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While it has taken many months to reach a consensus, most analysts now accept that global base metal prices reached their peak in April last year and probably won’t return to those dizzying heights in the current cycle. Now the question is: how long will prices remain elevated above the marginal cost of production, given the large lift in mine supply due in resources like iron ore and copper? Many had hoped the so-called “commodities super cycle” would run for two decades, but that prospect now looks decidedly doubtful.
“The exceptional price acceleration that was underpinned by resources demand growing at a faster rate than GDP growth in some countries, namely China, is over,” said Christian Lelong, executive director of commodities and resources strategy at Goldman Sachs in Sydney. “This was an abnormal trend that is unlikely to be repeated as we look into the future.”
Historically, industrial commodity price cycles last for decades, with the last bear market spanning nearly 40 years between the 1960s and the turn of the century. Bull cycles are usually fuelled by rapid demand in raw materials as nations witness a generational shift in prosperity — events like the rebuilding of Europe and the US after World War 2, and Japan’s economic rise. Usually demand for commodities is strongest when there is persistent economic growth in developing or emerging economies.
The current bull market started in a flurry in the early-2000s, and prices rose much faster than expected. In fact, the bull tore out of the gate at such speed that the upswing was soon being referred to as a “super cycle” with expectations that it would run longer and harder than any other cycle in history. The reason for the jubilation was China. “China’s robust appetite for raw materials kicked off in 1998 when Deng Xiaoping introduced a range of economic reforms that allowed commerce to flourish,” said Tom Price, global commodity analyst at UBS. “In the 1990s, when the economy was beginning to expand, the Chinese primarily exploited their own resources, but eventually domestic resources were depleted and mining costs lifted, so they went searching for resources abroad. Curiously, this large, structural shift in global trade was not properly understood worldwide for several years, and the resources equity rush did not really begin until 2005.”
Between 2003 and 2008, commodity prices soared with iron ore rising from $13 per metric tonne to $97 per tonne, and copper rising from $1,500 per metric tonne to $8,700 per tonne. When the financial crisis erupted and recession descended on Europe, prices crashed — but only for a moment. Within months of Lehman Brothers’ collapse, which is considered to be the nadir of the crisis, prices were making a speedy recovery, and by the end of 2010 were close to or above their peaks. Iron ore, for example, was now selling at $172 per tonne. Thomas Helbling, a division chief in the IMF’s research department, believes the rapid recovery occurred because real GDP growth and industrial activity in the developing world quickly returned to pre-crisis trends. “This was especially evident in China where strong stimulus policies further fuelled commodity-intensive investment,” wrote Helbling in a recent article on the origin of commodity prices booms.
With so much demand coming from Asia, and with new mines still under construction and unlikely to deliver extra supply to the market in the short term, pundits claimed the “super cycle” would endure and prices would continue to rise. Indeed, FinanceAsia published a cover story in August 2010 in which analysts said there were “good reasons to expect the upswing to go on for another 20 to 30 years”.
China applies the brakes
What has happened since then is an unexpected drop in Chinese growth. Instead of growing at more than 10% per year, China is now forecasting that its economy will expand by 7.5% in 2012, its slowest growth in eight years. Whether this is the result of fiscal policy levers being applied too firmly, or a prolonged slump in Western demand for Chinese goods, there is no doubt that a structural shift is underway in China.
In its analysis of the market, Credit Suisse has attempted to turn the spotlight off China and shine it on global GDP growth as a driver of commodity prices. “Many consider the issue of [commodity price rises] through the prism of the structure of the Chinese economy,” said Ric Deverell, head of global commodities research at the Swiss firm. “But, to us, the evidence is clear — broad movements in commodity prices over the past few decades have been driven by movements in global growth, not just Chinese growth, and there is little suggestion that this relationship has broken down.”
Deverell believes the fate of the “super cycle” is inextricably linked to the fate of the global economy. For the remainder of 2012 that means prices are likely to drift lower before stabilising towards the end of the year. “In April we forecast that global growth would return to 4% in the second half, but that appears to be too optimistic and our current forecast is for growth of 3.5%.” Looking to 2013, Deverell said Credit Suisse’s economists expect global growth to rebound to 4%, pushing commodity prices gradually higher over the course of next year. “However, this is highly contingent on a period of relative stability in Europe.”
Helbling at the IMF says the long-run outlook for commodities is murky because sources of growth in emerging and developing economies are changing. “China’s latest five-year plan strives to move the economy from investment- to consumption-driven growth and this is likely to change the nature of China’s commodity demand,” he said. At the same time, buyers are “adjusting to high commodity prices by innovating and finding lower-cost substitutes” that will eventually reduce demand for traditional resources.
That said, most of the industry experts that FinanceAsia spoke to for this story, believe there is room for the bull market to run. “The fact that we may have already hit peak prices doesn’t mean the sector is due for a hard landing,” said Lelong at Goldman. “In absolute terms, there are still plenty of opportunities to be had as demand for commodities continues to grow and mining companies continue to invest.” Lelong suggests markets are “returning to normal” after a peculiar period of supersonic growth. “The days when China’s economy was growing at 10% and its demand for commodities was growing at 10% plus are over and we don’t think this scenario will return. Instead resources consumption in China is likely to come in below GDP growth; something around 4% to 5% on average.”
Price at UBS is another analyst who expects commodities demand to remain strong for several more years, but not at “super-cycle” levels. “The size of trades has expanded and these trades will remain large — relative to long-term historical averages for the global commodities market,” he said.
Preparing for leaner times
Even if these predictions are true, mining companies around the world face some interesting challenges as they prepare to cope with a drop in prices and an increase in supply. Margins will be lower, and profits crimped.
BHP Billiton is already adjusting to the new environment. In August it announced the cancellation of two expansion projects in Australia worth a combined $50 billion on a hunch that now is the time to limit future production. This is significant given that miners tend to be a bit more optimistic in their price projections. “Some mining companies can have a biased view of the future, and this can drive bullish predictions of long-term demand growth and prices,” said Lelong, who worked inside BHP for several years. “Depending on the assumptions that companies choose to make, it is possible to come up with a wide range of forecasts within the industry,” he said.
Just how firm or soft miners choose to apply the brakes to production will depend on the outlook for each commodity. Deverell at Credit Suisse predicts that in the next 12 months there will be “modest downward revisions” in prices for iron ore, copper, platinum group metals and metallurgical coal, which is used in steel production. Prices for aluminium and nickel, meanwhile, will be trapped within generally narrow bands.
The commodity likely to suffer the greatest drop in price is thermal coal — the coal that is used in power stations. Thermal coal supply is in abundance, and when demand drops in major markets such as India and China, a surplus quickly develops. “We expect the thermal coal market to endure a painful combination of production cutbacks and project deferrals as producers attempt to achieve a level of supply discipline,” said Deverall. He predicts prices could stabilise and start to move higher in 2015, but only if miners make the necessary cuts now.
When production cuts become necessary, the first mines to pare back are those with higher cost-of-production rates — and this has implications for Asia’s mining sector. Despite having access to cheap labour, many mines in Asia operate at a higher cost of production due to lower-grade deposits and inefficient mining techniques. Poor infrastructure also makes it more expensive to deliver the product to market. Iron ore miners in China, for example, spend up to $100 to produce a tonne of ore compared to about $40 spent by producers in Australia and Brazil.
“China’s domestic production of iron ore is vulnerable because it makes up the last supply quartile in global markets,” explained Price at UBS. “That means China’s mines are the first to come under pressure as ore prices fall. Following the recent correction in iron ore prices, we expect China to report production cuts in coming weeks, and this would be an entirely rational response.”
Mining companies that make up the last supply quartile are always at risk when global commodity prices contract. And many of these are junior mining companies that are unable to take advantage of economies of scale. “Smaller projects aren’t viable when the spot price remains below the level to justify development,” said Richard Henning, CEO of Stonehenge, who spoke to FinanceAsia in February this year about his plans to develop three uranium mines in South Korea. Stonehenge is an Australian-listed junior miner that was planning to become Korea’s first uranium producer. At the time, the uranium spot price had stabilised at around $55 per pound, which was about $10 above the marginal cost of production for the most efficient producers. Henning said he was waiting on the price to hit $60 per pound for his projects to become viable, but since then prices have been steadily declining, dropping to as low as $48.50 at the end of August.
A lift in mine supply
While projects that are still on the drawing-board will probably be put on hold in coming months, others that are already funded and under construction are likely to go ahead. Several large projects that were started at the height of the super cycle are nearing completion and are about to come onstream. Fortescue Metals Group, an Australian company that is the fourth largest iron ore producer in the world, has invested $9 billion on its mines in Western Australia’s Pilbara region, including building new port and rail infrastructure. Its production levels are due to increase from 55 million metric tonnes today to 155 million tonnes by the end of June next year. Together with new projects being built by its bigger rivals — BHP, Rio Tinto and Brazil’s Vale — the global supply of iron ore is set to double in the next two years.
Copper is another commodity where a large lift in mine supply is expected. “China is heavily dependent on copper, and throughout the 2000s, the supply side massively underperformed,” said Price at UBS. “So miners went looking for copper in far-off places like Africa and Mongolia. If all of the projects that are in the pipeline eventuate, then there is a real risk of oversupply, leading to a price fall.” In this scenario BHP’s decision to delay its Olympic Dam expansion seems logical.
“In general, prices tend to fall in line with the costs of the marginal producer,” said Lelong at Goldman, attempting to put a floor under long-range forecasts. He predicts a drop in iron prices from today’s spot of around $105 per tonne to $77 by 2017 and beyond. Similarly Goldman’s forecasts see copper prices dropping from $4.40 per pound today to $2.28 per pound in five year’s time.
Long-range price predications aren’t an exact science and, in periods of market panic, prices can overshoot. Commodities trading can be impacted by macroeconomic events in buyer markets and everyone is aware that the European debt crisis has the potential to derail the recovery process once again.
Another factor that is difficult to model is the capacity for the big miners to influence prices by subtly adjusting supply. This is more prevalent in markets where oligopolies exist, such as iron ore where the three largest players control 75% of seaborne trade. “This isn’t collusion per se,” said one analyst, speaking off record, “but they observe each other’s behaviour and turn the supply tap on or off to support prices. This support can go on for a lot longer than I can project in my pricing models.”
Other analysts doubt whether such scheming can truly impact prices. “This practice may work in a market where margins are narrow,” says one, “but margins have been so attractive in recent years that the incentive to grow production as quickly as possible has been too tempting. From a commercial point of view, it doesn’t make sense to hold back production when each tonne you dig out of the ground gives you a 60% margin.” This analyst also dismisses the notion that the iron ore market is a tight oligopoly. “Having four large players is enough to create competition and cause someone to break ranks. The only market where there is true single-supplier concentration is mineral sands.”
The next 12 months will be very telling as the market comes to grips with the notion that the “super-cycle” party is over. Commodities demand and price movements are now likely to mirror global GDP growth patterns. The inevitable consequences of this are leaner margins for producers and lower returns for shareholders.
This story first appeared in the September 2012 edition of FinanceAsia magazine.
