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Strength of China's environmental drive surprises analysts

The success of China's environmental drive has surprised analysts who predicted it would take longer to flow through to commodity prices, but the broader economic climate remains "highly volatile" as China has clamped down on the housing market, an ANZ commodities expert said.

ANZ senior commodities strategist Daniel Hynes told attendees at the RIU Explorers Conference in Fremantle, Western Australia, this week that China's big environmental push has been "the biggest issue" that has changed to impact commodity markets over the past year.

Hynes said the success of the environmental push — which started when China signed up to the Paris Accord on April 22, 2016 — was clear when he saw the sky in Beijing "for the first time in memory," along with the mountains some distance away, when he visited at the end of 2017.

"The ability of the Chinese government to reduce pollutants and [boost] air quality has emboldened them to continue constraining heavy industry, reducing raw material movement around the county and pushing that market into more sustainable uses of their resources," Hynes said.

"The steel industry is where it has been front and center, and the targets to reduce steel capacity have come quite aggressively in the early years, starting to peter off a bit in 2017. The cuts they'll make over the next couple of years are only in the order of about 35 million tonnes."

Yet that was still having a significant impact on the type of raw materials being consumed.

"The steel producers have found themselves in the situation where steel demand is still going up but capacity is falling, and the quickest and easiest way to meet that demand with less capacity is to increase the amount of higher-grade ore, which has seen the spread [between 58% and 62% Fe] blow out to around US$20 to US$25 per tonne," Hynes said.

This has impacted the likes of Fortescue Metals Group Ltd., whose underlying EBITDA and cash generated from operations all dropped from Dec. 31, 2016, to Dec. 31, 2017, with net profit after income tax and basic earnings per share both plummeting by 44%.

Fortescue said on Feb. 21 that high steel mill profitability incentivizing blast furnaces to maximize production by using higher iron content ores drove the company's revenue down 18%, compared to the first half of 2017.

Hynes said that if the Chinese government pushes even harder than expected with the capacity cuts, then those diversions in the iron ore markets will continue — a trend also seen in other markets like coking coal and copper.

On top of that, Hynes said China's steel industry has also changed where it sources that iron ore from.

"The north has predominantly been where a lot of the domestic iron ore has been produced, but a lot of the capacity changes have been focused in the south and central where they've been replacing old inefficient steel mills with new ones," Hynes said. "This means the reliance on imports has increased significantly."

"In China itself, the movement of coal has been targeted and we've seen the growth in coal output fall, but others like aluminum and others have also resulted in import demand increasing even further."

While China's services sector has now overtaken the industrial sector in terms of GDP growth, Hynes said the use of fixed-asset investment to mitigate that slowdown has also helped commodity markets.

This was particularly the case in the infrastructure sector where "they've brought a lot of large, big-ticket items forward quite a few years to mitigate that slowdown."

The housing market has also been a concern for commodity markets.

Hynes said China's house price growth through 2016 to 2017 was "absolutely massive" and had "forced the hand" of the government requiring some clampdowns on investment, particularly in Tier 1 and Tier 2 cities, which has seen price growth fall substantially.

Yet there is still strong growth in Tier 3 and 4 cities, with urbanization continuing further inland "away from the eyes of the global marketplace," which the analyst said was a promising sign for growth in commodity demand.