNY in

the fear of a potential tighten-up in the physical market in 1Q14.

However, facing a rising order book, larger fabricators, who are carrying a lower level of raw

material stock, are planning to increase spot purchase for raw material in April; whereas medium-

to-small sized fabricators are pressured by tight liquidity to maintain a hand-to-mouth inventory

model.

Meanwhile, it seems most fabricators lack confidence in a recovery of demand for a sustained

period as they are anticipating a weaker strength in their real sales for further months to come; or

to put it in another way, the inventory of finished product is expected to rise. This pessimistic

outlook probably has something to do with the recent sell-off as this survey was conducted just

after the price slump.

Some refined copper disruptions for now, but the big picture untainted

The hot topic for this week is Jinchuan Group the third largest copper producer in China which

announced force majeure on some copper concentrate purchases and the long-term contract

supply of refined copper to their customers due to technical issues at its copper smelting furnace

in Gansu Province. While there is no official release on the production impact yet, we estimate

part (not all) of their refined copper production will be impaired from this accident. In the mean

time, the large smelters in our copper survey have lowered their capacity utilization in March. Our

detailed channel check suggested that one major smelter in Anhui province scheduled

maintenance work for its 150ktpa refined copper capacity from early March to end-March.

Fig 3 Copper semis inventory is declining

Fig 4 Large fabricators are planning to step up raw material purchases


0

10

20

30

40

50

60

70

80

90

100

Jun-1

2

Jul-12

Aug

-12

Sep

-12

Oct-

12

No

v-1

2

Dec-1

2

Jan-1

3

Feb

-13

Mar-

13

Ap

r-13

May-1

3

Jun-1

3

Jul-13

Aug

-13

Sep

-13

Oct-

13

No

v-1

3

Dec-1

3

Jan-1

4

Feb

-14

Mar-

14

Is copper semis inventory higher or lower than normal?

Total



Small Fabricators (200ktpa)


Small Fabricators (


24 March 2014 4

However, the production loss from such disruption will be offset by the incremental contribution

from projects that were commissioned in 2013. We are still firm in our view of rising refined

copper supply in 2014, in particular 2H14. More production is expected from Tonglings 400ktpa

double-flash capacity (commissioned in February 2013), Jinchuans 400ktpa Fangcheng Port

Project (commissioned in November 2013), Zhongtiaoshan Yuanqus 100ktpa capacity

(commissioned in February 2014) and Yuguangs 100ktpa capacity (commissioned in early March

2014) since late 2Q14.

Apparently, the temporary slow-down of the production growth, coupled with a recovering demand,

should help to tighten the domestic physical market for copper in the short term, especially when

major smelters are delivering more copper into bonded warehouse to reap the benefit from a

negative import arbitrage ratio. We estimated around 60kt of refined copper was delivered to the

bonded area in February and there will be around 90-100kt more to go in March (physical delivery

for some of these volumes could be extended to April).

Financing conditions still looks challenging for the copper industry

The financing conditions of the commodity sector have been in the spotlight since the beginning of

this year. Regardless of the size of the company, copper fabricators are generally suffering from

tighter financing conditions, with the large-sized companies apparently being hit most. In spite of

looser liquidity for the whole financial market since CNY, the industry-wide financing condition for

copper semis and trading companies still looks challenging.

Fig 5 Refined copper production contracted further in March

Fig 6 but looks set to recover


Fig 7 Fabricators feel more financing pressure Fig 8 No improvement for traders as well


65%

70%

75%

80%

85%

90%

95%

100%

Jun-1

2

Jul-12

Aug

-12

Sep

-12

Oct-

12

No

v-1

2

Dec-1

2

Jan-1

3

Feb

-13

Mar-

13

Ap

r-13

May-1

3

Jun-1

3

Jul-13

Aug

-13

Sep

-13

Oct-

13

No

v-1

3

Dec-1

3

Jan-1

4

Feb

-14

Mar-

14

What is your current level of capacity utilisation?

Total

Large Smelters

Medium smelters

Small Smelters

0

10

20

30

40

50

60

70

80

90

100

Jun-1

2

Jul-12

Aug

-12

Sep

-12

Oct-

12

No

v-1

2

Dec-1

2

Jan-1

3

Feb

-13

Mar-

13

Ap

r-13

May-1

3

Jun-1

3

Jul-13

Aug

-13

Sep

-13

Oct-

13

No

v-1

3

Dec-1

3

Jan-1

4

Feb

-14

Mar-

14

How do you expect production to change next month?

Total

Large Smelters (>500ktpa)

Medium Smelters (250-500ktpa)

Small Smelters (200ktpa)



Medium Traders (10-20ktpa)

Small Traders (


24 March 2014 5

Our understanding of such an industry-specific financing drain is as follows: firstly, the clamp down

by banks on copper financing trades (particularly those with irregular currency flows) coupled with

the hefty import loss that exists with the current price spreads makes it very difficult for copper

consumers and traders to benefit from copper financing trades now; secondly, domestic banks are

still rationing loans to industries that are environmentally-unfriendly and energy-intensive this year

commodity related companies are clearly on that list.

According to one of the big five banks, they have been trying to cut back bank loans to private

large-sized enterprises involved in commodities since the end of 2013. Meanwhile, banks are

pressured by margins and a more stringent monitoring of the loan quota this year. As a result, they

are inclined to lend more at above benchmark rates. This explains why large copper fabricators

(privately-owned) that used to have access to bank loans at a discount to benchmark rate are no

longer able to retain such privilege nowadays and are therefore reporting less favourable financing

conditions.

Market sentiment is still fragile

Market confidence has been shaken by the sell-off in the second week of March. Our proprietary

copper survey was conducted during this sell-off, and this is likely to have influenced the results.

What we can tell from the survey is the overwhelmingly pessimistic sentiment in the market during

the sell-off which explains why there wasnt as strong physical buying at the price lows this time

compared to what we have seen in the past.

Although the market sentiment is still fragile, we do discern some positive signals sent from the

central government to the market recently. Premier Li Keqiang accentuated the need for a speed-

up for the preliminary work and construction on key investment projects with timely assignment of

budgeted funds on 19th March. While we acknowledge the possibility of some volatility in the

copper price as the market worries over potential systemic risk to property industry and the

macro-economy, we continue to expect a demand recovery for copper in upcoming months, with

some sequential improvement already seen.

Fig 9 All fabricators are pessimistic about the market Fig 10 so is the majority of traders


0

10

20

30

40

50

60

70

80

90

100

Jun-1

2

Jul-12

Aug

-12

Sep

-12

Oct-

12

No

v-1

2

Dec-1

2

Jan-1

3

Feb

-13

Mar-

13

Ap

r-13

May-1

3

Jun-1

3

Jul-13

Aug

-13

Sep

-13

Oct-

13

No

v-1

3

Dec-1

3

Jan-1

4

Feb

-14

Mar-

14

Are you positive or negative on the market?

Total




Medium Traders (10-20ktpa)

Small Traders (


24 March 2014 6

Closing price * Closing price *

21-Mar-14 21-Mar-14 20-Mar-14 20-Mar-14 % ch. day 2014 YTD Ave 2013

US$/tonne US/lb US$/tonne US/lb on day US$/tonne US$/tonne

LME Cash

Aluminium 1,682 76 1,669 76 0.8 1,709 1,845

Aluminium Alloy 1,856 84 1,843 84 0.7 1,800 1,800

NAASAC 1,891 86 1,846 84 2.4 1,819 1,831

Copper 6,489 294 6,441 292 0.7 7,098 7,322

Lead 2,053 93 2,046 93 0.3 2,112 2,141

Nickel 16,070 729 15,811 717 1.6 14,482 15,003

Tin 22,825 1,035 22,996 1,043 -0.7 22,594 22,305

Zinc 1,944 88 1,943 88 0.0 2,037 1,909

Cobalt 30,877 1,401 29,875 1,355 3.4 30,311 27,326

Molybdenum 22,000 998 22,000 998 0.0 22,630 22,925

LME 3 Month

Aluminium 1,723 78 1,712 78 0.6 1,753 1,887

Aluminium Alloy 1,888 86 1,875 85 0.7 1,835 1,828

NAASAC 1,915 87 1,870 85 2.4 1,846 1,861

Copper 6,480 294 6,430 292 0.8 7,063 7,346

Lead 2,077 94 2,069 94 0.4 2,134 2,157

Nickel 16,100 730 15,840 718 1.6 14,534 15,078

Tin 22,825 1,035 23,000 1,043 -0.8 22,568 22,318

Zinc 1,952 89 1,952 89 0.0 2,033 1,940

Cobalt 31,000 1,406 30,000 1,361 3.3 30,357 27,515

Molybdenum 22,000 998 22,000 998 0.0 22,630 22,927

* LME closing price - 1700 hrs London time. Year-to-date averages calculated from official fixes.

1,336 1,327 0.7 1,292 1,410

20.55 20.17 1.9 20.55 23.80

1,439 1,436 0.2 1,430 1,486

789 754 4.6 741 725

100.33 100.30 0.0 98.40 97.89

1.380 1.379 0.1 1.369 1.328

0.910 0.905 0.5 0.894 0.968

Change since last report Cancelled End-13 Ch. since

(tonnes) 21-Mar-14 20-Mar-14 Volume Percent warrants stocks end-13

LME Aluminium 5,414,875 5,424,975 -10,100 -0.2% 2,525,450 5,458,075 -43,200

Shanghai Aluminium 351,047 326,929 24,118 7.4% - 181,644 169,403

Total Aluminium 5,765,922 5,751,904 14,018 0.2% - 5,639,719 126,203

LME Copper 265,700 267,850 -2,150 -0.8% 119,775 366,425 -100,725

Comex Copper 12,321 11,510 811 7.0% - 15,073 -2,752

Shanghai Copper 209,901 213,297 -3,396 -1.6% - 125,849 84,052

Total Copper 487,922 492,657 -4,735 -1.0% - 507,347 -19,425

LME Zinc 780,075 785,350 -5,275 -0.7% 157,500 933,475 -153,400

Shanghai Zinc 272,739 273,700 -961 -0.4% - 238,723 34,016

Total Zinc 1,052,814 1,059,050 -6,236 -0.6% - 1,172,198 -119,384

LME Lead 200,700 200,700 0 0.0% 29,150 214,450 -13,750

Shanghai Lead 80,937 83,033 -2,096 -2.5% - 90,209 -9,272

Total Lead 281,637 283,733 -2,096 -0.7% - 304,659 -23,022

Aluminium Alloy 54,760 54,760 0 0.0% 11,860 56,440 -1,680

NASAAC 75,420 75,500 -80 -0.1% 50,940 84,860 -9,440

Nickel 283,578 283,434 144 0.1% 134,940 261,636 21,942

Tin 9,430 9,245 185 2.0% 2,185 9,685 -255

Source: Comex, LBMA, LME, Nymex, Reuters, SHFE, Macquarie Research

Exchange Stocks

Commodities Prices

Gold - London PM Fix (US$/oz)

Silver - London AM Fix (US$/oz)

Platinum - London PM Fix (US$/oz)

Palladium - London PM Fix (US$/oz)

Oil WTI - NYMEX latest (US$/bbl)

EUR : USD exchange rate - latest

AUD : USD exchange rate - latest

Friday 21 March 2014


24 March 2014 7

Summary of changes, week ended 21 MarchLME metal prices (%) Cash 3-Month

Aluminium -0.9% -1.0%

Aluminium Alloy 1.0% 0.9%

NAASAC 0.3% 0.3%

Copper -0.1% 0.2%

Lead 1.6% 1.8%

Nickel 2.3% 2.3%

Tin -0.4% -0.4%

Zinc -1.7% -1.4%

Cobalt 0.0% 0.0%

Molybdenum -2.2% -2.2%

Other prices (%)

Gold -3.5%

Silver -3.8%

Platinum -2.6%

Palladium 1.2%

Oil WTI 1.5%

EUR : USD exchange rate -0.8%

AUD : USD exchange rate 0.8%

Exchange stocks tonnes %

LME aluminium 171,175 3.3%

Shanghai aluminium 24,118 7.4%

Total aluminium 195,293 3.5%

LME copper 14,400 5.7%

Comex copper 1,746 16.5%

Shanghai copper -3,396 -1.6%

Total copper 12,750 2.7%

LME zinc -17,825 -2.2%

Shanghai zinc -961 -0.4%

Total zinc -18,786 -1.8%

LME lead -1,150 -0.6%

Shanghai lead -2,096 -2.5%

Total lead -3,246 -1.1%

LME aluminium alloy 0 0.0%

LME NAASAC -720 -0.9%

LME nickel 12,564 4.6%

LME tin 345 3.8%

Source: Comex, LBMA, LME, Nymex, Reuters, SHFE, Macquarie Research


24 March 2014 8

Macquaries commodities matrix 3-6 month view

Source: Macquarie Research, March 2014

Bulk Commodities 3-6 month view Supply Growth Demand Inventory

Coking Coal Poor Strong Stable HighLooks set to trade at


24 March 2014 9

Macquaries commodities matrix longer term view

Source: Macquarie Research, March 2014

12-month view 3-5 year view

Coking Coal Neutral GoodDespite current woes, the lack of supply growth potential sets it apart in

the bulks. $180/t a medium-term norm

Steel Poor PoorGlobal steel market continues to suffer with chronic overcapacity, which

will take years to restructure

Iron ore Neutral PoorSupply is set to grow, though will underperform expectations. Has more

longevity than thought, and will struggle to berak $100/t sustainably

Thermal Coal Neutral Neutral Demand is not a problem, but on paper plenty of supply to keep up.

Commodity 12-month view 3-5 year view

Tin Good GoodDifferentiated due the the lack of large, scaleable supply which keeps

market fundamentals tight into medium term

Copper Poor Good

Market is in surplus 2014-15. However, steep gradient at the top end of

the cost curve is underestimated offering medium-term pricing

>$7,500/t

Uranium Poor NeutralThe market will need more primary uranium supply - just not yet. In the

interim any sustained pullback in Chinese imports is a big risk

Lead Neutral GoodDemand outlook ok if not stellar, but ex-China mine supply struggling to

cope

Aluminium Poor PoorDo not underestimate the prolonged negative impact of LME

Warehousing rule changes coupled with high inventories

Zinc Good NeutralConcentrate surplus set to end, elasticity of Chinese mine supply caps

upside

Nickel Good GoodPlentiful nickel ore and NPI capacity set to see a surplus, however there

is no easy or inexpensive way to fill an Indonesian ore void

Commodity 12-month view 3-5 year view

Platinum Good GoodStronger European demand and weak supply should ensure price gains

in 2014.

Palladium Good GoodEmerging market auto demand offers more demand support than peer

platinum, while supply problems are the same

Silver Poor NeutralQuestion for silver is whether its greater use in industry can allow it to

decouple from gold. We think not, at least on a 12m view.

Gold Poor Neutral

The normalisation of US monetary policy remains a sword over gold's

head. Medium-term outlook poor until other sectors shift sufficiently to

offset investor fatigue.


24 March 2014 10

Macquarie commodity price forecasts

Source: CRU, LME, McCloskey, Metal Bulletin, Platts, TEX Report, Macquarie Research, March 2014

2012 2013 2014 2014 2014 2014 2014 2015 2016 2017 2018

Unit CY CY Q1 Q2 Q3 Q4 CY CY CY CY CY LT $2013

Copper $/tonne 7,950 7,322 7,050 6,600 6,500 6,700 6,713 6,625 7,525 7,875 7,963 6,504

Aluminium $/tonne 2,018 1,845 1,800 1,730 1,780 1,850 1,790 1,863 2,075 2,200 2,375 2,200

Zinc $/tonne 1,946 1,909 2,000 1,900 2,000 2,100 2,000 2,250 2,400 2,350 2,350 1,875

Nickel $/tonne 17,527 15,003 15,000 16,000 16,500 16,500 16,000 17,500 20,000 22,000 24,000 22,000

Lead $/tonne 2,061 2,141 2,100 1,975 2,180 2,200 2,114 2,344 2,450 2,450 2,400 1,875

Tin $/tonne 21,092 22,305 21,500 21,750 22,000 22,000 21,813 22,750 22,000 23,500 25,000 20,000

2012 2013 2014 2014 2014 2014 2014 2015 2016 2017 2018 LT $2013

Unit CY CY Q1 Q2 Q3 Q4 CY CY CY CY CY

Manganese ore $/mtu CIF 4.9 5.4 5.2 5.2 5.2 5.2 5.2 5.4 5.8 5.8 5.8 5.0

FeCr (EU contract) c/lb 121 116 118 125 115 115 118 123 130 130 134 115

Molybdenum oxide $/lb 13 10 10 10 10 10 10 10 11 13 13 13

Cobalt (99.8%) $/lb 14 13 13 14 14 13 13 15 15 15 15 13

Steel - Average HRC $/tonne 653 615 629 636 628 591 621 585 578 588 588 590

Steel Scrap - average #1HMS $/tonne 380 346 343 343 303 313 326 293 303 277 277 262

2012 2013 2014 2014 2014 2014 2014 2015 2016 2017 2018 LT $2013


Iron ore - Australian fines c/mtu fob 196 203 194 192 168 171 181 160 159 142 142 127 Iron ore - Australian lump c/mtu fob 206 217 222 221 193 196 208 180 179 162 167 147

Spot 62% Fe iron ore China $/t cfr 130 135 130 130 115 118 123 110 110 100 100 90 130 136 130 115 115 120 120 115 110 100 100 90

2012 2013 2014 2014 2014 2014 2014 2015 2016 2017 2018 LT $2013


Thermal coal - Australian Spot $/t fob 97 85 85 84 86 88 86 90 90 93 95 80

Thermal coal - S.African Spot $/t fob 92 80 82 78 80 83 81 86 88 90 88 80

Thermal coal - JFY contract $/t fob 115 95 95 90 90 90 90 95 95 98 100 90 Hard coking coal $/t fob 210 159 143 150 150 145 147 156 170 180 180 155

Semi-soft coking coal $/t fob 140 113 104 104 104 100 103 105 115 122 122 105

LV PCI coal $/t fob 153 125 116 120 125 120 120 125 135 142 142 120 Coke - China export spot $/t fob 425 258 260 270 270 260 265 270 280 290 290 270

Unit 2012 2013 2014 2014 2014 2014 2014 2015 2016 2017 2018 LT $2013

CY CY Q1 Q2 Q3 Q4 CY CY CY CY CY

Gold $/oz 1,669 1,410 1,235 1,185 1,225 1,215 1,215 1,269 1,390 1,440 1,473 1,250

Silver $/oz 31 24 20 18 19 18 19 19 21 22 23 18

Platinum $/oz 1,548 1,486 1,450 1,450 1,550 1,600 1,513 1,750 1,888 1,906 1,975 1,800

Palladium $/oz 647 725 750 775 800 825 788 850 875 900 950 800

Uranium spot $/lb 49 39 36 38 40 40 39 44 53 58 65 60


24 March 2014 11

Chinas Urbanisation Plan: sketching out a development model

Chinas central government finally released its 2014-20 Urbanisation Plan on March 16 the first

top-level government document issued specifically for urbanization in years. While lacking detail,

the report provides some important guidelines for the future path of urbanisation. Key themes

include accelerating the pace of settlement of rural migrants in urban areas, improving the energy

intensity of urbanisation and continued infrastructure development. In general, we find some of the

headline targets in the plan to be conservative and others ambitious but generally supportive of

our medium to longer term views of Chinas commodities demand.

Slowing urban migration but accelerating urban settlers

A key target in the plan is for Chinas urbanisation rate to reach 60% by 2020. This looks low and

implies a rapid slowing in the pace of urbanisation over the next 7 years. The Chinese Academy of

Social Sciences estimates that the urbanisation rate will hit 60% by 2018, which is in line with what

we are currently using in our own construction model. On our assumptions, the urbanisation rate

will hit 61.7% by 2020 this may sound like a small difference, but is equivalent to approximately

22m people (we outlined the assumption behind our construction model here).

Fig 1 The urbanisation plan implies a sharper slowdown in urban population growth than we are assuming

Fig 2 but the plan targets a much higher % of urban hukou holders among urban residents

Source: CEIC, Macquarie Research, March 2014 Source: CEIC, Macquarie Research, March 2014

More significant is that for the first time in history, the government has also taken the percentage

of urban-Hukou holders in the total population as a formal policy target setting it at 45% by 2020

(compared to 35.5% in 2012). This implies that 75% of urban dwellers would be urban-Hukou

holders by 2020, compared with only 69% in our model.

This is important the hukou system is a household registration system that divides the

population into rural and urban status. It has been used since the 1950s to regulate population

flows by denying social benefits to rural hukou holders living in urban areas. These benefits

include education, medical care, pensions. More recently access has been restricted to property

purchase in some areas. As a result of this distinction, many migrant workers holding a rural

hukou but living in urban areas have not been able to fully access an urban lifestyle, instead living

in sub-standard accommodation (see figure 3 below) and in many cases maintaining a family

home in rural areas.

The official targets have both positive and negative implications for steel demand from housing

construction. On the positive side, if the government makes it easier for rural migrants to settle

down in cities by providing social welfare facilities, they are more likely to look for better housing

conditions (and thus bigger living space) in urban areas, which would increase urban housing

demand.

However, on the negative side, given the urbanisation plan targets a lower level of urbanisation by

2020 than in our current model, fewer people would require urban housing than we are currently

assuming.

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24 March 2014 12

Another negative implication for construction that could easily be neglected is the likely reduction

in rural construction activity that could result from a loosening of the restrictions on urban hukous.

As mentioned above, it is not uncommon for migrant workers to maintain a home in rural areas

while their primary job maybe in the city if nothing else, this home and the agricultural land use

rights that are allocated to rural hukou holders, and act as a kind of insurance should they lose

their job in the city. If migrants are able to attain an urban hukou and thus gain access to the full

suite of social benefits, it should be easier for them to commit to full urbanisation and give up their

rural home. As yet, this phenomenon is hard to observe empirically as urban-Hukou status

remains relatively difficult to get, but the opposite case that a high Hukou barrier has coincided

with considerable rural housing investment is a fact. According to the urbanisation plan, rural

residential land use went up by 2mn hectare in 1996-2012, although rural population dropped by

133mn.

Our long term construction model allows us to test the impact of these assumptions on steel

demand. Plugging in the official targets has a small net negative impact on steel demand versus

our current base case, i.e., reducing implied steel demand over the 2014-2020 period by 28mt or

an average of 4mtpa, although the difference is most pronounced after 2018. We have also tested

a best of both worlds scenario, where we stick to our original urbanisation rate but use the

targeted level of urban hukou holders. In this scenario, steel demand over the 2014-2020 period is

36mt higher than our base case forecast, or an average ~5mtpa per year.

Fig 3 Widening gap between urban population and urban-Hukou holders

Fig 4 Model impact of official targets on housing construction

Source: NBS, Macquarie Research, March 2014 Source: CEIC, Macquarie Research, March 2014

A boost to consumption and copper

Along with better living conditions, rural migrants, once theyve settled down in cities, could be

expected to emulate the living styles of their urban peers too. This would likely provide a boost to

consumer durables demand as shown in figure 5 below, ownership rates of appliances are

considerably higher among households that hold urban hukous than those with rural hukous

(although it should be noted that in the NBS household survey from which this data is sourced, no

specific data is collected from rural hukou holders living in urban areas. Given the difference in

living standards, however, it is reasonable to assume that ownership rates among migrant workers

are lower than for urban hukou holders). Given that the widest spreads exist between air

conditioner ownership, this seems likely to be the biggest beneficiary which in turn provides a

boost for copper demand.

Moreover, with higher usage of household appliances amongst other drivers, urban-Hukou holders

should also be consuming more electricity than rural-Hukou holders on a per capita basis. This

should also provide a boost to copper demand as the distribution network is built out.

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24 March 2014 13

Fig 5 Ownership rates for white goods are substantially higher among urban hukou holders

Fig 6 Electricity consumption per capita is higher among urban dwellers


Potential to redress imbalances in Chinas housing markets

Given the lack of details in such a guideline document, its too early yet to assess the feasibility of

both official targets. As mentioned earlier, the 60% urbanisation rate goal doesnt appear to be a

stretch. However, the 45% target for urban hukou holders seems much more challenging, given

that the gap between urbanisation rate and the share of urban-Hukou holders in the total

population has been steadily widening since 2003.

Moreover, an additional complication arises from the fact that the plans Hukou policy guidelines

vary by city size. While restrictions for urban-Hukou status are to be fully removed for small cities

and townships, population size will remain strictly controlled in cities with over 5mn people.

A major difficulty here stems from the increased fiscal pressure on local governments to provide

more social services (mainly education, social insurances, and medical care) to rural migrants.

Good news is that the central government this time seems willing to shoulder a bigger share of the

burden by claiming that each level of the government should undertake their corresponding fiscal

responsibilities according to the division of their responsibilities for public services. However,

given that smaller cities almost certainly have less economic clout than their larger peers but look

set to take most of the burden of the rising urban population, some difficulties around funding are

almost certain to arise.

One potentially positive consequence of the emphasis on migration to smaller cities is that it may

help to redress a current imbalance in Chinas property market (indeed, this may have been a

deliberate consideration when forming the policy). As illustrated in our property teams table

shown below in figure 7 (see their report here), housing inventory levels appear excessively high

in tier-3 and smaller cities, while supply in tier-1 cities looks considerably tighter. It is probably too

optimistic to assume that the urbanisation plan will deliver an immediate fix for the inventory

situation in lower tier cities, but the policy should help ensure this issue doesnt linger into the

medium term.

In general, the urbanisation plan suggests the current leadership seems to lean more on the

market to meet housing demand (and indirectly tackle the issue of rising property prices), rather

than pushing for measures that simultaneously stifle both demand and supply as the previous

government did.

For instance, the Plan pledged to establish a housing system where the government is mainly

responsible for social housing, and the market is supposed to satisfy most of other types of

housing demand. There was also no mention of direct restrictions on the housing market except

that on high-end residential units. Such a shift of official approach seems to suggest government

policy will be becoming a smaller risk to housing construction activities in the future.

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24 March 2014 14

Fig 7 Residential inventory turnover in selected cities

Residential inventory

(units) Inventory Turnover (Year) Sales (units)

City

by Mar 2

Indicated by past week

sales

Indicated by YTD

sales

Indicated by 4Q13

sales

Weekly sales in week end

with Mar 2 YTD sales

till Mar 2

Quarterly sales in

4Q13

Beijing 57,336 1.12 1.00 0.51 981 9,881 28,267 Shanghai 65,680 0.46 0.56 0.34 2,739 20,120 47,650 Guangzhou 50,593 0.41 0.78 0.53 2,390 11,252 23,682 Shenzhen 30,588 0.57 1.15 0.65 1,032 4,609 11,837 Tier 1 average 51,049 0.55 0.77 0.46 1,786 11,466 27,859 Fuzhou 23,305 1.12 1.50 2.07 400 2,693 2,821 Hangzhou 53,149 2.18 2.30 1.42 468 4,008 9,337 Jinan 52,326 0.80 1.27 0.76 1,262 7,130 17,136 Nanjing 32,996 0.55 0.48 0.32 1,160 11,824 25,777

Ningbo 155,973 5.72 3.85 2.53 524 7,007 15,411

Qingdao 130,045 1.16 1.43 0.87 2,154 15,741 37,206 Suzhou 42,558 0.63 0.86 0.54 1,297 8,605 19,816 Xiamen 18,310 0.55 0.47 1.43 640 6,694 3,199 Tier 2 average 63,583 1.24 1.38 0.97 988 7,963 16,338 Dongguan 97,943 2.05 2.56 1.28 918 6,614 19,082 Hefei 142,718 1.02 1.26 0.88 2,684 19,590 40,649 Huizhou 16,329 0.73 0.81 0.54 429 3,483 7,624 Nanchang 43,687 0.98 0.51 0.77 856 14,928 14,139 Nanning 47,452 0.99 1.56 0.67 922 5,250 17,613

Quanzhou 72,221 2.52 2.23 1.71 552 5,605 10,573

Wenzhou 45,363 2.27 1.43 1.49 385 5,495 7,616

Xi'an 237,782 2.17 2.81 2.02 2,111 14,622 29,481

Tier 3 average 87,937 1.53 1.61 1.20 1,107 9,448 18,347

Note: Inventory turnover in Hangzhou, Nanchang, Ningbo and Hefei is based on commodity housing sales Source: Soufun, CREIS, Macquarie Research, March 2014

Figures 8 and 9 below highlight another way at looking at the current property market imbalances

in the real estate market. The charts show the ratio of growth of housing units sold to growth in the

new households by provinces, grouped into regions. From 2006-2008, East China had the highest

ratio of sales to household growth, with a ratio above 1 implying sales growth exceeded population

growth. Since 2010 however (and the onset of Wen Jiabaos property purchase restrictions), that

ratio has sunk to the lowest across China, while other regions have stayed stable. A return to a

more market-driven approach to property policy should see this ratio revert back to a level that

suggests the undersupply of the last few years is being undone.

Fig 8 There used to be more housing supply in richer provinces

Fig 9 but more recently they have looked undersupplied


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24 March 2014 15

A drive to reduce energy intensity

The urbanisation plan also pushes for higher energy efficiency and a better environment. The

issue was placed in the context of fiercer global competition for natural resources, which makes

the current urbanisation model of high inputs, high [energy] consumption, and high emission

unsustainable.

Fig 10 Urbanisation brings down energy intensity Fig 11 so does growth in GDP per capita


In a way, urbanisation and economic development per se provides an answer to the issue. As

shown in Fig 10 and Fig 11 above, the energy intensity of GDP is negatively correlated with

urbanisation and GDP per capita across provinces (see the linear trend lines). So economic

growth and rising utilisation themselves should to some extent improve energy intensity.

Part of the improvement may be coming from economies of scale as denser population would

reduce energy consumption related to transportation and heating. Indeed, the plan calls

specifically for an increase in urban density and highlights that urban sprawl will no longer be

tolerated. This should serve to tighten further the correlation between urbanisation and falling

energy intensity over the period out to 2020.

One would also guess that a concurrent shift of industrial structure towards services from

industrial activities may also be helping; however, that doesnt seem supported by straightforward

evidence Fig 12 shows very weak correlation between the rise of tertiary industry in GDP with

the drop of energy intensity.

Fig 12 Changes in energy in the energy intensity of GDP are not obviously correlated with a shift towards tertiary industry

Fig 13 After peaking in 2008, the pace of reduction in energy intensity of GDP has slowed


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24 March 2014 16

That said, Chinas economy had seen the energy intensity of GDP falling at an increasingly rapid

rate in the years before the GFC. Following the stimulus package years, the pace of this decline

has slowed perhaps as the result of new energy-intensive projects being installed. This in turn

seems related to a slower drop in national energy intensity in the past two years (Fig 13).

With the impact of the grand stimulus gradually fading and with additional emphasis on the energy

intensity of urbanisation, the acceleration in reducing energy intensity could resume, thus adding

to the momentum of falling energy intensity.

An extra push for falling energy intensity is coming from the government, which is aware of the

political and social pressure that has increased exponentially as a result of the interwoven issue of

energy consumption and industrial pollution. As we highlighted in early January (see here for the

smog in Beijing), environmental issues seem to be driving a real change in Beijings attitude

towards pollution and industrial sectors such as steel-making.

Continued push for infrastructure investment

Also relevant for commodities are the infrastructure development ideas in the Plan. Previous plans

for railway and road construction were reiterated with the aim of 1) all cities with population above

200k being connected by both railways and highways by 2020, and 2) all cities with population

above 500k being connected by high-speed railways.

In its implementation, we are likely to see a disproportionate spend occur in central and western

provinces as the government tries to keep a bigger presence in less developed areas in the

economy. This would not be new trend figures 9 and 14 show that investment in housing and

transport links has been running at an elevated rate in the less developed regions for a number of

years. As the government guidelines didnt change much this time, we should expect the same

trend to go on for a few more years.

Fig 14 Transportation infrastructure development across regions

Source: CEIC, Macquarie Research, March 2014

Meanwhile, shortfalls in existing urban infrastructures are also to be upgraded. Specifically

mentioned are pipeline networks, drainage systems, modern power distribution systems, sewage

processing plants, and central heating systems.

In summary, rather than radically altering our view on Chinas longer-run development, we find the

urbanisation plan offers the initial outlines of how some of the longer-run themes we have been

calling for will be implemented. The target on raising the percentage of urban hukou holders is

genuinely new and ambitious but will not be easy. If the government can pull it off, this plan

implies that China will remain a significant and growing consumer of commodities over the period

of its implementation.

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24 March 2014 17

JFY contract: Preparing for the lowest thermal coal settlement in five years

Annual Japanese fiscal year (JFY) contract negotiations between Japans lead negotiator,

Tohoku, and the worlds largest thermal coal producer, Glencore, commenced last week. We

expect that they will yield a settlement of circa $82/t FOB Australia. This would be significantly

down on last years $95/t and also the recent $87.40/t settlement for the much smaller January

December 2014 contract.

Fig 1 Japanese fiscal year* contract settlements, in US$ terms, basis FOB 6,322kcal GAR

Fig 2 Japanese fiscal year contract settlements, in A$ terms: Gains from FX depreciation**

*April-March (i.e. FY 2014 = April 2014-March 2015)

Source: TEX Report, McCloskey, Macquarie Research, March 2014

**Assuming FX exposure is hedged at time of settlement


An $82/t settlement would be the lowest in five years and the third-consecutive decline. Our

expectations at the start of this year were that the settlement would come closer to $90/t, on the

back of the $87.40/t settlement, which has historically guided to the FY contract, and supply

disruptions through 1Q, which were expected to keep the market tight.

However, stronger-than-anticipated supply performance from the Pacific Basin has more than

compensated for weaker shipments from the Atlantic, while demand globally has been very

subdued (warm Northern Hemisphere winters, high inventories). Accordingly, FOB Newcastle spot

prices have dropped back to the mid-$70s from $86/t at the start of the year.

Analysts frequently postulate that the FY settlement is changing or perhaps even losing in

relevance when it comes to the global market, because:

Procured volumes outside of the FY contract have risen proportionally.

Japans share of global seaborne imports is falling and in the medium-term will continue to do

so, reducing the bargaining power of Japanese utilities.

Fig 3 Recent settlements across all four 12-month strips


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Oct'11-Sep'12 126.50 123.57 2.93 22/09/2011 Xstrata-Tohoku

Jan-Dec'12 115.75 110.28 5.47 20/12/2011 Xstrata-Tepco

FY12 115.25 107.04 8.21 30/03/2012 Xstrata-Tohoku

Jul'12-Jun'13 95.00 84.98 10.02 28/06/2012 Xstrata/Rio-Tepco

Oct'12-Sep'13 96.90 85.06 11.84 04/10/2012 Xstrata-Tohoku

Jan-Dec'13 97.50 92.02 5.48 17/12/2012 Xstrata-Tepco

FY13 95.00 87.07 7.93 11/04/2013 Xstrata-Tohoku

Jul'13-Jun'14 89.95 81.20 8.75 25/06/2013 GX-Tepco

Oct'13-Sep'14 85.80 79.59 6.21 01/10/2013 GX-Tohoku

Jan-Dec'14 87.40 86.36 1.04 20/12/2013 GX-Tepco


24 March 2014 18

Fig 4 Estimated volume backing the 12-month contract strips ending

Fig 5 Thermal coal consumption by utility in 2013 (wet tonnes basis)

Source: Macquarie Research, March 2014 Source: METI, Macquarie Research, March 2014

However, it is important to remember that the JFY contracts are still estimated to back 60mtpa of

AustraliaJapan thermal coal trade and thus remain significant for the earnings of Australian coal

miners. Fortunately for them, substantial A$ depreciation since last years settlement is likely to

compensate for all of the US$ decline in the headline number (assuming producers hedge their FX

exposure at the time of settlement).

With regards to the second point, while Japans share of global demand is falling steadily, its

share of high-quality coal demand most probably is not. Globally, Japan is the only natural

customer for Australian 6,322kcal GAR product (Korea and Taiwan are mainly mid-CV markets,

while Chinese demand centres on Australian off-spec coal). Over the past 12 months we have

seen the calorific value-adjusted discount of Indonesian coal to Australian coal narrow, illustrating

that the high kcal coal segment is more than adequately supplied at present. Japanese power

companies will be hoping this bolsters their negotiating position.

Meanwhile producers may well try to drag these negotiations into late-March if not early-April,

clinging to the hope that Chinese and Indian demand stages a late recovery and pushes prices up

a couple of dollars from current levels. It is also not unknown for producers to bid up tonnes in the

market themselves in order to create tightness around negotiation periods.

Fig 6 Newcastle spot price and swaps curve*

Fig 7 Japan as % of global seaborne thermal coal demand

* As of Friday 14 March.

Source: GlobalCoal, Macquarie Research, March 2014

Source: Customs data, Macquarie Research, March 2014

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EU China JapanKorea Taiwan India


24 March 2014 19

Premiums Japanese utilities are once again set to pay a premium over the spot market at the

time of settlement a consistent feature of these contracts. They do so in order to achieve supply

security of the coal brands that they favour and get the conditions that they desire (eg, shipment

date flexibility). But while premiums are a consistent facet of contract settlement, the size of the

premium is not, as can be seen in Fig 3.

An $82/t settlement this time would represent a ~$7/t premium over the spot market rate and ~$5/t

premium over the swaps market hedge that could currently be executed over the entire FY14

period (assuming volumes are equally spaced across the 2Q141Q15 period). This would be

broadly in line with the past two FY settlements but significantly above the slim $1/t premium the

Jan-Dec 14 contract saw. More than anything, this tells us that back in December, both buyers

and sellers lacked any conviction that 4Q13 price levels would be sustained across 2014. YTD

market performance is proving them right. Meanwhile, the geopolitical concerns over Crimea and

potential knock-on impact to European energy pricing are also on the radar of Asian utilities. While

we dont expect such market disruption in the near term, it does mean Japanese coal buyers will

likely pay a premium to current spot once more.

Will we finally see miners cutting tonnes An $82/t FOB settlement will be below the

expectations many coal miners had at the start of the year, and as the $95/t current contract price

rolls off, so more tonnes will be trading at levels below break-even costs. In theory, this should

lead to management teams reviewing the ongoing viability of some operations. However, while in

our conversations with coal miners many are again crunching the math on what price level would

mean it is worth paying up for take-or-pay contracts and not shipping tonnes (as this would cause

lower losses), we are not yet at that point. Therefore, we expect the game of who blinks first to

continue and producers to continue trying to drive costs down and throughput up. The challenge

for miners is to maintain the productivity gains, many of which we would consider unsustainable in

the medium term.

The wider question around supply reductions may surround the longer-term strategy. At present,

and as is common in downcycles, miners are high grading their output and pushing more material

out this is despite what looks like a prolonged period of trading into the cost curve. We would

expect increased discussions around whether this is in effect wasting the resource base

(particularly at short life operations) when the smarter approach may be to save this for a better

market environment. With increased Asian coal burn capacity due in 2016 and the lagged impact

of slowing coal growth capex set to see output stagnate around the same period, investment

cycles again look misaligned, which may see a tightening coal market. It would take a brave

company to make a resource preservation decision at the present time, however, given the short-

term nature of the current market and the resulting need to break contracts with established

customers.


24 March 2014 20

Shanghai gold premium (discount) or London gold discount (premium)?

In recent weeks the Shanghai gold price has gone from a premium over the international gold

price to a discount. This has raised concerns that China has more gold than it needs and its call

on the international market is set to fall. While China is well-stocked with gold, the biggest driver of

the Shanghai price premium in 2013 seems to have been London-based gold ETF outflows. This

suggests it was less a Shanghai gold price premium and more a London gold price discount, and

it is the reversal of that ETF flow that has been the main cause of the recent switch in relative

prices, not saturation in the Chinese market.

At 6:30am London time on Tuesday the gold price on the Shanghai Gold Exchange (SGE) was

269.19 yuan per gram of gold. As the USDCNY was 6.1841, this was equivalent to $43.53 per

gram and, therefore, $1,354/oz. At the same time the international, or OTC, price of gold was

quoted at $1,361/oz, meaning the Shanghai gold price was trading at a $7/oz discount to it.

That gold is cheaper to buy in Shanghai than internationally is a recent thing only since late-

February. Until then, for almost all of 2013 and early-2014, the Shanghai gold price was higher

than the international gold price (Fig 1), and at times by a lot. The premium peaked at over $50/oz

in early-May 2013 and was almost as high again in July 2013 (Fig 2). Furthermore, while there

had been occasions when it had fallen to a discount, they were both small and short-lived.

What drives this premium/discount? There is a clear relationship between it and the actual

international gold price. As Fig 3 shows, when the international gold price is falling, the premium

tends to rise, and when the international gold price is rallying, as in August 2013 or in the last few

months, the premium has fallen. This would fit in with a demand-led explanation, insofar as

Chinese gold traders are price-sensitive and reduce demand when the price rises.

Yet although it is obvious to think of the Shanghai premium/discount as an indicator of Chinese

demand (with a high premium indicating very strong Chinese demand and a discount indicating

weaker demand), only on occasion has there been a clear relationship between the turnover on

the SGE (which is normally indicated to mean demand1) and the premium (Fig 3). At other times

strong demand appears uncorrelated with the premium or a leading indicator of it, and in the last

few weeks demand has remained strong whilst the premium has turned into a discount.

It is also therefore worth considering that the premium/discount will also be driven by the

availability of gold in China. Despite liberalisation of the gold market, imports of gold into China

remain controlled, with only certain entities allowed to import gold and then to quotas allocated by

the authorities, which at times might restrict supply. Conversely actual imports into China were

very large in 2013, and it is widely thought that stocks of gold, some of which might be readily

available to the market, are high. One also has to account for China being the worlds largest

miner of gold, and this metal also has to be absorbed on an ongoing basis. Thus the

premium/discount might reflect the relative strength of demand to available supply, and therefore

the current discount might suggest, even though demand is strong, that supply is even stronger.

1 Whether or not it, and the closely related SGE deliveries, can be so interpreted is open to debate.

Fig 1 Gold price, SGE & international (OTC) gold price, $/oz

Fig 2 Shanghai gold premium (discount) over international gold price, $/oz

Source: Bloomberg, SGE, Macquarie Research, March 2014 Source: Bloomberg, SGE, Macquarie Research, March 2014

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24 March 2014 21

This sounds quite bearish, and while given bullion exports are all but banned from China, a flood

of gold exiting the country is highly unlikely, and it might mean Chinas imports of gold will start to

fall in coming months. Another possibility, however, which is less bearish, and, put simply, that we

are viewing the market the wrong way around, is that the international OTC price, most commonly

traded in London or NY, is at a discount/premium to the Shanghai price, and not the other way

around.

Fig 5 shows the Shanghai premium against the rolling exchange-traded fund inflows/outflows over

the previous month. There seems a clear relationship: when ETF outflows go up, the Shanghai

premium rises; when they fall, the Shanghai premium falls. In recent weeks ETFs have seen

inflows on a month-on-month basis for the first time since end-2012, and the Shanghai price is at

a discount. But it is hard to see why the decision to sell gold from ETFs vaulted in London would

cause the Shanghai price to rise to a premium; it makes much more sense that it would cause the

London price to fall to a discount, as holders lower their selling price to offload the unwanted gold.

Similarly recent ETF purchases seem unlikely to have caused the Shanghai price to go to a

discount; much more likely is they caused the London price to go to a premium.

Fig 3 Shanghai gold premium (discount) over international gold price & international gold price (inversed), $/oz

Fig 4 Shanghai gold premium (discount) over international gold price & SGE gold turnover, tonnes/week

Source: Bloomberg, SGE, Macquarie Research, March 2014 Source: Bloomberg, SGE , Macquarie Research , March 2014

Fig 5 Shanghai gold premium (discount) over international gold price, $/oz, and rolling ETF inflows (outflows), inversed, tonnes month

Source: Bloomberg, SGE, Macquarie Research, March 2014

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24 March 2014 22

We wouldnt take this analysis too far. That the Shanghai price is the real price of gold and the

London/NY price trades at a discount/premium seems unlikely. After all those two markets are

much longer established than the Shanghai market and, most crucially, have far fewer

impediments to gold trading and transfers. Chinas capital controls and near ban on bullion exports

must severely limit its price-discovery mechanism. Furthermore the flows of ETF gold is never

going to be the only thing driving the relative prices between the two markets, and the

premium/discount will reflect many other factors that are constantly changing eg, recently the

depreciation of the yuan. Nevertheless it is a reminder that the gold market is a global one and a

simple focus on the Shanghai premium/discount as a guide to Chinese demand without an

understanding of other global flows could be highly misleading.


24 March 2014 23

Zinc rally faces China headwinds

Zinc prices on the LME have outperformed both copper and aluminium in 2014, selling off only

recently. But Chinese zinc prices have performed less well and as a result the import arbitrage for

zinc has been closed since late-2013. By end-February 2014 the import loss for zinc was around

$200-300/t, which means that even the least costly of financing trades would need to yield 12-15%

annualised interest to breakeven. The spread narrowed at the end of last week as Chinese zinc

prices fell but the import arbitrage remains closed. This, coupled with increasing supply from

domestic smelters should reduce Chinese import volumes in zinc even when demand recovers,

which in turn should cap LME zinc prices.

Fig 1 LME Zinc outperforming peers YTD before this sell-off

Fig 2 Despite the sell-off, the arbitrage is still closed for importing physical zinc

Source: LME, Macquarie Research, March 2014 Source: LME, SMM, SHFE, Macquarie Research, March 2014

Chinese zinc smelters are well stocked

Chinese smelters are well stocked with zinc concentrate at the moment, with major zinc smelters

currently holding over 2 months use. The easy availability of concentrates is illustrated by

relatively high and stable TCs for both domestic and imported concentrate since late 2013:

domestic TC is currently quoted at RMB 5200-5300/t FOT and the imported TC at $130-140/dmt

Shanghai CIF. However, although TCs are still at high levels, the negative import arbitrage is

undermining smelters appetite for imported concentrate, especially as there is sufficient supply of

domestic material.

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$/t Physical import loss for refined zinc

Fig 3 TCs are still at high levels Fig 4 SHFE zinc inventory increased by 35kt YTD

Source: SMM, Antaike, Macquarie Research, March 2014 Source: SHFE, Macquarie Research, March 2014

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24 March 2014 24

There has also been some build-up of refined zinc stocks in China, but the inventory overhang is

much milder than in 1Q12 and 1Q13, when zinc smelters were struggling with over two months of

refined zinc inventory. This year, some smelters in Central and Northern regions where demand is

relatively muted due to the prolonged off-season in the winter period are holding around two

weeks of inventory.

With a lower stock level at smelters, the bulk of inventory build-up for refined zinc is well captured

by warehouse data. We estimate there was a roughly 100kt increase of refined zinc stock in

reported domestic warehouses by early March, of which 35kt was in SHFE-listed warehouses. In

bonded warehouses, the firmly-closed import arbitrage ratio in January/February brought about a

20kt rise of zinc inventory in Shanghai bonded area.

More refined zinc production will come

Capacity utilization at the zinc smelters was low in February, due to some maintenance work

during the traditional CNY holiday. At present, the industry is running at ~75% utilization, with

larger smelters operating at full capacity but with some capacity in Southwest China region having

been idled.

Sufficient concentrate supply and relatively healthy inventory of finished product (at the smelters)

means we are expecting a further sequential production ramp-up for refined zinc in coming

months as more smelters come back from maintenance. In addition to this existing capacity

ramping up, Chihongs new 140kt capacity for refined zinc (commissioned at end-2013) and the

restart of Baiyins idled 200ktpa capacity at end-March will add to supply volumes.

Galvanised steel output is running ahead of end-use demand

The demand situation for galvanised steel is mixed. Our recent steel survey indicates a good order

book from the manufacturing industry, in particular the auto sector. We are also hearing about

improving demand from zinc oxide plants and die-casting factories. But weak demand from the

construction sector, which accounts for 60% of zinc demand, dims the overall picture significantly.

Despite this, galvanisers are gradually ramping up their production to above 75% capacity

utilization nationwide from sub-50% during the CNY. This is largely because galvanised steel

mills are heavily dependent on bank loans, so they have to maintain a certain run-rate to generate

the cash flow required to fulfil their obligations for interest payments. A direct consequence of this

has been the inventory build-up of finished galvanised sheet at mills, from a level equivalent to

less than one month of sales before the CNY period to 1-2 months of sales at present.

Given the current price differential between galvanised steel and HRC is around RMB 1100/t,

private galvanised steel mills are still able to generate positive cash flow. However, the rising

inventory at mills will squeeze this, and make any further increase in capacity utilization unlikely

until the demand from construction industry, the largest end-use sector, recovers.

There are also a few non-price-related reasons for some production disruption in the Shandong

region, where local galvanised steel mills are only operating 50% capacity at present. The main

one is banks stringent credit rationing to the industry triggered by the recent bankruptcy of two

galvanised mills. Given the current outlook, it will likely take a while for local private galvanisers in

the region to come back to normal operation.

For 2014 as a whole, we are still expecting the galvanised sheet capacity to grow by around 150kt

or 2.4% YoY, although this marks a continuation in the sharp slowdown of new capacity additions

seen in recent years. What expansion there is will be mainly for hot-dipped galvanised sheet lines

in Eastern and Northern region of China, although a number of planned projects are likely to take

longer to come onstream given the current stringent bank credit to the steel industry.

Overall, with domestic zinc supply expected to rise as smelters ramp up production but

galvanisers sitting on increasing stock and demand from construction remaining muted, it is hard

to see why the Chinese market should tighten further in the near term. The import arbitrage will

need to continue to improve to incentivise Chinese buying, but in return the fundamentally justified

price in China is likely to undermine the strong rally above $2000 in the LME zinc price.


24 March 2014 25

Fig 5 Galvanised mills are still able to make money on cash basis

Fig 6 Galvanised sheet capacity continues expanding

Source: Mysteel, Macquarie Research, March 2014 Source: Mysteel, Industry sources, Macquarie Research, March 2014

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Electrolyic galvanised

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Hot-dipped zinc galvanised


24 March 2014 26

Important disclosures:

Recommendation definitions

Macquarie - Australia/New Zealand Outperform return >3% in excess of benchmark return Neutral return within 3% of benchmark return Underperform return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield

Macquarie Asia/Europe Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return +10% Neutral expected return from -10% to +10% Underperform expected return 5% in excess of benchmark return Neutral return within 5% of benchmark return Underperform return >5% below benchmark return

Macquarie - USA Outperform (Buy) return >5% in excess of Russell 3000 index return Neutral (Hold) return within 5% of Russell 3000 index return Underperform (Sell) return >5% below Russell 3000 index return

Volatility index definition*

This is calculated from the volatility of historical price movements. Very highhighest risk Stock should be expected to move up or down 60100% in a year investors should be aware this stock is highly speculative. High stock should be expected to move up or down at least 4060% in a year investors should be aware this stock could be speculative. Medium stock should be expected to move up or down at least 3040% in a year. Lowmedium

6_macquarie commodities comment

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