Wednesday, April 17, 2013

Falling Commodity Prices Spell Trouble

Indonesia, Malaysia, Australia on the firing line

The wheels are finally coming off the decade-long commodity boom. Watch out, Australia in particular. But beware Indonesia and to a lesser degree Malaysia. The price decline has probably only just begun.

Take gold, often seen as a harbinger of commodity price trends generally. Those who think it is cheap after a 20 percent fall from its high should remember that it is still four times its price just 10 years ago. Iron ore is still five times and thermal coal three times 2003 levels.

Of course valuing a commodity mainly seen as a store of value rather than a useful metal is almost impossible. But there are some guidelines worth keeping an eye on in assessing gold's average price over long cycles. One is the cost of production. This matters less for gold than other metals simply because annual output of around 90 million ounces is still small - about 1.5 percent -- relative to the total existing supply. But much of that supply is locked up in central bank vaults so at the margin changes in demand and supply can be very significant. That is where supply issues enter.

It is currently estimated that the all-in cost of new mines is around US$1,300 an ounce. So new companies are not going to open new mines unless they believe the price is going to be sustained above that level. But many projects are already well under way on the assumption that it will. Added in is the impact of new copper mines producing gold as a by-product.

A more important number too than all-in cost is the marginal cost of production for existing mines. That is now estimated to be around US$800 an ounce so the price still has a long way to fall before these find additional production uneconomic.

By chance, perhaps, this price roughly coincides with another so-called "fair price" calculation - the ratio of the gold price to the US consumer price index.

Gold like other minerals has seen advances in mining and processing techniques which have enabled production to double in the past 30 years without the discovery of huge new deposits such as those which once existed in South Africa.

Clearly gold was driven to nearly US$2,000 not by either the cost of production or as a multiple of the US CPI but by "safe haven" concepts associated both with the global financial crisis and more recently by fears of inflation caused by central bank quantitative easing, sometimes dubbed "money printing." In real terms gold almost regained the US$800 peak seen in 1980 when global inflation was rampant in the wake of massive oil price increases.

But once perceptions change the impact on prices can be sudden. Now the evidence that inflation is about to surge is hard to find. Despite QE, advanced economies are growing very slowly, if at all, China and India and most of the developing world have also slowed. Yet fears of global crisis have also receded.

Gold was always a momentum play and one encouraged by the emergence of gold Exchange Traded Funds which have been in existence for less than a decade but which were heavily promoted and even now, after significant withdrawals in recent months, hold some 80 million ounces or nearly a year's mine output. Some gold funds are also leveraged.

Add in the possibility that some central banks may sell gold rather than buy it and the short term demand/supply situation looks as weak as the longer term marginal cost one.

Quantitative easing may be creating some asset bubbles but definitely not in gold or other commodities. Indeed the broader fall in commodity prices caused both by underlying demand/supply issues as well as sentiment and ETFs may well ensure that inflation remains low despite QE in the US, Europe and Japan and by official stimulation efforts in China.

Already there is evidence that the fall in energy prices in the US caused by the shale gas boom is providing more stimulus to the rest of the economy than QE is. The fall in the price of thermal coal could well do the same for China. And it is only a matter of time before a combination of new gas and oil production elsewhere, plus shale gas development in other countries, ensures that energy prices are likely to be a global stimulus, not a drag - except of course for countries such as Australia, Indonesia and Malaysia.

In Australia mining and gas producers are seeing the writing on the wall and putting major projects on hold. But meanwhile others are too advanced to stop now and will go into production, having incurred costs far above original estimates thanks to the strength of the Australian dollar and the outlandish costs of labor in the remote regions of the country where the mines are located.

The much advertised and criticized Chinese mining investment binge in Africa, South America and parts of Asia is also beginning to have an impact on supply - much to the future discomfort of many Chinese companies but to the broader advantage of China which will see lower import prices.

Just as miners big and small failed to see the boom in Chinese demand and thus profited from shortages and high prices, so now the opposite is occurring. Chinese (and other developing country) demand is not increasing as fast as assumed. China's overall growth rate was unsustainable if only because of demographics. But more importantly, the miners forgot that as China grew richer demand increases would shift from commodity-hungry housing and infrastructure to services, household appliances etc. China would well continue to grow by 6-7 percent a year while barely increasing commodity imports. The scope for increasing energy efficiency also remains huge.

ETFs and momentum plays have had a role in prices of other commodities than gold - though to a much lesser extent. Speculative buying by Chinese companies has also played a role though it is hard to see whether unwinding is needed.

Not every commodity has suffered to the extent of gold or even oil. But the iron ore price looks more propped up by the collapse - for political reasons - of Indian production. Agricultural ones may in the medium term be less impacted if only because of scares about the impact of climate change on production. However, there is scant evidence that overall supply is falling behind demand, and China's need for imports may be plateauing given the huge increases already seen in protein and fat intakes in local diets.

Prices will likely continue to be driven by shorter term shifts in supply but those of tree crops have long cycles so with an oil price spike or a big setback to soybean production rubber and palm oil look more likely to go down than up.

So all this sounds like bad news. But it is actually good news for the majority of the world's population who are consumers, not commodity producers and will be a spur to growth in every country which is a net importer of them. Meanwhile new commodity exporters will make life harder for the traditional ones like Australia. Asia Sentinel

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