The second quarter is likely to still be tough for China's commodities companies. S&P Global Ratings believes demand is gradually recovering but has yet to normalize, even as aggressive measures have largely contained the COVID-19 outbreak in the country. We continue to see price weakness. Oil prices have stabilized at a much lower level than was seen during the first quarter, and chemical spreads generally remain subdued. Coal and steel prices are also soft as inventories increased during the lockdown.

A more meaningful recovery will likely unfold in the second half. We base this view on our assumption that COVID-19 will reach its peak in mid-2020 globally, allowing global economic activity to slowly normalize. Cement is better positioned than other commodities because consumption is tied to the region of production, and the resumption of construction and increased infrastructure spending in China has raised demand for cement in the country. These two factors will bolster demand for long steel products. Flat products will benefit from a recovery in auto sales in the second half, after a disastrous first quarter.

General Weakness In The First Quarter Performance Of Our Rated Names

The performances of our rated Chinese commodities companies generally weakened in the first quarter on lower commodity prices amid slack demand as the COVID-19 outbreak went global (see table 1). The exceptions include Zijin Mining Group Co. Ltd. and Shandong Gold Group Co. Ltd. which were supported by strong gold prices; China Oilfield Services Ltd., which benefited from a one-off settlement payment and greater volumes before the price of oil collapsed; and Beijing Haidian State-Owned Assets Investment Group Co. Ltd., which was likely due to its non-chemical segments.

Table 1

Despite higher inventories, the cash conversion cycle in the first quarter was generally comparable to that in the same period last year. This is attributable to either better accounts receivable management or longer accounts payable days. However, it was weaker than at end-2019, likely due to stronger working capital management toward the end of the fiscal year.

Oil And Chemical Firms Bear Brunt Of Negative Rating Actions

Table 2

Since the outbreak of COVID-19, we have so far revised our outlooks on six companies, or about one-fifth of publicly rated Chinese commodities firms, mostly in the oil and chemical space. This is primarily due to the slide in oil price since late March, coupled with lost demand.

We revised the outlook on gold and copper producer Zijin Mining to negative after the company completed the acquisition of Continental Gold Inc. We also revised the outlook on the rating on aluminum producer China Hongqiao Group Ltd. to stable from positive on softer aluminum demand and prices.

The rating actions so far are outlook revisions. The key reason is we always build in some buffer in our ratings. Further buffer came from the companies' generally strong financial performances in 2017 and 2018 on robust commodity prices and spreads. In addition, we believe that COVID-19 will be a short-lived event, though it will likely last longer--and the post-pandemic recovery will likely be milder--than originally anticipated.

More companies will likely come under rating pressure in the coming months. Metals and mining prices have generally been holding up in the first quarter as companies maintained production and built inventories. However, prices softened in the second quarter as COVID-19 became more widespread. High inventory levels also strained prices. The longer the pandemic lasts--especially with the potential for second and third waves of infections--the greater the risk for negative rating actions.

Oil: Sector strains will shift from downstream to upstream in the second quarter

Brent averaged US$51 per barrel in the first quarter due to higher prices in the first two months. As COVID-19 started to spread globally from end-February, and with price war breaking out between Saudi Arabia and Russia in early March, Brent fell below US$20 per barrel in late April. With the pandemic transmission seeming to slow down lately--with lockdowns in Europe and the U.S. gradually loosening--Brent is now above $30 per barrel (see chart 1). Brent should average US$30 per barrel for the rest of 2020 before recovering to US$50 per barrel in 2021, we assume.

China's refining margin was also on a declining trend and has triggered the US$40 per barrel floor price (see chart 2). China's gasoline and diesel prices reference international crude oil prices of the previous 10 working days, while refineries' crude costs reflect oil price of four to six weeks prior.

The floor price first took effect on March 18, 2020. We saw a spike in the refining margin from late April when lower crude costs flowed in, while gasoline and diesel prices were still set at US$40 per barrel. The excess profit should go to a national fund, according to the rules. If the government allows refineries to keep at least part of the excess profit, it will benefit the national oil companies.

Assuming a much lower oil price in 2020, credit metrics for oil companies will deteriorate significantly before recovering in 2021 based on our price assumption of US$50 per barrel.

Chart 1

Chart 2

As oil prices stabilize in the second quarter, we are unlikely to see large downstream losses. There should be no or limited inventory impairment or negative inventory hit as occurred in the first quarter. However as oil prices are at much lower levels, oil companies will suffer from losses in their upstream operations.

Coal: Oversupply will continue but is starting to ease

Coal prices in China will fall around 10% this year from 2019, we assume. Oversupply will continue in the second quarter of 2020. Yet, large coal enterprises will likely play a leading role in stabilizing the market and preventing excess fluctuation in coal prices. Promoting the use of medium and long-term contracts to lock in prices with end users would help achieve that.

An exacerbated imbalance between supply and demand has triggered a notable decline in coal prices at the beginning of the second quarter. In April 2020, coal production was largely back to normal while the downstream demand has not fully recovered. As of May 9, 2020, the CCI 5500 index (which tracks Chinese coal prices) reached Chinese renminbi (RMB) 469 per ton, the lowest since August 2016 (see chart 3). This implied that coal prices have fallen out of the price range of the "green zone" (RMB500-RMB570 per ton) and is now at the border of the "blue zone" (RMB470-RMB500 per ton) and the "red zone" (below RMB470 per ton).

Chart 3

While the pandemic is largely under control in China with economic activity resuming in the country, the price of coal will likely stabilize in what remains of the second quarter, as demand picks up. Other supporting factors, such as restrictions on imported coal, and declining stocks at major ports, will help this stabilization. We have seen the daily coal consumption of the six major power generation companies begin to rise in May, along with a decline in the number of days of coal inventory (see chart 4).

Chart 4

The credit metrics of Chinese coal companies will weaken in 2020 versus 2019 based on our assumption of falling oil price. However their ratings have sufficient buffer unless the price of coal is much weaker than our expectation.

Steel: Destocking in the second quarter alleviates working capital strains on mills

China's steel inventory reached an all-time high of 39 million tons in early March 2020, equal to about 15 days' national crude steel output. Among that, 26 million tons were with traders and 13 million tons were at steel mills. With steel mills producing continuously through a state-led lockdown to address the health crisis, demand tumbled and inventory levels surged. Crude steel output reached 234 million tons in the first quarter, up 1.2% year on year. Blast furnaces continued operations as usual. Electric arc furnaces suspended production in the second half of January, but gradually started producing again at the end of March.

We have seen a fast destocking of steel products since mid-March with China's industrial activity gradually resuming and inter-provincial transport back to normal. Destocking accelerated before the golden week holiday starting May 1, 2020, cutting total steel inventory to 25.2 million tons as of May 8, 2020. Of this amount, steel mills' inventory fell to 7.1 million tons, alleviating some working capital needs. The national steel inventory is still high. Any deviation from the destocking push will depress steel prices.

Chart 5.1

Chart 5.2

We anticipate the demand for long steel products to outperform that for flat steel products, due to divergent downstream demand. We see more resilience in long steel demand, backed by a resumption of work in key infrastructure projects, and returning property investment. The central government has implemented monetary and fiscal policies to stabilize the economy, specifically employment. Initiatives include lowering the loan prime rate and the reserve ratio of commercial banks, and issuing special bonds and local government bonds. We believe all such measures support spending on infrastructure and, therefore, long steel demand.

Chart 6

Flat steel demand will likely remain strained this year. China's automobile output dropped by about one-third in the first four months of 2020. Auto sales may decline by 6%-8% year-on-year for the second quarter of 2020 before increasing by 5%-6% in the second half of 2020, as some provincial governments introduced incentives to stimulate car buying. The Chinese auto sector's output and sales will drop 8%-10% in 2020, we expect. The pandemic outside of China has also dented China's export of home appliances.

Steel margins have been squeezed since February, with raw materials cost largely stable amid sliding steel prices. The margins on long steel products have recovered faster than that of flat products, mainly due to strong demand, with long-steel prices recovering since mid-March. The prices on raw materials will likely trend lower in the second quarter of 2020 as steel output outside of China declines significantly, which will stabilize steel mills' profitability.

We expect steel companies' credit profiles will improve in the second half of 2020 as inventory has run down in the second quarter and economic activity continues to improve.

Chart 7

Chemicals: Slow economic recovery clouds short-term prospects

Table 3

COVID-19-related disruption risks will linger for China's chemical sector in the second quarter. Domestic chemical companies will be focused on the challenge of returning sales volumes to pre-pandemic levels. While China's gradual economic return should support domestic consumption, demand risks remain as lockdowns in other countries depress China's export of chemicals and derived products this quarter (see chart 8).

Chart 8

Although April exports grew 3.5% from last year, the demand shock to exports should be visible in May or June data. Western countries' plan to reopen their economies in phases implies that a swift, full resumption in demand is unlikely. The risks of fresh outbreaks pose additional uncertainties to the timing of the recovery of China's chemical sector.

Apart from softened operational cash flows, the higher working capital requirements will also test the liquidity of weaker companies in the coming months. This is considering that the industry cash conversion cycle will likely remain long in the second quarter if inventory and receivables stay at elevated levels (chart 9). Companies' receivables have likely risen as companies loosen payment terms for their customers in response to the crisis. Most of our rated chemical companies in China are investment grade. These companies generally face less liquidity strain due to their diverse bank relationships and stable access to market funding.

Chart 9

Chart 10

Petrochemical margins were heavily hit in the first quarter (see table 3 and chart 10), and may only see a limited recovery in the second quarter. We consider here the double whammy of softened demand and low prices. The performance of agrochemicals and animal nutrition companies should be resilient, as demand for necessities such as food supplies have been steady despite a logistical shutdown in February. For instance, the domestic price of methionine, a nutrient used in poultry feed, has risen 35% since December. The product spread for these chemicals will likely be stable, as a lower price of oil is associated with cheaper raw material costs.

In general, chemical companies' credit metrics will weaken in 2020 due to both demand and spread shrinkage. We expect credit metrics will improve in 2021 based on our expectation that oil price will recover and economic activities continue to return to normal.

Aluminum: Expect price recovery after a weak first quarter

China's aluminum industry had a weak first quarter. The average aluminum price was down 6% quarter-over-quarter and down 2% year-over-year in the first quarter. China's nationwide aluminum inventory grew during the same period due to weak downstream demand.

Prices will likely recover in the second quarter as the Chinese economy improves, but are unlikely to swiftly return to their pre-COVID-19 levels. Capacity cuts will support prices. A significant portion of capacity is producing at a cash loss. We have observed a rebound in the price of aluminum since late March, by as much as 16% from its low. Nationwide aluminum inventory has started to decrease as downstream production recovers (see chart 11).

Chart 11

The credit profiles of our rated aluminum producers will stay resilient over the next 24 months, in our view. Leverage should increase in 2020, due to weak prices. A likely aluminum price recovery in 2021 will bolster firms' credit metrics. Our aluminum price assumptions are US$1,700 per ton for rest of 2020, and US$1,800 per ton for 2021. This takes into account decade-low inventory levels, capacity cuts, and our assumption the global economy will recover.

Gold: Output may increase in the second quarter as prices stay high

Following decent gains in 2019, gold prices have remained above US$1,500 per ounce for almost all of 2020 so far. Prices hit an eight-year high of $1,731/ounce in April, averaging US$1,609/ounce and increasing 13% since the beginning of the year to end-April.

Gold is the only major commodity that has gone beyond its pre-COVID-19 price level. Gold's strength reflects the gloomy global outlook, uncertainties around COVID-19, and low interest rates (with the U.S. Federal Reserve cutting rates twice in March 2020, following three cuts in 2019). These factors should support the price of gold for the rest of 2020, given its status as a haven during market turbulence. We believe the price of gold could remain volatile. We assume US$1,500/ounce for the rest of 2020, below prevailing prices, on the expectation that financial and economic conditions will eventually normalize.

China's mined gold output fell 10.9% in the first quarter (year on year) due to production disruptions related to COVID-19. Output will pick up in the second quarter, we expect, as the earnings prospects for the major miners look positive, as they likely increase output on favorable prices.

Chart 12

The credit profiles of our rated gold companies will remain resilient in the next 24 months even based on our gold price assumptions, which are lower than the current gold price. Production growth and disciplined capital expenditure (capex) support their credit metrics.

Cement: Demand hit hard in the first quarter, but now recovering swiftly

The COVID-19 outbreak halted construction in China, depressing cement demand in the first quarter. China's cement output was 299 million tons during the period, down 23.9% year on year. The domestic cement price remained resilient, averaging RMB456 per ton (tax included) in the first quarter, up 4.4% year on year. Reduced sales and logistics snare-ups challenged the ability of cement producers to manage inventories, especially the smaller firms. Cement inventory filled up 73% of dedicated warehouse capacity by the end of March, compared with 51% in early January. We believe top cement producers in China are less affected by tough times. Well established distribution channels helped these companies manage production and inventory levels, according to downstream demand.

Cement sales have been recovering since the end of the first quarter as economic activity gradually resumes in China. The production utilization rate in April reached about 88%, comparable to the same month last year, indicating a strong rebound in demand.

Cement demand will likely stay keen throughout the rest of 2020. Existing construction projects are making up lost progress during state-led lockdowns, and the Chinese government will likely raise infrastructure investment to support the economy.

Chart 13

Chart 14

The credit profiles of our rated cement companies remain robust given the stable industry conditions. Despite overcapacity, industry rationalization of production will support prices while infrastructure investment will uphold demand. Cement companies will generate sufficient operating cash flow to cover their capex.

Appendix

Table 4

Related Research

Commentaries:

• China's National Oil Companies Cut Spending To Weather Low Oil Prices, May 4, 2020
• China's Oil Majors Can Withstand Crude Price Slump…For Now, March 18, 2020

Research Updates:

• Aluminum Producer China Hongqiao Outlook Revised To Stable From Positive On Weaker Demand; 'B+' Rating Affirmed, April 27, 2020
• Anhui Conch Cement's Ample Cash Supports Its Exceptional Liquidity; 'A' Rating Affirmed With Stable Outlook, April 20, 2020
• Zijin Mining Group Outlook Revised To Negative On Elevated Leverage in 2020; 'BBB-' Ratings Affirmed, Off CreditWatch, March 27, 2020
• China National Chemical Corp. Ltd. Outlook Revised To Negative On Earnings Weakness; 'BBB' Ratings Affirmed, March 20, 2020
• China National Bluestar (Group) Co. Ltd. Outlook Revised To Negative On Weakening Parent Earnings; 'BBB' Rating Affirmed, March 20, 2020
• CITIC Resources Holdings Ltd. Outlook Revised To Stable On Lower Oil Prices; 'BB-' Rating Affirmed, March 18, 2020
• Xinjiang Zhongtai (Group) Co. Ltd. Outlook Revised To Negative On Demand Uncertainty; 'BB+' Ratings Affirmed, March 9, 2020

Bulletins:

• Shandong Gold Can Afford Purchase Of Canada's TMAC; Credit Profile To Remain Intact, May 11, 2020
• Chalco Can Withstand Falling Aluminum Prices, COVID-19, May 7, 2020
• Baoshan Iron & Steel Stays On Cost-Cutting Course Amid Profit Squeeze, April 30, 2020
• Zijin Mining's Porgera-Driven Spike In Leverage To Be One-Off, April 29, 2020
• Yingde Gases' Strong 2019 Will Carry It Through A COVID-Impaired 2020, April 28, 2020
• China Gold International Leans Toward Copper Amid Profit Slide, March 31, 2020
• Wanhua's Rating Buffer To Shrink Amid Soft Earnings And High Capex, March 31, 2020
• Yanzhou Coal Can Withstand Dip In Coal Prices, March 31, 2020
• Sinopec Girds For Challenging Year After 2019 Results, March 30, 2020
• CNOOC’s Record Dividend Recognizes Great 2019, Capex Cuts Acknowledge Gloomy 2020, March 26, 2020
• COSL Braces For What's Ahead After A Robust 2019, March 26, 2020
• Zhaojin Mining's Rating Buffer Tightens On Weaker-Than-Expected Results, March 26, 2020
• PetroChina's Cash Flow Goals Bolster Parent Ratings, March 26, 2020
• Ratings Buffers Of China Oil Majors At Risk As Crude Outlook Grows More Bleak, March 23, 2020
• CNOOC And Australian LNG Exporters Can Absorb Impact Of Force Majeure, Feb. 12, 2020

Full Analyses:

• Wanhua Chemical Group Co. Ltd., May 12, 2020
• China National Bluestar (Group) Co. Ltd., April 1, 2020
• China National Chemical Corp. Ltd., March 31, 2020