Interesting section in this week's Pierce Points newsletter by Dave Forest. Very relevent for copper longs.

China Compacts its Cost Structure

China has become "ground zero" for the base metals markets over the last few months. Record Chinese imports of copper and zinc have been one of the only bright spots for these metals recently. It appears that China has been nearly single-handedly responsible for driving base metals prices higher in 2009.

As we've discussed in the past, some of this demand was due to stockpiling. This is "apparent demand". Stockpiled metal might sit in storage for some time before its used to make industrial or consumer goods. Stockpiling is therefore a temporary source of demand. Sooner or later, stockpiles grow to desired levels. Then the owners stop buying.

But there are encouraging signs of "real demand" for base metals in China. Chinese production of automobiles was up 17.6% year-on-year in April. The Chinese government is offering rebates on new automobile purchases to stimulate demand. This appears to be working. Auto sales were up 25% year-on-year in April. Sales were over one million units in both March and April. China's first two-month, "plus-one million" period ever. China is also trying to stimulate demand for new appliances in rural communities, although this campaign doesn't appear to have had much effect on demand yet.

The pick-up in Chinese domestic demand is positive for base metal demand. Chinese domestic base metal prices have been running 10 to 20% above London Metal Exchange prices. Sellers around the world have been sending metal to China to capture these higher prices. Which has helped lift global prices for most of the base metals.

Why are Chinese prices running at premium to the rest of the world? As mentioned above, stockpiling of base metals by the Chinese government has helped drive up prices. The government is attempting to support its domestic metals producers. And the Chinese base metals industry needs higher prices than the current global average to survive.

That's because many Chinese base metals producers haven't yet modernized their operations. They're using old technology and production techniques. So their production costs are higher than in other parts of the world. Take zinc, for example. The average cost to produce a pound of zinc in China is $0.75. The current London Metals Exchange zinc price is $0.65 per pound. At this "global" price, the Chinese zinc industry as a whole would be losing money. Some producers would be forced out of business. The Chinese government wants to avoid producers going under (for the moment, anyway). So the government needs to push the domestic zinc price above $0.75 to keep everyone in business. In January, the Chinese zinc price was around $0.65 per pound. Government buying over the last few months has pushed prices above $0.85. A comfortable level for domestic industry. And a very attractive price for zinc producers throughout the rest of the world.

But China's elevated metals prices are having unintended consequences. Imports of copper, zinc and aluminum have jumped to record levels. Some of this is due to speculators buying metal in London at lower prices and bringing it to China in the hopes of selling at local prices and making a tidy margin. This is creating a massive flow of metal into China, probably more than the nation needs. As one of my colleagues put it, "The Chinese government wanted to support its domestic producers, not buy the entire world's supply of copper."

Unfortunately, the world's base metal supply will keep flowing to China as long as domestic prices exceed world prices. And domestic prices will have to stay high until Chinese base metals producers lower their costs.

The government realizes this. And this week they announced plans to do something about it. Authorities plan to spend $3 billion upgrading base metals production facilities throughout the country. This will modernize old factories and should reduce production costs. Some outdated facilities will be closed all together. The government will also attempt to reduce production costs by consolidating base metals sectors. By 2011, the government wants China's top 10 copper producers to control 90% of production. The top 10 aluminum producers will control 70%. Lead and zinc targets are 60%.

By putting more production in the hands of bigger and better operators, the government should be able to cut both operating and overhead costs. Bringing down overall production costs closer to global levels. This should eliminate the need for elevated prices in China. Chinese industry will now be able to compete at the same prices as everyone else.

This is another example of cost-driven deflation. Around the world, industries are responding to the economic downturn by tightening their belts and cutting production costs. And as production costs fall, sale prices can fall without causing a large number of producers to go out of business. The market can get the supply it needs at a lower price.

This is going to be a "headwind" for metals prices. Anyone betting on a large jump in base metals should consider the changing industry cost structure. It is going to be a major driver of prices going forward.