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The country with the biggest impact on commodity prices

20 February 2018

Rob Crayfourd, portfolio manager at New City Investment Managers, reflects on impact of Chinese trade and environmental policies on commodity prices.

By Rob Crayfourd,

New City Investment Managers

China is a major driver of global commodity markets, but where the discussion always used to be about demand, a new environmental focus is significantly impacting both the supply and demand sides of the equation.

There are many reasons to be positive on Chinese commodity demand. Firstly, commodity demand will grow with Chinese GDP. Tightening environmental regulations are also increasing China’s reliance on imported raw materials. In addition, the Chinese 'Belt and Road' initiative, a multi-trillion dollar infrastructure programme to better connect Asia, will lead to an incremental demand over the next decade.

China’s environmental transition has primarily been driven by deteriorating air quality and dissatisfaction among the increasingly wealthy urban areas.

Premier Xi Jinping has taken this very seriously and is championing a new environmental policy throughout the country and repeatedly stating that it will keep up its battle on smog with an aim of having “blue skies”. Although air quality is one aspect, water quality and the protection of farm lands are also important.

As an economy develops and its population becomes wealthier, quality of life becomes an increasingly important factor. When a population is struggling to feed their families, air quality is further down the priority list, but as they become more affluent they increasingly focus on those factors such as health and well-being.

This was seen in London in 1956 with the introduction of the Clean Air Act to tackle excessive smog, and in 1988 when the California Clean Act was enforced. The key difference is the speed with which China can enact change; the western world has typically taken decades to fully transform their economies, but central planners in China are implementing such regulatory and policy change much more rapidly.

One beneficiary of tightening emission controls is an improved demand for greater quality coal, as its higher calorific content reduces the quantity required to generate the same amount of energy, thereby reducing emissions.

Although China is a major producer of thermal coal to generate power and metallurgical coal for steel production, their domestic products are typically of lower quality than from international markets. Australia, from whom they are increasing imports, is displacing their domestic coal. This dynamic has also been seen for iron ore and metals such as zinc.

Uranium will also be a key beneficiary as China continues its rapid build out of nuclear reactors, an important source of predictable carbon free base load power. The build-out of renewable sources is material, but the variability of power delivery means gas peaking units are required to offset output troughs from renewables which in turn generates carbon, albeit at a far lower level than coal. Development of an extensive ultra-high voltage electricity transmission network to distribute power more efficiently also requires large quantities of copper and aluminium.

Tightening environmental practices and China’s crackdown on corruption, which previously allowed polluting waste such as tainted water to be released into the environment, is increasing domestic production costs and forcing many operations to close.

However, this is placing greater reliance on imported raw materials and is supportive for metals such as zinc where China is a major but diminishing producer. This also complements the prices of such commodities globally and improves the earnings of international producers that will also see an increased share of output destined for China. Adopting responsible mining western mining standards will substantially reduce environmental impact, but requires additional spending.

Underlying demand remains relatively stable, growing with GDP. A rule of thumb which can be used is that China constitutes roughly 50 per cent of global commodity demand, varying between commodities. It is never quite that simple as China is a major manufacturing hub, so whilst China imports 47 per cent of global copper, it is also the largest manufacturer and exporter of copper intensive products such as air conditioning units.

We believe China’s environmental policy is having a material impact and provides an additional tailwind for the current positive commodity outlook.

Rob Crayfourd is portfolio manager at New City Investment Managers. The views expressed above are his own and should not be taken as investment advice.

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