For the past two years, as regular readers know, I have been bearish on hard commodities. Prices may have dropped substantially from their peaks during this time, but I don't think the bear market is over. I think we still have a very long way to go.
There are four reasons why I expect prices to drop a lot more. First, during the last decade commodity producers were caught by surprise by the surge in demand. Their belated response was to ramp up production dramatically, but since there is a long lead-time between intention and supply, for the next several years we will continue to experience rapid growth in supply. As an aside, in my many talks to different groups of investors and boards of directors it has been my impression that commodity producers have been the slowest at understanding the full implications of a Chinese rebalancing, and I would suggest that in many cases they still have not caught on.
Second, almost all the increase in demand in the past twenty years, which in practice occurred mostly in the past decade, can be explained as the consequence of the incredibly unbalanced growth process in China. But as even the most exuberant of China bulls now recognize, China's economic growth is slowing and I expect it to decline a lot more in the next few years.
Third, and more importantly, as China's economy rebalances towards a much more sustainable form of growth, this will automatically make Chinese growth much less commodity intensive. It doesn't matter whether you agree or disagree with my expectations of further economic slowing. Even if China is miraculously able to regain growth rates of 10-11% annually, a rebalancing economy will demand much less in the way of hard commodities.
And fourth, surging Chinese hard commodity purchases in the past few years supplied not just growing domestic needs but also rapidly growing inventory. The result is that inventory levels in China are much too high to support what growth in demand there will be over the next few years, and I expect Chinese in some cases to be net sellers, not net buyers, of a number of commodities.
This combination of factors - rising supply, dropping demand, and lots of inventory to work off - all but guarantee that the prices of hard commodities will collapse. I expect that certain commodities, like copper, will drop by 50% or more in the next two to three years.
Not everyone agrees. In the July 17 blog entry I made a reference to a book by Dambisa Moyo, a former investment banker turned economic writer, called Winner Take All, in which the author argues that the world is facing a crisis in the form of a commodity shortage, and she expects prices to surge. Unlike her, however, I expect the price of hard commodities and certain industry-related soft commodities (like rubber) to drop sharply in the next three years, and to stay low for many years thereafter.
To address the first of the four reasons I expect hard commodity prices to drop, excess growth in supply, one month ago I spoke at a conference in Sydney, after which Gerard Minack, chief economist at Morgan Stanley Australia, gave a presentation on the world economy and, more specifically, on commodities. His presentation was an eye-opener for me.
Based on my many trips in recent years to places like Australia, Peru and Brazil, I had plenty of anecdotal reasons to believe that commodity producers had significantly overestimated the sustainability of the Chinese growth model (or, perhaps more accurately, had not really thought about whether or not it was sustainable). I was worried that they were expanding production very quickly. Everywhere I went I heard stories of large-scale investments to expand production.
Many producers have acknowledged recent price declines, but they seem to believe that these are likely to be short-lived and that prices will soon rebound when Chinese demand returns. For example the Financial Times' Alphaville quotes Nev Power, chief executive of Fortescue Metals, discussing iron ore at a recent meeting:
Iron ore prices have slumped to $US104 a tonne in recent days, yet Mr Power said it could soon rebound as high as $US150. "As soon as restocking and production returns to normal we expect to see prices back in the $US120 to $US150 per tonne range," he said.
Production capacity has grown
He will almost certainly be wrong. But whereas my evidence for claiming continued high growth rates in production was conceptual and anecdotal, Minack has actually gone out and tried to measure the potential increase in supply. Minacks' argument is that because of twenty years of stable or falling prices, until the early part of the last decade there had been a minimal amount of investment globally into commodity producing facilities. Commodities seemed to be in a permanent slump and no one was interested in expanding supply.
The surge in Chinese demand at the beginning of the last decade consequently caught everyone by surprise. Minack shows, for example, that in the past twenty years, global demand for steel grew by roughly 6% a year, with most of that coming in the past decade. If you exclude China, however, global demand for steel grew by only 2% a year in the past twenty years, implying that China accounted for almost all the increase in global demand in the last twenty years - and almost all of that occurred in the past decade. In the past ten years Chinese demand for iron ore has grown by 16% a year on average.
The initial surge in demand caught commodity producers off-guard. Because they were unable to ramp up production quickly enough, prices surged. After a few years of high prices, however, commodity producers responded to the huge new increase in demand by planning major expansions in production facilities.
Changing production requires years of exploration, investment, and upgrading, however, so the decision to increase production could only result in higher production many years later. This is shown by a set of cost curves, which are at the heart of Minack's presentations, and these curves graph the short-term relationship between price and volume. For any given amount of demand, in other words, the graph showed the corresponding price.
The supply curves, of course, are positively sloped - the higher the price of copper, for example, the more copper will be produced and sold. The slopes of the curves, furthermore, are very sensitive to existing production capacity, and Minack lists curves for several points in time as production capacity changes. As one would expect, when demand for copper is less than production capacity the curves slope gently upwards, implying that small increases in copper prices correspond to very large increases in copper supply.
But this curve slopes gently upwards only up to a point, representing the limits of normal production capacity, after which the slope of the curve is almost vertical. Beyond this point - of maximum capacity - no matter how high the price of copper, in the short term supply cannot be substantially increased. Or to put it another way, beyond that point small increases in demand translate into large increases in price.
In 2001, according to Minack's numbers, this transition point for copper was roughly 12 million tons, above which it would be extremely difficult for copper producers to supply demand except at extremely high prices. There was some improvement in capacity during this time but not much. By 2004 this same inflection point had increased only slightly, to roughly 13 million tons. This, as Minack pointed out, reinforces the argument that copper producers were not expecting any significant increase in demand and so had not prepared for it.
But by 2004-5 it was increasingly evident that demand was rising quickly. Copper producers responded, and thanks to increased investment in countries like Peru and Chile, among others, production capacity surged. By 2018 the inflection point is projected to be at roughly 21 million tons, suggesting that between 2004 and 2018 an enormous amount of additional copper production has become or is going to become available. In his July 17 "Down Under" note, Minack goes on to say:
What's notable, in my view, is the forecast increase in supply versus the actual supply increases seen over the past decade. For copper, the increase in global supply in each of the next seven years will be roughly equal to the increase in supply over the decade to 2011. Consequently, it would require a material acceleration in demand to keep prices at current levels in the face of this supply increase.
The same story is more or less true for iron ore, although the expansion is supply has been more dramatic. In 2006, according to Minack's numbers, the inflection point was at roughly 900 million tons, above which iron ore producers would have difficulty supplying demand. By 2011 it was at 1,300 million tons and by 2014 and 2020 it is expected to be1,900 million and 2,600 million tons respectively. In just over ten years, in other words, production capacity will have nearly tripled. This is a lot of iron that has to be absorbed by someone.
The supply considerations are exacerbated by the amount of stockpiling taking place in China. I won't rehash all my arguments from earlier newsletters about stockpiling but it is enough, I think, simply to list some of the articles I found in my daily readings last week.
The first article came on Tuesday from Bloomberg:
Cotton consumption in China, the world's largest user, may shrink 11 percent this year as a deteriorating economy hurts demand and causes a buildup in commodities, according to Weiqiao Textile Co.
…Coal inventories at Qinhuangdao port rose to 9.33 million tons on June 17, the highest since 2008, data from the China Coal Transport and Distribution Association showed. Stockpiles were at 6.69 million tons as of Aug. 19. While steel-product stockpiles at the nation's 26 major markets have dropped for five months as the end of July, they're still 19 percent higher this year, according to the China Iron & Steel Association.
Commodity-related companies have flagged their concern. Noble Group Ltd. (BATS:NOBL), Asia's biggest listed commodity supplier, expects a tough environment for the next 12 to 24 months, Chief Executive Officer Yusuf Alireza said yesterday. Vale SA (VALE5), the world's largest iron-ore producer, said this month that China's so-called golden years are gone as economic growth slows.
The article in Tuesday's Financial Times talks about excess inventory of a wide variety of products and refers to an earlier article, from July, that claims that China's coal inventory is up 50% from last year:
Memories of the London Olympics are already beginning to fade. Li Ning, a Chinese sportswear maker, had better hope that they last a while longer. Like thousands of Chinese companies from property developers to car manufacturers, Li Ning is sitting on a mountain of unsold products. Whether they can whittle down these bulging inventories is the single most important question facing corporate China and arguably the economy as a whole.
…The problems of Li Ning and the sportswear industry are just the tip of the iceberg in China. Across virtually all corporate sectors, inventories are excessive. The stock of unsold homes is the most worrying, because property plays such a dominant role in the economy. Vanke, the country's biggest developer, estimates that it would take about 10 months to absorb all the unsold homes in China, which is reasonably quick. The snag is that this figure doesn't count the millions of homes that have been sold but are sitting empty.
Then there is the auto sector. Car sales have been remarkably resilient despite the economic slowdown. But manufacturers have been more bullish than consumers. The inventory index (inventories divided by sales) was 1.98 at the end of June, according to industry data. More than 1.5 is seen as critically high.
The unsold mountains of electronics and white goods are also looking Himalayan in scale. Over the past week, the country's main retailers descended into a price war. It began when online retailer 360buy.com vowed that it would sell home appliances at a zero profit margin.
The commodities sector is also dealing with a huge inventory overhang, most graphically in the piles of coal that have built up at ports across the country.
In an article one day later from the South China Morning Post, the concern is about copper:
At first glance, China's copper demand is soaring. According to Ross Strachan, commodities analyst at independent research house Capital Economics, if you add domestic production of refined copper to China's imports and changes to official stockpiles, then it appears that copper consumption leapt 22 per cent in the first seven months of 2012 compared with the same period last year.
But if you look at the volume of copper products actually turned out by China's factories - pipes for air conditioners, windings for electrical transformers, foil for circuit boards and the like - then output was flat in July compared with a year earlier (see the second chart). Weak output makes sense. Together, manufacturing industries, home appliances and the construction sector accounted for half of China's copper consumption last year.
With economic growth now slowing and property investment weak, demand is bound to be soft. Analysts at Credit Suisse expect China's copper usage to grow by just 2 per cent this year and 1 per cent in 2013, in contrast to the 26 per cent growth seen at the height of China's stimulus effort in 2009.
This gaping discrepancy between apparent demand and actual consumption implies there has been a massive build-up in unreported stocks of refined copper held in bonded warehouses and elsewhere.
Strachan at Capital economics believes these stockpiles have climbed by 900,000 tonnes since the middle of last year. Standard Chartered puts the total amount held in bonded warehouses at 600,000 tonnes, together with another 400,000 held elsewhere.
To put these figures into perspective, the LME's worldwide network of warehouses reports copper stocks of just 231,000 tonnes. In other words, China is sitting on a huge overhang of refined copper.
This partly reflects state corporations' efforts to build strategic reserves of the metal. But it is also the result of massive speculation in copper. The details of the trade are complex. But in a nutshell, companies buy copper on margin, then use the metal as collateral to obtain low-cost loans, using the proceeds to bet on higher-yielding assets.
Not just the raw stuff
And just one day later I saw this article in Bloomberg:
Rubber is poised to drop as sustained supplies from Southeast Asia and falling demand from China's tiremakers push stockpiles to match their record at Qingdao port, the main shipment hub, an industry executive said. Futures fell for the first time in four days.
Inventories in the bonded zone, where traders store deliveries before paying duties, will probably climb to 250,000 metric tons by end-August from 240,000 tons last week, Li Xiangou, chairman at the Qingdao International Rubber Exchange Market, said in an Aug. 17 interview. China accounts for 33 percent of global demand and tires represent 70 percent of natural-rubber consumption in the country. Reserves last reached 250,000 tons in mid-January, he said.
The article goes on to quote one Chinese rubber trader as saying "Many Chinese tire makers are mired in high inventories of end-products right now."
I can easily cite many more articles, but as this short roundup suggests, finding articles about huge stockpiles in China is a pretty easy game to play. This shouldn't come as a surprise and indeed I have been discussing this for the past three or four years. When financing costs are low or even negative in any economy, there is a tendency to accumulate inventory since it is not only easy to finance but, thanks to low or negative financing costs, it can also be extremely profitable. If prices just keep up with inflation, inventory earns a profit, and the greater the pile, the greater the profit.
In addition in the past decade as China's trade relationship with the rest of the world has expanded and as China's economy has grown, most Chinese businesses have only experienced rising prices - both for commodities and many kinds of goods. As a result firms that tended to hold high inventory have outperformed firms that haven't.
This has created a selection process that favors accumulation. Companies that prefer to hold more, rather than less, inventory of commodities and goods in which commodities are a high cost component have outperformed their rivals, and so the whole market has moved towards a preference for stockpiling, much in the same way that, according to Hyman Minsky, periods of stable or rising asset prices force the financial system into taking on excessive risk. Since overstocking has always been a winning strategy until very recently, it is a pretty safe bet to assume that Chinese traders, speculators, end-users and investors have a built-in prejudice towards being long or longer inventory.
The overstocking problem in part has also had to do with financing constraints. In late 2010 and early 2011 in this newsletter I wrote often about commodity inventory financing as a popular tactic among Chinese businesses and banks aimed at getting around regulatory constraints on lending.
By importing commodities that were funded through trade financing and then using inventory receipts to borrow domestically, banks and borrowers could get around lending restrictions. We have never been able to figure out exactly how much of this was going on, but there was plenty of anecdotal evidence to suggest that this was a pretty wide-spread scheme and it involved a variety of commodities - copper, most famously, but also soy, magnesium, cotton, rubber and several others.
Finally, I should add that in China there is, more than in any other country I know, a sense that physical ownership of commodities or of commodity producing facilities creates substantial intangible benefits. This may be a legacy of Maoist perceptions of self-sufficiency, or it may have to do with a history of unstable political and monetary arrangements, but whatever the reason Chinese are often obsessed with the need for physical control of commodities.
The result has been a tendency to hold much larger commodity inventories than can be justified by business needs and risk management concerns. By the way when economists try to calculate the amount of unsold inventory of commodities they typically focus on the raw commodity, but it is important to remember that inventories of finished goods are also forms of raw inventory.
An empty apartment, for example, contains lots of copper wiring, and although it is extremely unlikely that the copper will ever be melted down and sold, it nonetheless has the same price effect as unsold copper inventory. Why? Because an empty apartment today is one less apartment that will be built tomorrow to fill real demand, and so it represents a reduction in the future amount of copper that will be purchased to make copper wire. The same is true of other finished goods.
What about demand?
China currently is the leading consumer of a wide variety of commodities wholly disproportionate to its share of global GDP. The country represents roughly 11% of global GDP if you accept the stated numbers, and substantially less if you believe, as I do, that growth has been overstated because of the difference over many years between reported investment, i.e. its input value, and the actual economic value of output. China nonetheless accounts for between 30% and 40% of total global demand for commodities like copper and nearly 60% of total global demand for commodities like cement and iron ore.
The only reason China has provided such an extraordinarily disproportionate share of global demand for hard commodities has been the nature of China's growth model. While China may represent only 11% or less of the global economy, it represents a far, far greater share of the world's building of bridges, railroad lines, subway systems, skyscrapers, port facilities, dams, shipbuilding facilities, highways, and so on.
Over the next decade, two things are going to change. The first is increasingly recognized, and that is that Chinese growth rates will drop sharply. The second is that China will rebalance its economic growth away from its appetite for commodities.
The consensus on expected economic growth among Chinese and foreign economist living in China has already declined sharply in the past few years. From 8-10% just two years ago, the consensus for average growth rates in China over the next decade has dropped to 5-7%. But the historical precedents suggest we should be wary even of these lower estimates. Throughout the last 100 years countries that have enjoyed investment-driven growth miracles have always had much more difficult adjustments than even the greatest skeptics had predicted.
After all, there were many Brazilians in the late 1970s who worried that Brazil's growth miracle was unsustainable and would end badly, but none expected negative growth for a decade, which is what happened during the terrible Lost Decade of the 1980s. Towards the end of the 1980s, to take another example, a few brave skeptics proclaimed that the Japanese miracle was dead and predicted that for the next five or ten years average Japanese growth rates would slow to 3 or 4% (in 1994 the IMF belatedly proclaimed that Japan's long-term growth rate had dropped to 4%), but no one, even the most skeptical, predicted twenty years of growth below 1 percent. Finally when the USSR's economy was hurtling forward in the 1950s and 1960s, and expected to overtake the US within a few decades, even the most die-hard anti-communists did not expect the virtual collapse of the economy in the 1970s and 1980s.
Similarly, the current consensus for Chinese growth over the next decade is almost certainly too high. Even if Beijing is able to keep household income growing at the same pace it has grown during the past decade, when Chinese and global conditions were as good as they ever could be, it will prove almost impossible for the economy to rebalance at average GDP growth rates over the next decade of much above 3 percent.
This 3% average will not be distributed evenly, of course, and we should expect higher growth rates at the beginning of the period (perhaps 5-6 percent over the next two years) and lower growth rates towards the end. But as this happens, over the next two years the consensus on China's long-term growth rate will continue to drop sharply, and this will further affect commodity prices.
But even this underestimates the change in demand for commodities. For thirty years, and especially for the past ten years, China's extraordinary GDP growth was driven by even higher rates of investment growth - generating for China the highest investment rates and investment growth rates in history. Consumption growth failed to keep pace during this time.
But rebalancing means, by definition, that for the next few years consumption growth must outpace GDP growth, and so also by definition investment growth must be less than GDP growth. Even if China is able to achieve 5-7% growth rates over the next decade, which I think is almost impossible, this implies that consumption growth will rise to 7-10% annually, and so from 25% growth in the last few years Beijing will be able to allow investment to grow no more than 2-4% annually, and much less if GDP growth rates are as low as I expect.
Which way can prices go?
For these reasons I am very pessimistic about hard commodity prices and expect them to drop substantially further in the next two to three years.
Production capacity for hard commodities is rising much too quickly, in a belated response to the unexpected surge in demand just under a decade ago.
Expected economic growth rates in the country that has been biggest source of new demand - virtually the only source - have fallen sharply and commodity prices have fallen with them. Historical precedents and the arithmetic of rebalancing suggest, however, that the current consensus for medium-term Chinese growth is still too optimistic. Expected growth rates will almost certainly fall further in the next two years.
Beijing has finally become serious about rebalancing China's economy, and rebalancing means shifting Chinese growth away from being disproportionately commodity intensive. Instead of representing 30-60% of global demand for most hard commodities, Chinese demand will shift to a more "normal" level. Remember that even a very limited shift - from 50% of global demand, for example, to a still high 40% of global demand - represents a sharp drop in global demand.
There has been so much stockpiling of commodities and finished goods with implicit commodity content in China that the country could well become a net seller, and not net a buyer, of a wide variety of commodities in the next few years.
This is going to come as a shock to many people. In my discussions with senior officials in the commodity sectors in Brazil, Australia, Peru, Chile and even Indonesia, it seems to me that many analysts have been insufficiently skeptical about the Chinese growth model and are unaware of how dramatically the consensus has changed in the past two years. They have failed to understand how deep China's structural problems are and how worried Beijing has become (this worry may be best exemplified by the extraordinary growth in flight capital from China since early 2010).
Under these conditions I don't see how we can avoid a very nasty two or three years ahead for commodity producers. This isn't all bad news, of course. What will be a disaster for hard commodity producers will be great news for companies and countries that are commodity users or importers. One way or the other, however, we are going see a big change in the distribution of winners and losers.