China Polyolefins Divorced From Fundamentals

A permanent separation?


Source of picture:


By John Richardson

IT IS pretty easy to predict specific events that will cause declines in polyolefins pricing in China next year thanks to the big role that macro-economics now plays in setting the market.

No longer do you need to mainly sweat over increasingly difficult polyethylene (PE) and polypropylene (PP) supply and demand balances to clear the mist from the crystal ball.

It is now a moot point whether, in fact, watching out for the big-picture economic signposts is more useful than the traditional hard grind of collecting domestic production data, imports and real consumption (whatever that is!) in specific end-use sectors.

The last couple of years have seen the evolution of two much-more distinct languages when the market is being discussed: That of the traders and end-users as opposed to the producers and industry observers, who still mainly still stick to the traditional measures.

The reason is the increasing role of the Dalian Commodity Exchange’s RMB-priced futures contract in linear-low density polyethylene (LLDPE) which helps act as a guide to price direction across many other grades of polyolefins.

Several sources indicate that the Dalian is set to launch a homopolymer PP contract next year, which they say will be in yarn grade, meaning a potentially even-bigger role for the exchange.

Producers might not be, as yet, be hedging on the exchange – but the traders and end-users certainly are.

And the most active contract on the exchange, usually the one closing four-to-five months out, is being used by end-users in price negotiations for imports.

Traders often import resin to back deals on Dalian. If they guess the futures market the right way they then sell before physical delivery is due, thereby closing out their obligations with the exchange through paper trading only.

Good returns on the Dalian can make them more willing to sell these physical imports in the real market at a discount.

This is causing confusion among producers who see traders off-loading cargoes in declining markets at what look like heavy losses – as they are not aware of what positions the traders have taken on the exchange.

The problem with the Dalian, or any futures market for that matter, is that it can be very difficult to work out who is involved and the extent of long or short positions.

With total volume traded in November on the exchange approximately four times global demand, the vast majority of business is obviously paper trade.

Hedge funds, financial institutions and retail day traders, who are all understood to be heavily involved in the market, don’t obviously have any intention of either supplying or receiving resin.

So the big apparent role of the financial players on the Dalian means that is behaving like any other financial instrument.

And because of the big role that the futures contract plays in setting physical pricing, (click below for a graph that illustrates this point), this brings us back to where we began this article: The macro-economic news that sets the daily direction of the Dalian has led to what feels like a diminishing role for traditional industry fundamentals. 


The relatively easy job, therefore, of picking out next year’s economic signposts involves studying the financial press- and macro-economic analysis services such as the online Beijing-based China Economic Quarterly (CEQ).

The CEQ is predicting three -to four further interest rate rises next year and warns that the bank-reserve requirement (the amount that banks have to set aside against lending) could rise to as high as 25% over the next 18 months.

China has already raised the requirement by six times this year to 18.5% with the latest increase occurring earlier this month.

All these measures are designed to take the heat out of the economy and have, as a result, caused falls in equities and many commodities futures markets, including Dalian.

The housing market could also be a big source of negativity for polyolefin pricing next year.

“Year-on-year construction growth will fall to single digits in the final quarter of 2010 and the first quarter of 2011,” writes the CEQ in its Q4 report.

“And year-on-year housing sales could fall as much as 25% in the first three months of 2011.”

The CEQ argues that additional monetary tightening will in the great scheme of things be moderate as underlying inflation, taking out the effect of volatile food prices, remains low.

Rising oversupply in residential property will only be a temporary problem because of huge demand for more construction of social housing, the report adds.

It also points out that while China’s gross domestic product (GDP) growth might slow down from around 10% this year, the economy will still expand by approximately 8% in 2011. This would hardly be a devastating collapse.

But since when has the truth mattered to financial speculators who tend to enter markets on rumours and exit on facts?

Talking of speculation, you don’t have to be a genius to know that crude will set the floor for physical polyolefin pricing, as it has always done, next year.

As we said, Dalian tends to dip and rise in line with equities and commodities in general, including the movements in crude.

“The crude price has to be about speculation because there is still 6m bb/day of spare crude output,” said an oil and refining consultant.

“There is also still 2-3m bbl/day of surplus refinery capacity and gasoline inventories in the US were recently five times their historic average.

“The banks have once again a lot at stake in making the crude bull argument. Refinery margins will recover next year, but not by that much. It will be the complex, full-conversion refineries that will benefit the most and not the simple refineries.

“Even diesel inventories are high in the US and have been at comfortable levels in Europe, despite the cold weather.”

With truth at a premium next year, it therefore seems likely that negative economic news from China might be counteracted by bullish forecasts by banks of oil moving to $100/bbl or more over the next two years.

The Dalian – and with it the physical market – could as a result be even more volatile in 2011, making the planning process for producers even more difficult.

That is a cheery thought to take into the end-of-year holidays….

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