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As China becomes the dominant presence in global commodities markets, S&P feels downside scenarios are unlikely to occur, "but the shocks will be felt around the commodities world."

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RENO, NV -

Standard & Poor's expressed concerns Wednesday that record commodity prices could represent an "unsustained bubble, subject to a sudden correction."

In their report, The Potential Risk of China's Large and Growing Presence in Commodities Market, S&P credit analysts noted, "Market bubbles inevitably burst, although they are much easier to recognize in hindsight."

Nevertheless, the analysts anticipate that China will sustain high growth rates over the next few years, albeit with some moderation from recent levels.

S&P estimated that China's consumption of refined copper grew at a compound annual growth rate of almost 16% over the past five years. By contrast, global copper demand, excluding China has declined 2.1%. Meanwhile, China's share of total world copper consumption reached 39% in 2010, making China the world's largest copper-consuming nation.

"We expect that with moderating economic growth in China, and with government-backed electrification projects having run their course, copper consumption growth in China could decelerate to a level somewhat below overall GDP growth over the next several years-to a still robust 6%-8% per year," said the analysts.

Nonetheless, China's share of world market copper consumption is still expected to well exceed 40%.

Although China is expected to bring additional mining and refining capacity online over the next few years, S&P still anticipates that copper consumption will continue to outpace domestic production.

Meanwhile, China has surpassed the United States as the world's largest consumer of primary aluminum, accounting for about 43% of global consumption.

With an estimated 17 million to 18 million tons of domestic smelting capacity, China is now an exporter of aluminum ingots and alloys. China is expected to start up new smelters with production capacity totaling more than 5 million tons annually over the next three years.

In their analysis, S&P observed that if all of China's older aluminum smelters remain in service as new smelters come on line, "China could end up with excess supply, which producers would like try to export."

The substantial amount of still-idled aluminum smelting capacity globally "puts some constraints of price increases because, as prices rise, it makes sense economically for producers to restart even with some of the less-efficient capacity," the analysts advised.

As is the case with copper and aluminum, Chinese steel consumption has significantly outstripped steel demand from the rest of the world. China is now the world's largest steel consumer, accounting for 42% of global consumption last year.

However, China is also the world's largest steel producer and exporter, accounting for 44% of global steel production. S&P observed that the Chinese steel industry is still catching up with more developed countries in technology to produce specialty steel products, such as those used in the automotive sector.

S&P expects China to sustain steel consumption growth in the range of 6%-8% annually, compared with other world demand growth in the range of 2%-4%.

As may be anticipated, growth in China's consumption of coking coal and iron ore has tracked its steel production, according to the analysts.

"In part that's because, compared with other major steel-producing countries, China, similar to India and Korea, has a greater than typical dependence on iron ore and coking coal, because its steelmaking capacity is heavily skewed toward the integrated process," S&P noted. "Thus China accounts for a disproportionate share of world iron ore and coking coal demand, accounting for 60% and 52% of world consumption, respectively, in 2010."

While China continues to invest in expansion of its domestic iron ore and coking coal mining capacity, it relies to a large extent on foreign markets, importing more than half of the amount it uses for each of these raw materials. As China suffering from declining iron ore grades domestically and lacks deposits of high-quality coking coal, it has caused a number of Chinese companies to purchase existing or developing iron ore properties outside of the country.

"Prices in the spot market have weakened somewhat in recent months in response to the pause in recovery of steel consumption and resumption of production that was disrupted for weather-related reasons," S&P observed.

Economic Slowdown Would Brake Commodities Consumption

In their analysis, S&P foresees "a range of hypothetical scenarios that could lead to an abrupt deceleration of the Chinese economy and a negative effect on commodity prices. Some emanate outward from China; others originate elsewhere."

S&P views Chinese government policymakers' "continued reliance on a centralized macroeconomic management as a credit weakness of China." If administrative measures are based on untimely or inaccurate analyses of the economic situation, "they could have abrupt or unpredictable effects."

If the gradual changes Chinese policymakers have adopted to mitigate economic slowdown risks begin to increase in size or speed, the analysts fear "significant economic volatility could result."

"In such a scenario, demand for commodities could fall precipitously as investment is curtailed," S&P suggested.

Nevertheless, S&P observed that "concern about the potential consequences of a sharp downturn in China appears far from the minds of most commodity industry players."

"Instead, the more prevalent worry seems to be over the extent of market strains resulting from having to ‘feed the dragon,' given the ongoing worldwide capacity expansion that will be necessary to accommodate Chinese demand," the analysts said. While commodities producers have reaped surging earnings and operating cash flow, most of their earnings have been plowed back into capacity expansion.

A rapid deceleration of China's consumption of these commodities "could quickly leave the global markets beset by excess supply," said the analysts.