20th October 2015
Rowan Dartington Signature’s Guy Stephens says it is wrong to blame China for the adjustment in commodity prices and pain for the industry.
“And so there we have it, quarterly Chinese growth of 6.9% on an annualised basis compared to market forecasts of 6.8% and the government’s target of 7%. Signs of weakening growth in the industrial sector are being offset by strong growth in the services sector, which is conveniently consistent with the government’s policy of moving the economy from export-led manufacturing to internal consumption.
“This all presents perfectly for the government and smacks of the usual manipulation which bears little reality to what is being suggested by other statistics. We have no ability to audit the numbers as happens in the West and so this data release has to be taken with a mountain of salt. This is why we have seen almost no response from the markets, either positive or negative. We know no more today than we did yesterday The macro view in the West is having to rely on the evidence coming from individual bottom up analysis of affected companies and neighbouring countries, and this is complicated by the characteristics of the businesses and economies themselves.
“If you stand back from the Chinese economic debate and look more closely at commodities, there are perhaps some clearer, more predictable features which are showing themselves up once more. The insatiable demand for raw materials throughout the Chinese building boom of the last ten years has led suppliers to ramp up production. One thing the world has in abundance is stores of accessible iron ore and copper and the industry does not face the same extraction challenges, state and OPEC intervention than the oil industry.
“It is human psychology to invest for tomorrow’s expected supply requirement based on today’s demand and profits, in complete ignorance of what really lies ahead. The UK housing market is a classic example and this is why housebuilders are always restrained these days, no matter how buoyant the market may be. They have learnt lessons from the past that to have significant work-in-progress and capital tied up can lead to disaster when housing prices fall. If the selling prices of houses had halved over the last year, planned new projects would have been cancelled and all developments would be loss-making with some corporate casualties in evidence.
“In the commodities sector, it takes at least 3-4 years for a new mine to be fully operational and productive with significant investment required. However if the environment turns down, the mine can be mothballed, all leased equipment returned, jobs go and the operator can return when the environment improves. Profits from the facility will disappear but many of the costs are variable and so cash-flow can be preserved.
“We know that commodity businesses are feeling the pain of weak prices, but is this pain self-induced rather than mainly due to a drop in Chinese demand? Official figures from the World Bank reveal that Chinese GDP rose by US$870bn in 2014 from the prior year to a total of US$10,360. This was down from an increase of US$1029bn the year before and US$969bn the year before that. However, when we consider that in 2006, the entire Chinese GDP figure was US$2,269bn, it is little wonder that the rate of growth is falling as the numbers get bigger. But even last year, the increase was equivalent to 40% of the entire figure from 2006 and was still over three times the growth of the UK economy, and 1.3 times that of the US.
“The pain being felt by the commodity producers and extremes seen in the pricing cycle have been witnessed before, when Chinese demand did not feature in the equation. Higher prices have the effect of attracting supply without discipline from poorer countries who perceive a bonanza unlike no other. This then leads to a glut in supply a few years down the line and would now appear to be all the greater as the global economy has opened up and many export tariffs have been removed.
“The price of copper is currently $5,000 per metric tonne and has halved since early 2011. However, for much of the 90s, it was priced at $2,500, reaching a level of $7,000 in early 2008 from when the credit crunch hit the West. The price of iron ore has shown similar behaviour where it is currently around $50 per metric tonne falling from a peak of $200 in early 2011 but was just $10 in 2003. Similarly, with Steel, which was priced at $300 per metric tonne in 2003, peaked at $1,000 in late 2008, stabilized at $875 in early 2011 and is now $420.
“China has been vilified as the great pariah for distorting the global commodity market but in reality, the industry has geared itself up for a pricing environment which was unsustainable. This will continue to be the case whilst operators continue to forge their long-term plans based on the current short-term environment. Today, it is difficult to see where any significant marginal demand will come from and we still have a glut of supply. It is very easy to blame the Chinese slowdown and the accuracy of their data releases but the reality of the commodities pricing environment is here and for now, it is very difficult to see why it should change for the foreseeable future.”