Copper vs. Steel Demand & Price Implications In A Consumer Driven China ::Citi

 China in Transition — Our economists argue that China is on the cusp of an imminent rebalance towards consumer-led
growth. Indeed investment to GDP which peaked at a record 49.7% in 2011 has begun to roll over, falling to 47.5% in 2012.
Such a rebalance is clearly negative for early cycle commodities such as steel and iron ore, while copper should be relatively
resilient due to its late cycle demand profile. In this note we quantify the impact of this transition on demand and prices.
 Credit could be key — Declining returns are likely to force capital away from investment and towards consumption. Between
2008-2012 total social financing, the broadest measure of credit extension, accelerated from 130% of GDP to 186%.
Profitability of investment has been sacrificed as excess credit has had to chase lower returns. The ratio of credit required to
generate a unit of GDP averaged 2.4x in 2009-2011, up 71% on pre-crisis levels. Unsurprisingly, the credit to commodity
relationship is strong as the lion’s share of investment went into infrastructure spend. Copper and iron ore display a strong
relationship with credit growth with R2 of 65% and 67% respectively. The declining efficiency of credit is reflected in the
increasing amount of funding required to drive a tonne of consumption which has risen 2x since 2008; from $167k/t to $339k/t
for copper and $1,738/t to $3,350/t for steel.
 Impact on Commodity Markets — Using a range of scenarios based on % of GDP spend and urbanisation trends seen in the
development of other countries, we conclude that by 2020 copper consumption in China could actually be up to 20-35% lower
than consensus expectations of ~12.7mt at 8-10mt, while steel fares worse with up to 30-55% downside vs. consensus
expectations of >1bn tonnes at 450-700mt. Based on our cost curve analysis this would reduce the long term price of iron ore
to $55/t (real) and copper to $5,000/t (real). This compares to consensus long term prices of ~$80/t iron ore and $7,000/t
copper suggesting ~31% downside to iron ore forecasts and 29% downside to copper price forecasts
 What are equities pricing in? — One could argue that the bearish iron ore story is now well told and priced in to equities,
while in copper the market continues to maintain faith in the concept of limited supply growth. However, we calculate that the
UK iron ore equities are pricing in $90/t long term and copper $7,100/t, suggesting ~40% downside to iron ore equities and
30% to copper. This suggests that the potential scale of the decline in iron ore demand has still not been fully appreciated,
while the downside in copper is also not reflected in the market’s perception of the equities.

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