London, 26 July 2011: Reuters

China, lest we forget, is the rock on which the bull case for base metals rests. China's hunger for the industrial inputs necessary for its stellar growth has been the defining characteristic of the metal markets for a decade. Yet, the country's import demand in the first half of this year has largely worked against the consensus narrative to the point that, in the case of copper, it has become the single biggest impediment to higher prices.

APPEARANCES CAN BE DECEPTIVE

Superficially, China's metals trade in H1 2011 was negative for both tin and copper but positive for the other four base metals, namely zinc, nickel, lead and aluminium. However, headline changes in China's net trade in primary aluminium and lead signify very little. Primary aluminium imports, for example, registered the greatest year-on-year increase of 64 percent but in volume terms the change was just 31,000 tonnes, a drop in the 40- million global aluminium ocean.

Further, rising imports of primary aluminium should be seen in the context of faster-growing exports of aluminium alloy and of semi-fabricated products. To what extent China is a net importer of aluminium at all is a highly moot point.

In the case of refined lead, China remained a net exporter in the first half, although those exports dropped to 1,250 tonnes from 3,300 tonnes in the year-earlier period. In essence net trade has been flat since the end of 2009 with only highly marginal fluctuations into net import or net export territory.

Refined zinc net imports, meanwhile, rose by 17 percent year on year but, as with aluminium, the volume change was an insignificant 19,500 tonnes. Moreover, this steady flow of metal to China seems to have nothing to do with fundamental dynamics, given the country is currently visibly oversupplied, and everything to do with "financial arbitrage".

CHINA NEGATIVE

It is in the other three metals that shifts in Chinese trade patterns have made a much more significant impact in the first part of this year. And copper first and foremost. Net imports of refined copper slumped by 39 percent year on year in the first half of 2011.

In tonnage terms, the decline totalled a massive 601,000 tonnes, equivalent to 3.2 percent of global production last year. It was the biggest shift relative to market size in any of the base metals. The absence of this visible metal draw is why global exchange inventory has remained stubbornly high during a period of expected market deficit and why the bull charge above the $10,000-per tonne level fizzled out in February. Lower import demand in China was a direct result of destocking in the face of high prices, primarily of the metal that had accumulated in bonded warehouse in Shanghai.

It's no coincidence that the only other metal to experience such a sharp year-on-year drop in imports was tin, which like copper hit record price highs in the early part of 2011. Net tin imports slumped 58 percent year on year to 4,551 tonnes. The volume decline was "only" 6,200 tonnes but tin is a small global market and the drop was still equivalent to around 1.7 percent of global output. In the case of tin the destocking seems to have come from producer inventory accumulated during the Great Contraction of late 2008 and 2009. Some of it may even have seeped out of the country but in a form that didn't make it onto the official customs figures.

FROM DESTOCK TO RESTOCK?

Both copper and tin show China's sensitivity to rapid price acceleration such as was seen in both markets in the closing months of 2010 and early 2011. And in both cases the scale and duration of the resulting destock has surprised markets. But it has not changed the underlying bull narrative, merely postponed what bulls regard as the day of reckoning when China "must" return to the import market.

Certainly, de-stocking by its very nature can only be a finite phenomenon. And certainly, in the case of copper there is good anecdotal evidence that the mountain of metal sitting in bonded warehouse in Shanghai has shrunk significantly over the last couple of months. The latest assessment is that it is now around 300,000 tonnes.

Indeed, net imports of both copper and tin blipped appreciably higher in June, fuelling expectations that some sort of "normal service" from the world's biggest buyer may be resumed in the second half of the year.

There are two important caveats, however. Firstly, metal imports in the coming period will take place against a backdrop of slowing economic growth in China.

Copper's usage exposure to infrastructure build and tin's to the electronics sector afford both metals some protection against a general cooling of activity but neither will be completely immune.

Secondly, Chinese buyers will remain highly sensitive to outright price. This is particularly relevant to copper, given the LME price is once again zoning in on the big $10,000 level. If fabricators declined to restock at $9,000, they are even less likely to commit at $10,000. Rather, like buyers everywhere else, they can be expected to pounce on any price setback to lock in tonnages.

This inserts a conundrum into the core copper narrative. While bulls push the price higher in anticipation of a return of Chinese import demand, that demand will most likely only be occasioned by price weakness.

CHINA POSITIVE

China's H1 trade flows were a significant positive only for nickel. Net imports of refined nickel rose by 45 percent year on year in the first half of 2011. The tonnage change of 24,400 tonnes may look small but nickel, like tin, is a small market and that volume change equates to 1.7 percent of global 2010 production.

Higher Chinese imports have played out against falling LME inventory but the analyst community has been unimpressed. The mid-year Reuters poll showed nickel has won few friends despite such positive micro signals. What is causing analysts to fret is the scale of the new supply pipeline and booming production of nickel pig iron (NPI) in China itself.

While the NPI sector has outlived the many expectations of its demise, becoming an integrated part of China's stainless steel production chain, it may not have been booming quite as much as feared.

With no official figures for output of NPI, analysts have used imports of nickel ore as a proxy for calculating production. Ore imports from the two key origin countries, Indonesia and the Philippines, exploded in the second quarter to the point that any extrapolation of NPI output simply stopped making sense.

The best explanation of what is going on comes from researchers at Macquarie Bank. Their contention is that nickel ore from the Philippines is being used by steelmakers not for the nickel content but for the iron content. Stronger iron ore prices together with the drop-off in exports from India have make this a viable materials substitution.

If true, it becomes extraordinarily difficult to calculate how much nickel ore is flowing to the NPI and how much to the steel sector. It is also yet another reminder as to how appearances can be all too deceptive when it comes to China's metals appetite.

Ends --

By Andy Home, Reuters market analyst – for Commodities Now.

The views expressed here are his own.