Commodities

The meteoric rise of commodities during the past decade makes you feel that there is only one way for them: up. Peak oil; exhausted mines; we’ve lived up all the resources on Earth – that is all over the news. Add in the sense of drama from Iran which keeps oil prices high despite too much demand.

Are we talking about 2012? Maybe, but the same general sentiment ruled in 1979 as well, with the same arguments, same fears and a somewhat different kind of Iranian crisis. As Mark Twain famously said: “History does not repeat itself but it does rhyme”. As we all know, after 1979-1980, commodity prices moved sideways nominally for two decades, which means that they suffered huge losses in real terms. Of course, this sideways action was exactly the thing that sowed the seeds of the coming bullmarket of the last 10 years – as it has happened many times in the past. This was a classic commodity cycle since as the prices of many commidities fell below costs it made no sense to start new mines, they even closed down some. Supply of most commodities was dwindling while demand was also on the retreat during the 80s due to energy (and other commodity) efficiency programs (just like now) but started to rise during the 90s as everybody forgot the threat (and even possibility) of rising commodity prices. Demand rising, supply falling – this usually means prices on the rise. And then came China, a real demand shock. There would have been a bullmarket even without them due to the above, but with them – all hell broke loose, and many commodities quadrupled, quintipled or even more.

Since the supply of commodities is famously inelastic, it takes years to create new capacity, to build new mines, therefore it takes quite a long time to catch up with demand. However, this process already started around 2005 when commodities were on a seemingly unstoppable march and finding a gold mine – or a new iron ore deposit for that matter – seemed like, well, a gold mine. The supply from these sources is starting to hit the market now. And it is not only shale gas, but also shale oil, conventional oil, metals, and many-many other things. As a result of years of development there seems to be more and more of almost all commodities – right when the global economy is hitting the doldrums and demand is very weak.

“Steel demand growth had been stagnant, or even dwindled, since the fourth quarter of last year, leading to some dramatic changes in the iron ore market,” Zhang Changfu, general secretary of the China Iron and Steel Association, told the 12th China International Steel & Raw Materials Conference, on Sept. 27 in Dalian. “Iron ore supply is gradually moving into surplus.” An iron ore surplus looms in 2015 after capacity expansions in Brazil and Australia, the biggest exporters, help boost global seaborne exports by about 35 percent from 2010 levels.

Just looking at the huge numbers they spent on new mines is mind-boggling:

“…While some expansions have been delayed because of declining prices, Rio, which says it’s sold more than 1 billion tons of iron ore to China since 1973, BHP and rivals are pressing ahead with capacity increases.These two, and Fortescue, may boost output 65 percent in the next five years to 703 million tons, Citigroup said in a Sept. 3 report, referring to a “building wave of Australian exports.” Rio has an approved spending budget of $22.4 billion on ore projects underway, while BHP is spending $8.4 billion. The proposed BHP port expansion at Port Hedland was estimated at $22 billion by Credit Suisse Group AG in an April 12 report.

https://www.bloomberg.com/news/2012-10-02/iron-ore-heads-for-longest-bear-market-in-20-years-commodities.html

This seems to be the 70s/80s all over again with the notable distincion that central banks are not in an inflation fighting mode now but trying – in vain – to create new demand. What Volcker was in 1980, the global recession is in 2012. Volcker raised rates and drove the economy into recession to stop inflation – and stop he did. Demand fell, rising supply caught up with lower demand and magically the bullmarket of the 70s was over in commodities. The same thing is happening now, but there is no need for another Volcker, since China is weak, the US and Europe needs to tighten fiscally, so we have a case of self-induced recession, pushing down demand.

This is so classic:

Low prices (60s/90s) = no investment in new capacities = dwindling supply = (when demand started to rise) prices rising =new investments (70s/00s) = supply rising (end 70s/end 00s) = collapsing prices (when demand fell due to Volcker/due to credit crisis)

So where do we go from here?

Commodity prices will most likely not rise the next few years, although there is a big if, because central banks could definitely go totally mad and really start their helicopter-operations, which might eventually turn inflationary, but I think we are not there yet.

Classic commodity exporter will most definitely suffer with the Brazilian real and Australian dollar devaluing. However, I believe that Russia is the one big danger spot. This country behaves as any oil-producing emerging country during the 70s, upping spending from oil revenues, with ensuing consumption boom (noticed all the Russian tourist everywhere in Europe?) that is ready to turn into a bust. Ten years ago, the government budget was balanced at around 20 USD/bbl prices, now it is more like 100. What happens if oil dives to 60-70 dollars? Russia – with no serious exports other than oil and gas – will immediately feel the pinch and will have to tighten policy. This latter however, could lead to a fast escalation of the fragile political situation. Anyone exporting to Russia (eg. Hungarian pharma companies) is in grave danger.

As for Hungary, I am not concerned about inflation at all (in stark contrast to the National Bank of Hungary), because of all the above. With internal demand weak and commodities probably not giving any headaches, the only source of inflation could be the devaluation of the forint. Unless we really screw up – and unfortunately we have in  the past years, losing credibility due to unorthodox policies – Hungarian interest rates could go down to 3-4%, driving up credit demand, and leading to a new growth phase after years of stagnation. The most important thing though would be to regain credibility, because without credibility there is no credit, and without credit there will not be much growth…