Companies Can Make Money in China but It Comes With its Own Unique Risks

Chinese demand for natural resources was a key driver of growth in the mining industry...until the country's growth started to moderate. China is still clamoring for resources and growing relatively strongly, but slower growth coupled with a ramp up in supply led to steep price drops in many commodity markets. And that should serve as a warning sign for two currently attractive areas.

Holy coal demand Batman!
According to the U.S. Energy Information Administration, coal consumption in Asia increased 400% between 1980 and 2010. China was responsible for the bulk of that growth, with the country now accounting for around 50% of world coal consumption.


Source: EIA

It's no wonder coal was a hot commodity. However, that demand and relatively high prices, particularly for metallurgical coal, led miners to aggressively open new coal mines -- even marginally profitable ones. So, when Chinese growth started to moderate, supply quickly outpaced demand.

The result was a precipitous fall in coal prices. For example, Peabody Energy (NYSE: BTU  ) watched the realized price of its Australian coal fall from about $102 a ton to slightly less than $78 a ton year over year in the third quarter. That's more than a 20% decline.

More than just coal
This is a big issue for other miners, too, including BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RIO  ) . Like globally diversified Peabody, both of these giant miners have notable Australian operations that sell to China. The problem they face, however, is that in addition to coal, they also sell other resources. And the same supply/demand imbalance that's hurting coal has taken a toll elsewhere.

BHP, for example, saw low single-digit revenue increases in its oil and copper businesses more than offset by double-digit declines in iron ore and coal during fiscal 2013, ended June. The top-line shortfalls at these divisions showed up despite the fact that BHP actually sold more tons of iron ore and coal. The culprit was clearly weak pricing.

What now?
Mining-equipment maker Joy Global (NYSE: JOY  ) notes continued strong demand for its equipment within the copper industry. That's good news for Joy, which has seen sales fall off throughout most of the other industries it serves. But increased spending in the copper industry could simply be setting up a supply/demand imbalance similar to what's taking place in iron ore and coal.

About half of BHP and Rio's businesses are tied to iron ore and coal. However, neither would like to see copper, which makes up about 10% of Rio Tinto's business and 18% of BHP's, add to the pain. Imagine, however, how Freeport McMoRan Copper & Gold (NYSE: FCX  ) would feel, as one of the world's largest copper miners.

That helps explain why Freeport recently paid $19 billion to diversify into the oil and gas exploration space; a move similar to one made by BHP a few years earlier. However, copper isn't the only "hot" commodity to keep an eye on.

Timberland companies Weyerhaeuser and Rayonier both noted Chinese demand for lumber as a key performance driver in their third-quarter conference calls. If Chinese demand for wood slows down, both would feel a pinch even if domestic lumber demand brightens.

Yin and yang
Chinese demand is a mixed blessing. As an investor, you need to watch what China is doing because any changes could have an outsized impact on your natural-resource holdings. Copper and timber are two areas to monitor right now.

That said, China is still one of the fastest growing countries in the world -- a silver lining for even out-of-favor industries like iron ore and coal. When supply and demand balance out, prices will again start to rise and companies like Peabody, BHP, and Rio will benefit. 

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