Apparantly, a lot of the this year's strength in keeping copper north of 2 bucks has been increased Chinese buying as it rebuilds its inventory.

To get "behind the headlines," I extracted this bit from this week's Pierce Points written by Dave Forest. This is one of the better weekly reads that hits my inbox...and it's a free sign-up.

Anyone else out there?

Gryphon, how about an update?

What China is Really Thinking

China came to the rescue of base metals markets over the last few months. When the Chinese government announced earlier this year that its State Reserve Bureau would buy strategic stockpiles of copper, zinc and aluminum, prices for all of these metals took flight.

The government's purchase program did a few things. Firstly, it supported market prices with fresh buying. This pushed metals prices higher at all of China's buying hubs. So high in fact, that Chinese prices reached up to a 20% premium above London Metals Exchange prices. At that point, the game was on. Speculators in China realized they could make good money importing cheap LME metal and re-selling it on the Chinese market. Some chose to hold copper, zinc and aluminum in anticipation of even higher prices as the government continued to buy. A wave of Chinese import buying swept through the global base metals market, further propping up worldwide prices.

And there was a third benefit. Increased confidence in the base metals. So much that prices are staying buoyant even though Chinese government buying has ended. Last Friday, the Chinese National Development and Reform Commission told a forum in Beijing that the government will stop building stockpiles of non-ferrous metals. To quote the Commission, "Nonferrous metals prices have bounced and aluminum smelters have already obtained profits under the current market condition. The government's attempt to help the nonferrous metals industry has been achieved."

Given that Chinese buying has been one of the only bright spots for the base metals recently, many observers feared that the end of the government purchasing program might crater prices. But so far there has been little impact. Copper held firm this week around $2.30 per pound. Aluminum and zinc also were little changed. The world seems to believe in base metals again. With or without Chinese buying. Same goes in China. Even though the government purchasing has ended, Chinese prices continue to trade at a premium to LME. Copper is trading at $2.70. Zinc at $0.90. A 20-30% premium to LME prices.

Why is everyone suddenly so bullish on base metals? Only three months ago, copper was trading at $1.25 and zinc at $0.50. The recent bounce in global stock markets has helped. Investors are thinking that the world may recover from recession sooner than expected. But a larger part of the current base metals enthusiasm is coming from the "China safety net" theory. Many investors believe that any future dips in metals prices will bring the Chinese back into the market, supporting prices. China needs metal, and it will buy whenever prices get attractive in order to build its stockpiles. So the story goes.

This argument sounds good for base metal bulls. But it ignores some of the information we've got recently from Beijing. Particularly regarding the intent of the recent metals purchases. Many analysts assume that China was buying because it needs the metal to feed its infrastructure development. This is only partly true. The government was also buying metal to support its domestic mining industry. China's mining sector has yet to be fully modernized. Production costs at many Chinese mines are high by world standards. So when world metals prices collapsed, much of the industry was losing money. Half of China's iron mines have reportedly shut down. Up to 30% of nickel mines have also been idled.

This is a major concern for the government. Not because the country will run out of metal (they could simply import it from abroad, at a lower price). But because they don't want to see thousands of miners unemployed. Preventing social unrest is job one for Beijing, and there's nothing more unrestful than a large number of idle young men (for the most part) throughout the country. These mines need to stay open for political reasons. And that means metals prices have to be high enough to cover the cost of production. Cue the government buying. Prices rise, and suddenly mines are profitable again. Everyone keeps their job. Peace and stability reign. Remember the government quote above, "Nonferrous metals prices have bounced and aluminum smelters have already obtained profits under the current market condition. The government's attempt to help the nonferrous metals industry has been achieved." Officials are most concerned that their smelters (and mines) achieve a profit. Helping the metals industry is top priority. Building stockpiles is a side benefit.

The Export Problem

Part of the problem for the Chinese government is that pushing up domestic prices has caused some "collateral damage". As we discussed above, high Chinese prices have created an arbitrage with the LME. Causing a flood of imported metal. This wasn't exactly what the government had in mind. As one analyst put it, "Beijing wanted to support its domestic producers, not buy the world's entire supply of aluminum." In fact, high imports work against the government plans. Now the domestic mines (that Beijing wants to support) have to compete with supply from around the globe!

Iron ore is a good example. Chinese iron ore imports have been on a tear in 2009. At the end of April (the last month for which we have data), 188.5 million tons of ore had landed in China so far in 2009. This is 33 million tons more than was imported during the same period in 2008. A big increase. Some of this was to replace domestic production as high-cost Chinese iron ore mines shut down. But lost production was only about 15 million tons. Less than half of the amount of extra imports. Where did the other 18 million tons go? Chinese steel output has been almost flat through the first five months of 2009, so there hasn't been an increase in iron ore demand. The extra imports must have gone to stockpiles. Held either by iron ore users or by speculators hoping to resell the ore at higher prices. Either way, this is a lot of supply waiting to "come out of the woodwork".

The government is now moving to prevent this kind of "over-importing". Last week it announced export tax reductions on 90 commodities, including a number of metals. The reduced tax makes it cheaper for holders of metal in China to sell their product abroad. It should encourage traders to start sending metal out of the country rather than endlessly importing new supply. This should allow China to give back some of the metal it has accumulated recently. And could put a damper on global prices if significant supply starts making its way back to warehouses around the world.

The export policy initially focuses on tungsten, molybdenum and indium, but similar measures have been discussed for other metals. It will be important to see how the prices of these metals respond. This will give us an idea on the coming fate of some of the other base metals.

The Mining Sector Grows Up

Of course, even if Chinese metals buying is aimed at supporting local miners rather than building stockpiles, the end result for prices should be the same. If we get a dip in base metals prices, the government will be forced to step back into the market to drive prices up again and ensure profitability for its domestic producers.

For the moment anyway. Obviously it isn't feasible in the long-term to support a high-cost industry by keeping domestic prices at world-highs. The Chinese government knows this. And they're encouraging the mining industry to modernize. Earlier this year a plan was floated to combine numerous small operations in several metals sectors to create larger, more efficient producers.

Chinese mining companies (under the direction of Beijing) are also putting a lot of money into their individual mines to bring them up to world standard. So far in 2009, fixed investment in mining has reached $19 billion. Up 30% from last year. The iron ore sector has seen a particular increase in investment, with fixed asset purchases here up 50% year-on-year. Upgrading the mining industry is a priority. By contrast, the Chinese domestic petroleum sector has only received $10 billion of new investment this year. Up just 10% from 2008. China certainly needs oil. But mining is taking the front seat in terms of investment.

How might the mining industry lower its cost structure? Modernizing equipment and practices at existing mines will help. As well as consolidating small operations to achieve economies of scale. And part of the answer is simply finding better, lower-cost deposits to produce. Some of the increased investment in the mining sector is therefore going into exploration.

And that exploration is paying off. Last month a geological team in Liaoning discovered what appears to be a world-class iron ore deposit. The deposit is estimated to contain 3 billion tons of iron ore reserves, twice the size of CVRD's giant Carajas deposit in Brazil. And the geologists involved believe the size of the deposit could double with further exploration. A large deposit like this is likely to have lower production costs than existing, smaller mines. Exactly the sort of thing China needs in order to lower the cost structure for its mining industry.

If the Chinese can bring their mining operations up to world standard, there will be less need for Beijing to support metals prices. At that point we will see how much metal the country actually needs to stockpile for industrial use alone.