Supply Cuts Set Stage for Rally (Eventually)

The recent, "It's official; we're in a recession" announcement on Monday comes as no surprise to most people, and definitely not to anyone investing in the commodity markets. It just means that we can "officially" use the word everyone has been whispering in the back room.

Commodities investors took the hit on the demand side early in this recession, but it seems like only recently that the realization has come on in full force. On November 11, the AP ran this quote from Richard Feltes, senior vice president and director of commodity research for MF Global in Chicago, which summed it up nicely: "Commodities and equities, which are typically inversely proportional, seem to be trading in lockstep. Commodity demand is tied to economic growth, and to the extent that the equity markets are signaling continued economic slowdown, that means lower demand for basic commodity materials, be it steel or grains or whatever."

So far, the commodities crash has been the story of demand drying up. As we point out here again and again, commodities are the home of microeconomic purity, where supply and demand come home to roost.

But an interesting thing has been happening recently, which has major implications for the commodities market in the future: Supply is starting to dry up as well.

The canary in the coal mine for this is the Baltic Dry Shipping Index, which is trading at record lows. Large bulk carriers are reportedly available for hire for literally less than the cost of the suite at The Ritz.

The ship prices are absurd. It now costs just $2,800 a night to rent a bulk carrier, down from $250,000+ just six months ago.

Let's be realistic; there aren't really a lot of ships running around the Pacific at those rates. Those rates are symptomatic of a complete collapse in that corner of the market, with huge numbers of carriers sitting idle.

And the reason the prices are so low in the first place is that mining companies are slowing down production, even closing mines, as fast as they can.

What Does It Mean?

It's perhaps blasphemous to suggest that the market is acting in a fairly rational way. Demand has fallen, and we're finally seeing supply contract as a result. Ultimately, this means prices will stabilize for what we suspect is a depressed level of demand, which primes them to go higher in a hurry when demand resumes. And this could happen in a significant way.

Iron & Steel

Nowhere is the supply crunch more evident than in the big bad industrial sector - the one made out of steel and stone.

The biggest headline, after years of watching, is that BHP finally called off its hunt of Rio Tinto. Citing the global downturn, low commodity prices and tight credit markets, BHP just let the deal evaporate.

But canceling deals isn't the only thing BHP has been doing ... or not doing. In the latter part of November, they announced iron pellet production cuts in Brazil, and on Tuesday this week, they announced temporary cuts in manganese production because of weak market conditions. While not a tradable metal, this minor metal is strategic - in other words, another canary - in making steel, batteries and items like aluminum cans. (For a discussion of minor metals and their strategic role, check out HAI's interview with Charles Swindon from this past June.)

BHP is not the only company that is cutting back. U.S. Steel just announced yesterday that they will be idling three of their steel mills - but for how long, no one is saying. "The length of the layoffs depends on the strengthening of customer demand," Erin DiPietro, a spokesperson for U.S. Steel, was reported as saying.

In other words, don't hold your breath.

In India, there have been a ton (pardon the pun) of iron mine closures, and India's largest iron ore producer, National Mineral Development Corporation (NMDC), is contemplating reducing its prices by 40% in an attempt to increase demand from steelmakers.

How bad has demand for steel been? Well, try this on for size.

"Steel mills around the world have already announced production cuts amounting to 36.1 million metric tons this quarter. The outlook is for more steelmaking cuts in 2009 as most research firms believe demand will decline by as much as 10%," writes Tom Stundza for Purchasing.com. He goes on to say, "This quarter, European Union steel mills have accounted for 10.5 million metric tons of the production cutbacks; China for 10 million metric tons, Russia for 5.5 million metric tons and North America for 5.5 million metric tons, according to [Merrill Lynch & Co. commodity analyst Tom] Price."

To put those numbers in perspective, Marius Kloppers, CEO of BHP, put steel production in China down 17% so far this year, according to a Bloomberg article on coking coal. Speaking of coking coal, demand is down there too, so much so that analysts are expecting prices to drop anywhere from 30 to 50%.

But even crashing prices don't necessarily mean contracts will get fulfilled. There's news that Nippon Steel is hoping to flat out cancel some deliveries of iron ore and coking coal due to lack of steel demand.

No wonder everyone involved in the iron and steel industry is in full-on shrink-your-way-to-greatness mode; even to the point of trimming 9,000 sales and administrative jobs to tighten their belt, like ArcelorMittal. (The fact that there were 9,000 nonproduction jobs in that one steel company that could be cut is itself astounding).

Beyond Steel

It isn't just steel either. In October, Alcoa cut 265,000 tonnes of aluminum production at its Australian Wagerup mine. (Wagerup is 60% owned by Alcoa.) It followed up with an additional cut of 350,000 tonnes per year for a grand total of 615,000 tonnes, or 15% of Alcoa World Alumina and Chemicals' annual production output. Considering that a full quarter of the world's alumina comes from this one joint venture between Alcoa and Alumina Ltd., that's a pretty big reduction.

Not to be left home from the party, copper is seeing production cuts too. Freeport-McMoRan, the largest copper company in the world, is cutting production estimates for 2009 by 200 million pounds (a 5% reduction), and lowering 2010 estimates by 500 million pounds (11% reduction) from its previous estimates in October. A lot can change in one month, apparently.

Also worried about not having a date for the recession prom, Nippon Mining is thinking about reducing copper production by 10 to 20% - a decision should come by the end of the year.

When Does It End?

These are just a few sectors of the commodities market - those most immediately heralded by the ridiculous collapse of the BDI shipping index. We're certain there will be similar stories unfolding in Agriculture (Potash in particular), and even to some extent, Energy. So far, it looks like precious metals producers are the only ones not making some kinds of plans to reduce production.

Even though producers are responding appropriately to the steep decline in demand by cutting supply, don't expect to see prices stabilizing immediately. These things take time, and cooperation from the global economy. In fact, RBC Capital Markets just released a note yesterday that projects commodity prices remaining in the dumps until the second half of 2010.

But when they do turn, the supply cuts could make the rebound sharper.

Comments

[kennyB:]

Materials will rebound as bottom is past. Large miners with tons of cash will rebound quickly as demand will increase dramatically and survivors will quickly ramp -up production. In the supply and demand game, the supplier has stronger hand; China will blink as supplies shrink and Miner's stocks will begin a rapid rise. Much of the hysteria surrounding markets will begin to abate. CU, AL, iron-ore, basic materials will soar.

2008 Dec 10 09:49 AM