Macquarie's commodities analysts have been to China and they've come back ... gloomy.
The bank has previously highlighted the steel industry as a poster child for commodities woes, with particular emphasis on overcapacity in China. In the face of slumping metals prices, the pressure is on miners and producers to cut supply. Unfortunately for global commodities prices, a chunk of the world's metals producers seem reluctant to do so—even in the face of losses.
The Macquarie chart below shows steel mill profitability in the red.
Why would Chinese steel mills maintain production in the face of low or nonexistent profitability?
Macquarie has a few thoughts.
For a start, analysts led by Colin Hamilton point out that steel mills have been pulling some levers to offset losses. Those levers include encouraging traders to prepay for purchases and, putting it diplomatically, attempted "VAT evasion among small and private mills." Such measures have mitigated the effect of lower steel prices, Macquarie says.
Other dynamics are at play, too.
Such prisoner's dilemmas are of course being played out among other Chinese commodities producers and non-Chinese commodities producers as well.
CreditSights analysts last month cited the example of China Hongqiao Group, a local aluminum producer that was opting to expand its output capacity in the face of lower metals prices. Elsewhere in the world, the head of Chile's Codelco said last week that he would rather rein in costs than curb copper production. The ultimate prisoner's dilemma in commodities? OPEC and its oil production.
Still there may be limits to steel mills' stubbornness, Macquarie says.
"It was thus quite gloomy to hear that the Chinese mills would just keep producing no matter how much their losses get," the analysts concluded.
"However, in our opinion, while all the factors mentioned above underline the stickiness of Chinese steel production, they still have their own limits, and sticking to them risks underestimating the pace of potential capacity exits."
Source: http://www.bloomberg.com/