Short Covering and Commodities Re-Stocking
The papers have cover in early Nov. The heavy Dec iron ore demand (re-stocking might be a more correct term) appears to have contributed to the last month rally.
Participants have taken advantage of a Long the Carry Arb that was possible during november and december with the DCE Exchange for Physicals Delivery. Iron ore curve now appears flatter.
Dry Bulk FFAs
At time of writing is at Iron ore at 7-week low while freight is at a 8 week high. With the DEC spot 4TC currently trading at 33K, the front month appears backwardated against JAN at 19.5K.
Technically, Dry-Freight FFA could appear counter-seasonal because demand for steel is usually weak during the winter.
NOV was a consolidation month [low volume, low liquidity] and in DEC, Market realized that the renewed demand was real, then volatility has exploded.
Many people have said that Capesize was in the top of the range at the 30.5K resistance, but “Charts” (charterers) and FFAs traders have continue to cover DEC cargoes and short DEC swaps.
The reality is that if big funds are bearish on Q1, Q2, Cal14, they tend to cover with the spot 4TC.
Q1 and Q2 14′
Real freight demand and supply is around the corner as increased australian, brazilian iron ore supply hits the market for Q1 and Q2. Freight supply is quite inelastic, underlying commodities (Prices) and Cargo demand might be able to sustain this rally above current levels in 2014. In 2014, We could see a divergence between Freight Market and the Commodities Markets.
The idea that “Steel is playing a key role in growth” is anchored into the Chinese economic thought and the forward curve might not catch why the Chinese state government sees a convenience yield by holding ores stocks. Steel production is a key pillar of the economic planning sets by the PRC since Mao Zegung.
China has a powerful government-corporate partnership with steel producers. The country has become the world’s biggest steel producer. and the world’s top steel exporter. In America our bridges, roads, buildings are built with Chinese steel but it is not easy to determine who is flooding who; the U.S is flooding the world with the U.S Dollar, China is flooding the world with its steel !
Castalia suggests a perspective in which internally the Chinese banking system and Chinese local companies are suffering from real liquidity problems. They cited the example of the Liansheng Group and other coal miners relying [like the rest of the economy relying upon the leverage of the shadow banking layers], experiencing tough financial times because of low commodities prices and weak domestic demand.
It’s about a local coal miner ranked among the highest marginal cost producers in the supply curve, not likely about interest rates. Lower commodities prices are hurting high-marginal cost commodities producers first, this sets the tone for more Ores imports potential in China, so positive implications for freight ? I believe that this part of the analysis is worth for every commodity producers in the world: things were rosy during periods of high credit expansion/high prices and Cash is king during slow periods of growth/lower prices.
Shadow banking in China, L/Cs and Commodity Trade Finance
Shadow banking is the lingo for the financial system outside the spectrum a central bank [For China it is the People's Bank of China (PBoC)].
RMB traded on the offshore market has a different value than RMB traded on the mainland.
All Chinese trading houses have offshore HK or Macau subsidiaries where they just get financed at lower rates (cost of money) than official PBoC rates [ 6% official PBoC rate, vs 1% offshore effective rate] but it is not just about interest rates…
Sophisticated Chinese Traders use offshore financing to :
- keep away profits in offshore accounts from mainland higher taxation rates.
- get away from PBoC‘s currency restrictions. [a huge tobin tax between 3 and 5%]
- get Renminbi-denominated Letters of Credits (RMB L/Cs) to finance back their onshore operations.
Behind the L/Cs there is a commercial paper market between banks funding their daily liquidity needs.
Refinancing risk arise when a company rolls long-term obligations with short-term papers. Contagion starts when one bank defaults, the market loses confidence and the spreads widen ex: if overnight paper rate is skyrocketing from 1.25% to 14%.
Bankers are aware that commodity traders are risk takers when they underwrite credit lines. Hong Kong as an offshore financial center is no different from Zürich. Chinese Traders are no different from other traders. Over time, Commodity Trade Financiers have developed a plethora of safeguards and standardized methods to ensure they can mitigate risks while continuing to accommodate the intricacies in the lucrative commodity trade business.
In the case of L/Cs, the creditworthiness of a buyer is substituted by the creditworthiness of a major bank.
L/Cs are a conditional promise to pay subject to required documents [ The L/C terms, cargo inspection certificate, certificate of origin, Clean on board B/L]. There is no market for trading L/Cs because L/Cs aren’t an unconditional promise to pay.
L/C specifies a deferred payment date after the L/C acceptance ex: a time-draft of $10,000,000 face value with maturity of T= 90 days after the L/C acceptance. Once the bank gives the L/Cs acceptance stamp, the L/C beneficiary may choose to wait 90 days to get the face value or can endorse the back of the time-draft and demands an immediate payment. The Bank will issue Banking Acceptances (BAs) for the commercial paper market and will pay the L/C beneficiary at a discount to the face value draft. Holder of the BAs will get paid by the bank in 90 days. Demand for these Yuan-Denominated BA’s is also fueled by Yuan appreciation, which in turn sustains low refinancing rates for Yuan-Denominated L/Cs.
Banks deal strictly in documents, when seller submit the documents, the L/C applicant’s bank (buyer’s bank) is obligated to pay, even if the buyer becomes insolvent. This is why banks require that the L/C applicant(commodity buyer) will put collateral (Cash and the Cargo itself). Banks do so by requiring they be listed as the consignee on the B/L, so they have the title to the cargo and claim it in case the buyer defaults on the L/C.
A Bank gets a really good understanding of their client ‘s day to day activities and risk exposure. Most L/Cs are revolving lines, traders use them so a series of transactions/shipments fluctuating each month.
Government export agencies [EXIM, EDC, ECA...] offer supplemental credit insurance layer against default by a foreign bank.
All this said, Transactional risk is very low with these Renminbi-denominated L/Cs, refinancing risk remains but we are not in the eye of a storm.
China’s policies and commodities
China is able to produce and export consumable goods at a lower cost than the rest of the world but not able to produce all its commodities at a cheap cost like the rest of the world, so import them. One of the intentions of the PRC with the Iron Ore Trade liberalization on the Dalian Commodities Exchange is to lower costs on what they consider as a strategic resource that can’t be produced cheaply internally under central planning.
In the case of agri-commodities, spread between CBOT and Chinese Spot is fetching 4$ sometimes 5$/BU. For PRC, it is just not only about price differential like in a
market driven economy... In a centrally planned economy, when domestic market is deemed by the State as well supplied, there is no rush for stock piling up inventories.
PBoC is now allowing a gradual appreciation of the undervalued RMB, thus creating currency leverage for Chinese traders and importers.
Y-T-Y Yuan is up
- 3% vs the USD
- 8.5% vs the Canadian Dollar
- 20% vs the Brazilian Real (China has a direct yuan swap line with Brazil Central Bank).
- 25% vs the Australian Dollar.
In 2013, the gradual appreciation was not so gradual for BRZ/CNY and AUS/CNY. Most commodities are priced in USD but Chinese traders can triangulate rates and buy these % ( more in tons) of commodities for the same price.
Because sophisticated Chinese entities use offshore financing, the ability for the PBoC to control the liquidity in its economy by raising/lowering interest rates is amputated. On the other-side the main Offshore financing system, Hong Kong is pegged to the U.S dollar. Offshore RMB is left in a gray zone because the Hong Kong Monetary Authority HKMA regulates only rates on the Hong Kong dollar (HKD). Offshore RMB is also debased from mainland RMB because of currency transactions costs [a Tobin tax].
I also briefly touched the BA’s market. RMB-Denominated BA’s in Hong Kong is also backed by investors who see a currency yield enhancement. The RMB-Denominated BA’s very akin to a long forward RMB position for t days with the BA’S yield as a borrowed stop. On a monthly or quarterly compounding period, investment returns on this trade can be quite profitable.
High demand for RMB-Denominated BA’s is attracting liquidity in offshore banks and push Yuan-Denominated L/Cs rates lower. You can see now the utility of the Shadow-banking system for Mainland Chinese traders and the relevance of commodity trade financing for markets.
Not all prices are equal. In the end, if you want to understand commodities you must understand their upstream structures. I welcome your inputs or questions since most people find this gearing rather tedious ! Thank you
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