Commodity prices can only go up

Indications that three of the world’s biggest economies – China, Japan and the US – are growing at a faster pace than forecast might be occurring at an inconvenient time for investors with a bearish view of the resources sector.

The issue is not so much about a sudden recovery, but the combination of moderate economic growth with continued supply cutbacks.

Developments this week cast a spotlight on the matter, starting with China reporting a surprisingly strong 10.4% year-on-year expansion of industrial production. Meanwhile, one of the world’s biggest resource companies, Glencore Xstrata, announced a fresh round of project deferrals.

One of the projects being deferred is the $5 billion Wandoan thermal coal mine in Queensland, which has been designed to produce 30 million tonnes of coal a year for use in Asian power stations.

Glencore Xstrata chief executive, Ivan Glasenberg, announced the mothballing of the Queensland mine at an investor’s day in London, where he also pulled the plug on three proposed copper mines – one in each of Argentina, Papua New Guinea and the Philippines.

“We are fearful of greenfield projects,” Glasenberg said, adding that their suspension represented a saving of $US21 billion in capital.

Glencore Xstrata is far from being alone in shelving resource projects. Every big mining company, including BHP Billiton (Olympic Dam expansion and Port Hedland outer harbour), Rio Tinto (Mozambique coal, Guinea iron ore) has slowed or deferred developments as a result of reduced demand, falling commodity prices and a shareholder rebellion.

But what made the Wandoan decision interesting is that it occurred shortly after it was reported that Australian thermal coal exports hit a monthly record high of 17.9 million tonnes in July.

Low prices mean that profits on that record month of coal exports would not have been high, but what the tonnes indicate is that demand for Australian coal in Asia is growing, not falling.

It’s the same with most commodities, which have seen their prices cut more by excess supply than reduced demand.

The question for investors with an appetite for resource stocks is whether “producer discipline”, which is taking surplus commodities off the world market, is heading for a clash with rising demand caused by a faster-than-expected recovery in growth.

Buy and sell trends

Two interesting tests of a possible resource turnaround can be observed on the buy and sell side of activity on the Australian stockmarket.

On the buy side there has been strong outperformance of mining shares since late June, when the market appears to have bottomed with the XMM (metals and mining) index rising by 22.8% between June 25 and yesterday. Over the same 12-week period, the All Ordinaries Index rose by 12%.

On the sell side, there has been a sharp fall in short selling resource stocks. Damien Klassen from the broking firm, Wilson HTM, monitors the “shorts” data compiled by the ASX, reporting in the latest edition of his Short and Stocky newsletter that resource-stock shorting levels were back to two-year lows.

“The key movement in short selling over the last few weeks has been the sharp decrease in short positions in the resources sector,” Klassen wrote.

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The period examined includes the federal election campaign and increasing confidence of the election of a Coalition government, which has promised to end the mining and carbon taxes as well as being more business friendly.

The big end of the mining sector is likely to be the major winner from the pullback of short sellers, a point confirmed by the 17% rise in the price of BHP Billiton since June 25 and the 25% rise in Rio Tinto’s share price.

But Klassen also noted a decline in short positions in small miners. “While short selling in small resources remains relatively high, it has also declined substantially over the last few weeks,” he said.

Currency investors are also becoming more optimistic, driving the resource-heavy Australian dollar back above US93c thanks to a combination of the change of government and Chinese growth.

BHP Billiton and Rio Tinto, the miners which dominate Australian resource production, are hedging their bets when it comes to project investment. Both have delayed projects, but both are also expanding in selected areas, apparently having a more optimistic view of the future than Glencore Xstrata’s Glasenberg.

In the case of Rio Tinto, coal and iron ore projects in Africa have been slowed and surplus assets sold (Northparkes copper in NSW), but investment in WA iron ore is showing no sign of slowing thanks to the handsome profit margins on offer.

At BHP Billiton there have been even stricter investment cutbacks, but that is not stopping ongoing investment in building a world-class potash business in Canada. It also has not dimmed the optimism of its chief executive, Andrew Mackenzie, who sees global commodity demand growing by 75% over the next 15 years.

The challenge for investors is assessing how quickly demand is rising and how quickly producer discipline is cutting supply.

Commodity prices lag

Share prices might well have risen quickly since mid-year and short sellers retreated, but on commodity markets there is no sign, yet, of a substantial price recovery.

Copper, the bellwether metal, has risen since mid-year, but by a lowly 6% from $US3.05 a pound to $US3.24/lb. Nickel, zinc and aluminium have done worse, rising by around 3%.

An interesting approach to assessing where the world of resources might be heading is contained in an analysis by Macquarie Bank, in which it assigned simple stop, pause, go colours (red, amber and green) to a number of key supply/demand assumptions.

The bank’s three-to-six month view (see graphic below) considers 14 commodities and four important factors – supply growth, demand, price and inventory (stockpiles).

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Those four factors are then combined in the first column to arrive at a general view of each commodity over the next three-to-six months, with explanatory notes in the right-hand margin. Two of the commodities (tin and uranium) get a green light, eight get amber, and four get red.

Interestingly, the overall “traffic light” count produces more green and amber boxes than red – 27 green (38%), 26 amber (37%) and 17 red (25%) which, depending on your glass-half-empty or glass-half-full view of the world is evenly balanced.

The longer-term view (second graphic) produces a slightly less optimistic 12-month outlook (two green, six amber and six red), but over a three-to-five year view green dominates (eight versus three amber and three red).

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Demand vs supply

Of the two primary forces at work in the resources sector (supply and demand) there appears to be a virtuous circle developing. Producer cutbacks are combining neatly with rising demand, with the principal unknown being the speed at which events are moving.

China’s better-than-expected rate of growth is one factor being very closely watched, as Chinese statistics always are, with that 10.4% increase in industrial production during August appearing to cement that country’s overall economic growth target of 7.5% for calendar 2013.

Some close observers, such as the investment bank Credit Suisse, are suggesting that China could modestly outperform, lifting its 2013 growth forecast for the country from 7.4% to 7.6%, and then up slightly again to 7.7% in 2014.

Marginal as the revised outlook for China might be, the point is that Australia’s biggest raw materials customer appears to have ended its period of economic correction and is now growing at a handsome and potentially sustainable rate.

A similar picture is emerging elsewhere. Japan, after almost 20 years in an economic wilderness, is growing at around 2.6%. This might not seem much, but it is a rate broadly similar to that of the US, which could get over the 3% market this year. Even Britain, another poor performer over the past five years, is heading for 2% growth next year, and perhaps a bit more.

As ever, some economies are doing better than others. India, for example, seems unlikely to hit its growth target of 6.5% for this year. Other emerging markets are also passing through a period of slower growth, and everyone is watching how the US manages its withdrawal from years of monetary stimulus.

However, the overall picture is for global growth this year of around 3% (the same as last year), rising to 3.8% next year as the developed world (and China) emerge from the five year slump that followed the 2008 global financial crisis.

Miners cut back

Layered on top of this picture of improving economic growth is the issue of resource company cutbacks, which Macquarie Bank noted last week was continuing as big miners bowed to shareholder demand for higher dividends and small miners struggled to raise development capital to fund new projects.

Macquarie referred in the latest edition of its Commodities Comment newsletter to an assessment of future mining capital expenditure by the British consultancy, Wood Mackenzie, which pointed to savage future cutbacks.

In previous surveys, Wood Mackenzie had nominated 2014 as the peak year for mining investment. It now argues that the peak was last year.

Describing the scale of Wood Mackenzie’s forecast capital expenditure cutbacks as dramatic, Macquarie notes a 16% decline in 2013, followed by a 44% fall next year (from project investment plans previously reported), and a drop of more than 50% in the 2015-to-2018 period “as projects previously thought likely to have progressed are shelved or delayed”.

If correct, and it is only a forecast, then the Wood Mackenzie assessment will sit comfortably with the optimistic view of the resources sector heading towards a surprisingly strong recovery in 2014. If demand is rising and supply is falling, there’s really only one way for prices to go – and that is up.