Column: China's sale of state zinc reserves is a well-timed trade

By Andy Home

LONDON (Reuters) - The inclusion of zinc in China's sales of state metal reserves is testament to the market's continued surprising strength.

London Metal Exchange (LME) three-month zinc hit a near three-year high of $3,108.50 per tonne last month and is currently trading around $2,900.

The Shanghai Futures Exchange (ShFE) zinc contract has out-performed London, last month hitting its highest level since 2007.

There is no evidence of the speculative excess the Chinese authorities have targeted in other over-heating commodities such as iron ore.

ShFE zinc volumes shrank in both 2019 and 2020 and have risen only marginally this year. Market open interest hit a six-year low at the end of February. It has partially recovered but was still 24% down on last year at the end of May.

The lack of investor interest derives from a less-than-exciting narrative of a market inexorably moving into over-supply after the price spike of 2018.

Yet zinc has stubbornly declined to perform to script, particularly in China.

The largely unexpected price resilience is proving a boon for Western producers. It may prove to be highly propitious for China's state stockpile managers.

ACCIDENTAL RESERVES

Zinc isn't classified as a strategic metal in China and the state's reserves have to some extent been accidental.

Low prices in 2009 and again in 2012 saw what was then the State Reserves Bureau (SRB) coming to the rescue of local producers by buying up surplus metal.

Tonnage and pricing were fully disclosed because the government wanted to send a price signal. As was also the case when the SRB sold 50,000 tonnes back to a resurgent market in 2010.

Net purchases over the 2008-2013 period amounted to 354,000 tonnes, which is what the market assumes is the volume of zinc held by what is now The National Food and Strategic Reserves Administration (NFSRA).

The NFSRA is tendering for the sale of 30,000 tonnes of zinc in July with the potential for more monthly sales if required. The auction is only open to industrial users.

It's a neat way of combining limited firepower with maximum price signalling power as the government tries to dampen the inflationary heat.

ALLEVIATING TIGHTNESS

It is also intended to alleviate short-term tightness in the Chinese supply chain caused by power rationing in Yunnan province.

The hydro-rich province, which accounts for around 12.5% of the country's refined zinc production, is currently suffering from drought. All large power users, including zinc and aluminium producers, have been forced to reduce operating rates.

This supply constraint has coincided with a period of super-strong demand growth as Chinese manufacturing rebounds from the pandemic, led by the steel sector, a big zinc user for galvanised sheet.

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The resulting tensions in the Chinese market-place have been the primary driver of higher zinc prices, both in Shanghai and in London.

China is the world's largest processor of mined concentrates into zinc metal and its supply woes - a lack of raw material due to COVID-19 lockdowns last year and the current operating cap in Yunnan - have coloured the global picture.

World mine supply surged by 11.3% in the first four months of this year as the disruption caused by lockdowns in key producer countries such as Peru fades.

Yet global refined metal production grew by only 4.5%, according to the International Lead and Zinc Study Group.

It estimates the zinc market recorded a supply-demand surplus of just 31,000 tonnes in January-April, compared with a surplus of 256,000 tonnes in the same period last year and an April forecast for a 353,000-tonne surplus this year.

The tighter-than-expected market is all down to the bottle-neck in China's processing sector. The country's refined metal production slid by 8.2% in May relative to April due to the power curtailments in Yunnan.

TURNING THE TIDE

Yunnan's rainy season normally starts around now, which should feed through to normalised operations at zinc smelters over the next couple of months.

At which point analysts at Macquarie Bank expect zinc to "drift back towards balance" amid both concentrates and refined metal surpluses. The bank forecasts the zinc price to fall from an average $2,720 per tonne this year to $2,300 next year. ("Commodities Compendium," June 17, 2021)

Fitch Solution analysts are still gloomier, expecting "a steady downtrend in prices out to 2030", largely driven by slowing steel production in China. ("Zinc: Price Downtrend To Be Less Steep Than Previously Anticipated," June 18, 2021)

The country's steel production growth is expected to brake sharply from 7.8% in 2018-2022 to 1.3% over the subsequent five years. The flow-through drop in zinc demand for galvanising will transform China into a consistent net exporter, adding to global oversupply, Fitch warns.

The country hasn't been a net exporter since 2007 and imports have been running just north of 500,000 tonnes in each of the last two years.

That's because the domestic market was in persistent supply deficit to the tune of 292,000 tonnes annually in 2016-2020, according to Fitch. That deficit market is expected to flip to an annual average surplus of 196,000 tonnes over 2026-2030.

SELLING THE HIGHS

Given such gloomy forecasts, it's no surprise that some are striking while the market is still hot.

Australia's New Century Resources has just announced it has hedged forwards around 25% of its planned mine production - equivalent to around 90,000 tonnes payable zinc - out to June 2024.

The transaction with Macquarie Bank locks in a weighted average price of A$3,717 per tonne (or US$2,900 per tonne). "The zinc price has never averaged above the company's achieved hedge price for a three-year duration," New Century noted.

China's stockpile managers find themselves in the same fortuitous position, releasing metal into what just about every analyst thinks will be zinc's last bull hurrah.

The SRB bought its zinc in 2008-2009 at prices under 12,000 yuan per tonne. The Shanghai price has slipped from its May highs but remains at a lofty 21,105 yuan.

Selling state reserves right now looks a very good zinc trade, whatever the broader political motivation to tame commodity price inflation.