Tuesday, July 17, 2012

Develop the West (西部大开发): Michael Komesaroff on A Tale of Contrasts--China, Aluminum and Cooper

Michael Komesaroff, principal of Urandaline Investments, a consultancy specializing in China’s capital intensive industries, and a former executive in residence at the School of International Affairs, Pennsylvania State University, has produced an excellent presentation China's position in the markets for aluminum and copper, "A Tale of Contrasts:  Aluminum and Cooper," that he presented at Macquerie Capital in Beijing, China in May 2012. 

Of particular interest in the presentation was a reminder of the importance of dis aggregating Chinese metals sector performances in analyzing China's global position in metals markets, and the effects of these differences on State Council approaches to the application of the "go out" (走出去战略) policy and the equally important but less well understood "Develop the West" (西部大开发) policy for each.   This post presents a summary of Mr. Komesaroff's presentation.

Komesaroff starts with the contrasts in the relationship between China and markets in aluminum and cooper.  For that purpose, Komesaroff first looks at the structure of China's aluminum industry  and the five year outlook for China's aluminum production in the structuring context in which China is the world's largest producer of aluminum.  He then looks at the structure of the cooper industry, focusing on China's consumption of copper in a context in which China is now the world's largest consumer of copper but where the uses of cooper are safe from substitution with aluminum.   

Aluminum prices have been flat (at about $2000 LME 3M ($ per ton)) but copper prices have exploded (as have the prices for other metals and ores) (from $2000 to about $9000 LME 3M ($ per ton).  

(Pix credit Reuters Luke MacGregor; from Susan Thomas and Josephine Mason, Copper surges as shorts run for cover, Reuters (June 30, 2012) "Copper surged over 4 percent on Friday, its biggest one-day gain since November, as the latest euro-zone rescue deal boosted a broad range of commodity and financial markets with investors scrambling to cover short positions.")

But they are two quite distinct base metals.  The differences become even more apparent when Chinese interests and positions are brought into the mix. China is the dominant producer and consumer of aluminum .  There are relatively low barriers to entry and it is a price elastic consumer metal. In contrast, China is the dominant consumer of copper.  There are high barriers to entry and it is a price inelastic industrial metal. Komesaroff then elaborates:

China's aluminum production has grown by a factor of five over the last decade from  just over 0.15 (Mt) in 1999 to just under 1.8 (Mt)  in 2012 (with just a small dip in 2009).  China accounts for about 40% of global production, making it the world's dominant aluminum producer. The Aluminum sector has been characterized by low barriers to entry and to even lower exit barriers. But not much is left after paying for power, alumina and carbon. The average Chinese power tariffs have more than doubled in the past seven years, which has increased production costs by ¥4,200 per ton. This is important because global aluminum prices appear to be driven by the price of energy. Yet the Chinese have managed to produce  aluminum facilities that are among the best in the world, especially with respect to the energy efficiency of their smelters.

Despite the apparent opposition of the government, China's aluminum sector continues to grow.  The reasons provide a window on the flexibility of regulation within China, where what Beijing wants may not be effectively or promptly translated into action well away from the center.  First, about half of the smelters are wholly or partially owned by local governments which offer generous incentives. Second, technical innovation used to overcome size and energy decrees have partially offset the rising cost of power.  Third, investment in integrated power stations insulates from some decrees and assures uninterrupted power. Lastly, the low cost of project delivery and cheap finance reduce the risk of defying the central authorities in Beijing.    

And, indeed, most aluminum production occurs well away from central authorities in Beijing.  In 2010, production centered in Heinan, and then looped around the northern fringes of the PRC--Inner Mongolia, Gansu, Ningx and Qinhai and then down the spin of central China--Sichuan, Yunan, Guangxi, Guizhou, and Shanxi.  However, there appears to be a westward movement in development.  Because of more competitively priced power, the aluminum sector appears to be starting to move to Xinjiang. It is a still largely undeveloped region, but with rich deposits of coals.  It also has a restive ethnic minority population.  However, movement to Xinjiang accords with Beijing's "Develop the West" or "Go West" policy.  According to the China Daily in 2011:
   China's "Go West" strategy, launched just before the country's entry into the World Trade Organization in 2001, has been a milestone in the nation's economic development.
The aim was to boost the poorer western parts of the country that had so far not enjoyed the economic benefits of China's opening up to the outside world.
Since then, some $325 billion has been invested in major infrastructure projects in the western region, one of the biggest economic regeneration programs of all time. (From 'Go West' policy is an economic milestone for nation, China Daily, December 9, 2011).
As a consequence, development in Xinjiang reduces power tariffs as well.  Lower power tariffs of (¥200 per MWh) more than offset the additional costs of freight and capital with a cash cost of ¥13000 cf ¥16000.  More importantly, smelters can be built to more effectively utilize power by integrating power sources directly into the smelter and avoid the need to draw power from the grid.  The expectation is for more than 10 Mtpa of productive capacity by 2015, built mostly by experienced producers.  There will be little likelihood of errors. As a consequence there is a possibility of achieving cashing savings approaching ¥3400 per ton--a compelling set of arguments to relocate to Xinjiang.

Copper is another matter, though one where Komesaroff still belives there are compelling reasons to be positive.  First, China remains the key to future copper demand and the outlook is still positive.  Second, forecasts of demand destruction have been over done; they lack appropriate recognition of new applications of copper.  Third, new capacity projects continue top slip, as does current supply due to water, power shortages, strikes and the like.   Komesaroff noted that while the rest of the cooper world stood still, Chinese consumption expanded. China now accounts for more than 40% of global copper consumption, from less than 10% on 1995. As the world's largest consumer of refined copper, China is now a key driver of demand. The United States, Japan, and Korea are substantially less significant by contrast. Over 60% of China's copper is used in price inelastic industrial applications. But these semm to be in areas where Chinese industry is moving decisively.
New-energy-related industries will be the main contributor to growth in copper consumption during the next five years, according to the International Copper Association.

Meanwhile, low-carbon-related businesses, including solar and wind power generation equipment as well as electric vehicles and batteries, will contribute at least 20 percent of that increase, Victor Zhou, the association's China and Southeast Asia president, said at the International Metal Solar Industry Alliance conference in Beijing.

An electrified society will hugely boost demand for copper, according to Zhou. Use of copper in wind and solar power equipment could be four-to-six times higher than that in coal-fired projects, he added. But cables, which consume more than one million tons of copper, will remain the largest contributor to consumption.

(Victor Zhou, From Liu Yiyu,  New energies to lead copper growth, China Daily,  Nov. 16, 2010).

For all that, Komesaroff argues that China's copper demand seems insensitive to price.  And China's consumption of copper has a strong correlation to fixed asset investment. The price inelastic power industry appears to account for half of China's copper demand, and indeed, copper is the backbone of any modern power system.
Copper is used in generator windings, distribution transformers and reticulation (bit not in transmission). Transformers are a mass of copper and special steel, about 60 tons of copper per 1 gross value added (GVA).  Every 1 GW of generating capacity requires 3 to 5 GVAof transformer capacity.  Generators use around 1 ton of copper per 1 GW. And thus the planned increase in grid expenditure is very good for copper.  The Chinese State Grid Corporation is the world's largest purchaser of copper.  SGC purchased 1.15 to 1.25 metric tons of copper in 2011, up slightly form 2010.SGC's new five year plan provides for a ¥2.55 trillion expenditure on grid, up 68% from the previous five year plan. This five year plan is based on programs not investment, according to Komesaroff, so grid investments will not be affected by copper price. This makes a lot of sense, Komesaroff suggests.  Following a rapid build in capacity, it is time for China to develop a copper intensive grid.  China has under invested in transmission and distribution, compared to generation.  Transmission and distribution account for just under 60% of investment in the U.S., the U.K. and Japan, but only just over 20% in China.  

Aluminum is not a substitute for copper in electric power systems.  Komesaroff explains why: With 62% of copper's conductivity, aluminum transformers would have to be much larger than copper ones.  Aluminum cannot handle fluctuating magnetic forces as well as copper suggesting the possibility of a high failure rate from broken windings. Copper is much easier to work with than aluminum.  Aluminum windings require more specialty steel in the transformer core, again adding to the cost.  Many authorities prohibit the use of aluminum wire because it may present a safety hazard when overheated or when connections loosen. And, in any case, substitution is a long term problem rather than an immediate concern. More over the difference in the coefficient of thermal expansion causes aluminum to expand and contract at a different rate to copper which is used in fittings.  Aluminum is subject to creep (it ¡deforms) under sustained pressure and more so at high temperature. Lastly, the use of copper avoids corrosion from use of dissimilar materials.  Even if all of these problems could be overcome, substituting aluminum for copper is a very long term action; and indeed, there is little evidence of substitution.

So the immediate future--China will continue to put pressure on global copper markets raising copper pricing as its seeks to expand its pose infrastructure and as new uses for copper make the metal more useful to industry.  Aluminum serves as an example of the connection between public policy--in this case the management of the western provinces of China, and economic policy. In both cases, Chinese domestic policy appears to increasingly produce global effects on markets and production.

No comments: