From Our Briefings Newsletter

Published on24 SEP 2018
China Commodities Sustainability

The article below is from our BRIEFINGS newsletter of 24 September 2018:

Briefly . . . on China’s Environmental Initiatives and the Impact on Commodities 

China’s environmental initiatives are rippling through the global commodities market. We sat down with Goldman Sachs Research’s Trina Chen who explained why China’s latest policies were a key topic of conversation among the company executives, industry leaders and investors who convened at Goldman Sachs’ Asia Commodities Conference, which was recently held for the first time in Shenzhen.

Trina, can you explain the background behind China’s environmental initiatives and how they are connected to commodity prices?

Trina Chen: China’s government started to crack down on pollution around 2013, when Beijing experienced some of the worst air pollution in decades. The public outcry that followed spurred the government, led by President Xi, to impose strict controls on air pollution through its first “air act,” which included quantifiable targets for air quality improvement. This effort, combined with supply-side reforms, led to cuts on capacity across the commodities sector, including steel, coal and basic metals. As a result, commodity producers — which have long operated with excess capacity — found themselves operating instead with capacity constraints, leading to tighter supplies and higher prices.

Do you expect these effects to last?

TC: We believe these higher prices are more sustainable given policymakers’ long-term focus on the environment. Take, for example, the Chinese steel industry. This is a sector that has typically been saddled with excess capacity, producing more steel and other goods than is otherwise needed. Not only has the industry eliminated most of the excess capacity due to the government measures, the steel factories are running at close to 100% capacity and Chinese steel exports are at almost half the levels they were just a few years ago.

The changes we’re seeing on the supply side as a result of these initiatives are unprecedented in terms of both scale and sustainability, and are clearly impacting the broader Asia-Pacific region and the global commodities market. Since we’re in unknown territory, it’s a subject we’re getting the most client inquiries on.

Can you talk about China’s efforts to develop clean energy?

TC: The investment in clean energy is clearly one of China’s major government initiatives and a way to reduce the country’s dependency on oil, coal and other fossil fuels. Electric vehicle production is experiencing robust growth. Year-to-date output in EVs, for example, grew 75% year-over-year, although that growth is still off a small base. It’s likely to be another 10 years before EVs become cost competitive with other automobiles and represent a meaningful part of the market. That said, the demand for EVs is starting to benefit pockets of the commodity sector, such as cobalt, lithium, nickel and copper, that make up EV-related batteries.

All of these environmental initiatives require investments that will likely result in higher commodity prices down the road. How is the industry responding?

TC: By and large, these environmental investments, as well as new regulations such as the International Maritime Organization’s or IMO’s plan to enforce a cap on marine fuel sulfur emissions by 2020, are inflationary and carry the risk of tamping down demand. The investments to make the global shipping industry compliant with the new IMO rules will translate into higher fuel costs, as well as higher raw material costs for the refining, chemicals, mining and industrial sectors. So far in Asia, we’ve seen the majority of the commodity price hikes being absorbed further downstream in the value chain and by consumers, so we haven’t yet seen much response in demand. But all of these initiatives — against the backdrop of a trade war — are inflationary and impose medium-term risks.

It’s important to note that Chinese commodity firms — given their pricing power — are seeing strong profitability, improving balance sheets and higher cash flow generation. And because many have reduced their capex expenditures, dividend payouts are also trending up — a factor that hasn’t yet been priced into the companies’ stocks. We believe these conditions are sustainable over the long term given the government’s multi-year environmental mandates.

So are China’s clean energy initiatives working? How much real progress is being made?

TC: China has come a long way in reducing its levels of air pollution. The government has identified clear, quantifiable environmental targets as part of its Five-Year Plan through 2020, as well as over the long term. For example, the concentration of particulate matter pollution, known as PM2.5, was about 90 to 100 micrograms per cubic meter in 2013. Today, the national average is about 50, versus a long-term target of 35. To put the numbers in context, if you go to a US city such as Boston, you would typically see a PM of 2 or 3. So there’s still a long way to go. But from a layperson’s perspective, there are more ”blue sky” days when you visit cities such as Beijing, so there is clearly progress being made. And while the environmental efforts prioritize air pollution control, China is also embarking on a multi-effort approach to improve water quality and reduce soil pollution.