Over the past few days many local governments began to cut power supply to energy intensive producers (such as steel ,ferroalloys and cement mills) to enforce the energy intensity targets. However, such policies are likely to be short lived and supply shortage in the raw materials sector may only support prices tentatively, in our view.

The initial attempt to shut down production capacity in energy intensive sectors in the first half of this year resulted in no improvement in energy intensity (defined as energy consumption per unit of GDP) -– in H1, energy intensify still rose 0.09% yoy. The government now finds itself running out of time in meeting the year-end target of energy intensity reduction by 5.2% for this year. In recent months, specific energy consumption reduction targets have been decomposed to the provinces (especially provinces that have failed their H1 targets by significant margins, including Hebei, Anhui, Jiangsu and Zhejiang) which in turn imposed these targets on city and county level governments. It was reported last few days that in many cities or counties of these provinces, power supplies for hundreds of companies are being cut off for a few weeks (many until early or mid-October), while some local governments claim that these power cuts will last until the end of the year. In some other locations power supplies are being rationed (e.g., 9 days of power supply followed by blackout for 5 days). In Anping county of Hebei province, the government went too far to suspend power supply to households, hospitals, schools and even traffic lights. Media reports of this incident immediately resulted in a NDRC order for Anping government to rescind its decision.

Many of these power blackouts are hitting steel,ferroalloys  and cement mills, which are heavy users of electricity. As a result, steel and cement prices begin to rise on expectation that supply shortage will be severe in the coming months. However, we believe that these power cuts will be short lived and production will likely resume after about a month. Unless underlying demand from the economy is picking up – which is unlikely in our view, it is difficult to support a sustained price rally for cement and steel. Here are three reasons why we think the power cuts cannot last very long:

First, it is political imperative to aggressively enforce the energy intensity targets before the October Party congress, in which the government will need to report its achievement over the past five years including on structural issues such as energy intensity reduction. After that, although theoretically the annual (year-end) target remains important, in reality its political significance will fade as there will be no major conventions that draw public attention to the numbers.

Second, one month of power blackout would result in significant reduction in industrial production (in some location could be 10-20% decline), financial loses, decline in tax receipts and even default on bank loans by affected firms. By mid-October, some local governments will likely complaint loudly about job losses as well, in our view.

Third, yoy GDP growth will likely fall below 9% in Q3. This number will be reported in mid-October, and by then more officials would realize that GDP growth would trend towards 8% and IP growth would also slow to about 8% yoy in Q4 (from 16% in Q2). Historically, when GDP growth slows to 8%, the energy intensity target (4% reduction per year) would be automatically achieved without additional government intervention, as demand for heavy manufacturing products weakens faster than GDP. The realization of the demand deceleration in October will help convince the government that mandatory production cuts will become unnecessary.

In sum, we think the supply shortage of steel,ferroalloys and cement will likely be only a tentative support for their prices.

• [Editor:editor]