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Krishnan Thiagarajan

THE stock price of Hindalco Industries, the non-ferrous metal powerhouse, has dropped by over 25 per cent since end-April and settled at Rs 890.

Before this fall, the stock price had soared over the past year. Such a rise and fall is no isolated instance. Other commodity stocks such as Tata Steel, Steel Authority of India and Sterlite Industries suffered a similar fate.

As the BSE Sensex declined by about 11 per cent over this period, what explains the sudden reversal in market sentiment in large-cap commodity stocks as an investment class? One explanation could be that in end-April, the Chinese Government, feeling that its economy was growing too fast for comfort, initiated the first tentative measures to "cool it down". All of a sudden, it seemed the "China factor," which had provided such a firm underpinning to the commodity stock spiral, no longer seemed to rest on such a solid footing.

Was this reason enough for investors churn their holdings in commodity stocks? To put this issue in perspective, it is important to examine the position that the Chinese economy has come to occupy in the global arena.

Since 2001, the industrial output of most of the developed world, including the US, has been flat or down. Instead it has been Chinese economy that has been responsible for a preponderant share of the incremental industrial demand. And the spectacular industrial growth recorded by China has been the primary factor fuelling demand for industrial commodities from across the globe.

As China has been a relatively "resource poor" country, its voracious appetite for key industrial commodities ranging from copper, aluminium (including alumina), and steel (including iron ore) to polymers has led to an unprecedented surge in imports and a runaway trend in global commodity prices.

With the Chinese government applying the brakes to slow the economy, at the moment there is only limited cause for concern. But in the months ahead, if the Chinese economy falters in this attempt, the international commodity markets could take a knock. In this backdrop, it may be interesting to examine where China stands in the global industrial commodity pecking order and how Indian commodity companies can be affected, if that country works forcefully at "cooling down the overheated economy".

But mind you, this trend in global commodity prices may be applicable over only a one-year time frame:

Non-ferrous metals — a mixed bag

The China effect in aluminium

According to the database of Alcan, one of the top aluminium producers, China's primary production of the metal grew at 24.8 per cent on an annualised basis between 2000 and 2003. Of the total global smelting capacity of 30.8 million tonnes in 2003, 6 million tonnes were in China. And between 1995 and 2002, China accounted for nearly 40 per cent of the total net increase in the production of primary aluminium worldwide.

The primary aluminium consumption growth between 2000 and 2003 was 13.8 per cent on an annualised basis, with 16.8 per cent and 22.4 per cent growth in 2001-02 and 2002-03 respectively. Any attempt by the Chinese Government to rein in demand or curb the rampant supply creation for aluminium may depress prices or at least keep them volatile in the near term. Since mid-April, when aluminium touched a high of $1,826 a tonne on the London Metal Exchange, cash prices have dropped by nearly 15 per cent.

Implications for Indian producers

In the near term, the volatile aluminium prices will affect realisations of producers such as Hindalco, National Aluminium (Nalco) and Bharat Aluminium (of the Sterlite group). Moreover, with the domestic tariffs at 10 per cent (and abolition of 4 per cent special additional duty), the differential between the landed cost and the domestic prices may shrink further. This may put pressure on these producers to sell at lower prices in the domestic market.

... in copper

China has become the world's largest user of copper. Its share of the world's copper demand rose from 6 per cent in 1990 to 12 per cent in 2002 and exceeds 20 per cent now. It is significant to note that in 2003, China recorded a 23 per cent growth in copper consumption over 2002 when the US and Western Europe were in the negative territory. Clearly, if the copper market fundamentals have improved significantly, it is largely due to the jump in Chinese consumption and to some extent due to planned/unplanned mine cuts. If China's incremental demand slows, international prices of copper may suffer a decline. Copper prices have slumped by 14 per cent at the LME after reaching an eight-and-half-year high of $3,110 a tonne in mid-April. Since May 2003, prices have risen 65-70 per cent till early April. In the near term, a bearish trend is likely to persist. But two factors will dictate the price movements. One, since the supply deficit in Asia (relative to demand) is widening, a slowdown in demand may not result in a sharp drop in international prices. Two, much would hinge on the scale of reduction, and the nature (copper cathodes versus concentrates) of, imports by China in 2004.

Implications for Indian producers

For the two key Indian producers of copper — Hindalco and Sterlite Industries — the implications may, to a large extent, be neutral in the near term.

Custom smelters such as Hindalco or Sterlite derive their revenues from spot treatment/refining charges (TC/RC). If China decides to reduce its copper concentrate imports, which rose an unprecedented 35 per cent year-on-year, the availability of concentrates in the market will improve.

This, in turn, will push up the TC/RC that had had touched historic lows in 2003. Second, as Asia continues to face a huge supply deficit in copper, Hindalco and Sterlite will be able to step up exports to this region. For instance, in 2003-04, Hindalco's exports of 96,726 tonnes of copper was higher than the domestic sales of 80,955 tonnes and deemed exports at 17,449 tonnes. The international copper prices may be lower, but the producers will be compensated to a large extent by higher TC/RC.

Steel: Tougher to export

China factor in Steel

China has a steel production capacity of 260 million tonnes, which is expected to rise in a phased manner to 330 million tonnes in 2005. This is larger than that of the US and Japan combined.

Given the massive demand coming up in the light of the 2008 Olympics, China has been importing raw materials for steel at a frenetic pace and in 2003 remained one of the largest importers of steel (particularly iron ore) at the global level.

With its own iron ore extraction enough to produce only 90 million tonnes of steel, it has developed a voracious appetite for iron ore to satiate which it looking as far a field as Brazil.

Moreover, China's share of the global steel consumption has risen from 13.5 per cent in 1995 to 31 per cent in 2004. But this spell is likely to be broken as steel will be one of the key industrial commodities whose imports may be curbed in the "cooling down" process the Chinese government has initiated. But changes in the quantity and mix of demand will determine the nature, grade and extent of decline in international prices.

Impact on Indian producers

While declining prices are bound to affect the realisations of the Indian steel producers, it may not be too worrisome. Of far greater concern for the main Indian steel producers such as Tata Steel, Steel Authority of India and Essar Steel may be the loss of export opportunities that China had opened up.

Though the scale of exports vary among these three key players, the flexibility offered by exports had definitely helped them over the past year. This will be an issue especially if domestic demand which is showing signs of firming up slackens for any reason.

Petrochemicals: Minimal impact

The China impact

The prices for a host of polymers such as polyethylene, polypropylene, PVC, POY and PSF are still considerably lower compared to the last up-cycle, in 1995-96. As no significant new capacity additions are expected globally in the next few quarters , even if China slows down and the incremental demand suffers, petrochemical prices may not be significantly affected.

Anyway, as international capacities are aligned to demand, international prices of polymers, may, even in the worst case, be maintained at current levels.

Impact for Indian producers

Since the international prices of polymers are expected to remain stable, the domestic prices will move in tandem.

From a margin perspective too, the two key Indian producers — Reliance Industries and IPCL are well placed — since they are fully integrated from raw materials to finished polymers. Hence, the firm raw material prices (namely naptha) may not affect them significantly.

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