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What If China Undershoots The IMF Growth Forecast?

Monday, July 20, 2015

There could be a 7-30% decline in prices across the commodity complex. This will be a short-term positive from India’s trade balance, subsidy burden and inflation perspective, But collateral impact on GDP growth is  likely over the medium term, says Crisil Research in an overview on the prevailing situation…

With an $11 trillion economy that has accounted for about 25% of global GDP growth over the last decade -- and given its resource-intensive growth (see Box 1) -- China has a disproportionate influence on commodity markets. Recent developments there have rattled the markets so much that the prices of many commodities are hitting multi-year lows. While the International Monetary Fund (IMF) has not revised its forecast of Chinese GDP growth (6.8% and 6.3% in 2015 and 2016, respectively) there are real concerns about potential downside risks.

In this context, CRISIL Research analysed two scenarios of Chinese GDP growth – where it falls either 100 basis points (bps) or 200 bps below the base-case IMF estimate -- to map their repercussions on India and global commodity prices. While lower prices will provide some support to demand, our analysis suggests sharp downside risks to many commodities assuming there is no significant infrastructure investment stimulus undertaken by the Chinese government.

Steel prices will melt more than aluminium
Global steel demand growth will be severely impacted as China’s (which account for nearly half of global steel consumption) construction, housing, automobiles and consumer durables sectors slow down. Our calculations show global steel demand will contract 0.5% in the next two years, compared with the base-case scenario of 1-1.5% growth if Chinese GDP undershoots the IMF forecast by 200 bps. The demand-supply mismatch will result in the entire input value chain (iron ore, coking coal) getting squeezed. However, steel prices will fall more, compressing producer margins even further. As for aluminium, demand growth will decline, albeit less than steel, given that a higher proportion of aluminium demand comes from consumption-linked sectors. Our analysis indicates global aluminium demand will slow down to 2-3% compared with a base case of 3-4%.

Brent crude could plunge to $45 a barrel by 2016
Our base-case incremental oil demand is 1.8-2 million barrels per day (mbpd) over the next two years. But a severe slowdown can lop off nearly a third – 0.4-0.6 mbpd -- of that incremental consumption. With no supply shock foreseen in the medium term, a decline in Chinese demand would increase surplus oil supply to 2.1 mbpd and push down the price of Brent crude to $45 per barrel by 2016.

Non-coking coal prices will slide
As per our base case, demand for non-coking coal in China is expected to decline 1.5% a year between 2014 and 2016 on account of relatively slower increase in electricity demand and rising competition from cleaner fuels (hydropower, renewable energy). But a 200 bps undershoot in Chinese GDP can result in coal consumption declining ~6% per annum.

China’s coal market is already over-supplied and miners are resorting to price cuts to maintain competitiveness with imported coal. A decline in demand will intensify competition between domestic miners and importers, which will pull down global prices by 13-15% compared with the base case.

Petrochemicals spreads will shrivel
Globally, ethylene-naphtha spreads will contract by ~$40 per tonne if Chinese GDP undershoots the IMF forecast by 200 bps. However, spreads are not expected to fall below $340-360 per tonne, which is the breakeven for ethylene producers.

The fall in commodity prices will impact Indian companies as well, but the magnitude will vary with metal players facing a significant downside risk compared with domestic oil companies.

Domestic metal companies will face operating losses
Domestic steel and aluminium players will bear the brunt of a fall in domestic prices. Steel companies will start making losses at the EBITDA level with domestic prices falling below cost of production in the next two years (if Chinese GDP falls 200 bps below IMF forecast). Integrated players will be hit the most as they will not benefit from lower iron ore and coal prices.

Aluminium makers could face operating losses. Hindalco and Balco, for instance, are slated to increasingly rely on costlier captive coal from the second half of the current fiscal.

Downstream gain, upstream pain
While the under-recovery burden of public sector oil companies in the upstream sector will decline due to the fall in crude prices, it will be more than offset by a decline in gross realisation. For upstream public sector companies, realisation will be about $35-40 per barrel by fiscal 2017, or $10 lower than the base case and well below the $45 per barrel realisation seen in the last fiscal. Operating profit of these companies will also fall more than 25%, or Rs 120 billion, compared with the base case.

But lower oil prices will benefit PSU downstream companies since their share in under-recoveries, if any, will be minimal. Further, lower subsidies will reduce their interest burden. If Brent crude falls to $45, overall benefit for the downstream companies will be Rs 20-25 billion.

Government, consumer biggest beneficiaries in the near term
A $1 per barrel decline in oil prices reduces under-recovery on petroleum products (kerosene, LPG) by ~Rs 12-13 billion. Therefore, overall under-recoveries will decline by Rs 240-260 billion versus the base case. This will mean the government’s burden (at 65% of overall under-recovery) will be lower by Rs 155-170 billion. A $10 per barrel decline in crude price, ceteris paribus, will reduce retail prices of diesel by ~Rs 6 per litre. Such a fall will help curb inflation and benefit consumers.

However, medium term impact of Chinese slowdown is negative on India
Slower Chinese GDP growth would have global repercussions. A drop in oil and gas prices will pull down economic growth in the Middle East as well as Russia, while a fall in exports to China will impact countries such as South Korea, Japan, Brazil and Australia (exports to China are ~20-30% of total exports for these countries). India, too, won’t be spared as overall global growth falters and trade flows slow down.

China, the commodity giant

  •     44-47% of global aluminium and steel consumption
  •     23% of global primary energy (oil, natural gas and coal) consumption
  •     25-30% of petrochemical (polymer) consumption
  •     45-50% of overall global aluminium and steel production capacities


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