KGB Interrogation: Vivek Tulpule

In a week where coal prices tripled and iron ore prices looked set to soar, Alan Kohler, Robert Gottleibsen and Stephen Bartholomeusz spoke Rio Tinto's chief economist Vivek Tulpule about why the commodities super cycle still has some way to go.

Stephen Bartholomeusz: Vivek, can you provide a historical context for today’s commodity prices? In real terms, where would they rate?

Vivek Tulpule: If we start with a comparison relative to 2004, the prices of coking coal, iron ore, aluminium, copper and oil are probably about three-and-a-half to four times higher than they were at the start of 2004, or the middle of 2003. Which is of course was probably the start of the commodity boom as we know it today. Now, depending on the commodity you look at, we’re looking at very, very high prices in real historical terms – probably between a one-in-100-year event and a three-in-100-year event for most prices. So it really is something a little bit different to what we’ve seen in the past, or certainly what most people have seen in the past.

SB: In the past, while there have been some long commodity cycles in either direction, the sector generally has been cyclical. Why should this period be any different?

VT: Commodity markets are cyclical and they will be cyclical going forward. It’s inevitable that when demand rises a lot, supply tends to be more constrained and prices go up. And then when prices go up, that encourages investment and prices then come off as increased supply meets that growth in demand at a lower marginal cost. So I think that the markets are cyclical and they will be cyclical from here to eternity. But what we are seeing at the moment is something a little bit different, in that it’s a different level of cycle. I think people’s views about commodity cycles have probably been slightly affected or infected by fears of what happened over the 1970s and 80s and 90s and what we’re observing now is really quite different to all that. We haven’t seen this in recent times.

Alan Kohler: In fact, 100 or 200 year events in the price of anything are usually seen as bubbles. Why is this not a bubble?

VT: I think quite frankly bubbles are a slightly lazy explanation and before you refer to a bubble argument you have to be able to demonstrate that there aren’t fundamental underlying forces driving the level of commodities. I think that when you look at any decent subset of commodities it’s quite easy to explain the price levels by reference to fundamentals, such as shortages of supply growth relative to demand growth and the fact that you’re observing probably a two-in-100-year event in the growth of China. It may even be a one-in-100 year growth event, given that we are looking at more than one billion people going through an industrialisation and an urbanisation phase.

AK: So how much of the price increase in commodities is due to China?

VT: I think China’s driving the story to a very large extent, but not entirely. Growth in India and the Middle East and ASEAN economies is also quite important. Every commodity is slightly different, or in some cases quite different, so it is difficult to drive a generic story over commodities. But the one generic factor in them all of course is China.

Robert Gottliebsen: Vivek, normally when commodity prices jump so much it lowers demand because the costs can’t be passed on. Why is this not happening to Chinese demand for commodities?

VT: There are a couple of issues there. The first is that the source of the demand growth is essentially GDP-driven, so the desire to create value-added at an increasing rate is driving the growth in demand for commodities. Essentially, value-added at China’s current state of development is a function of required commodities, so to generate value-added you need commodities and you need them at an increasing rate. Some of that value-added is transferred into the hands of the owners of the fixed factors that help generate that growth and commodity producers are among that set, so that drives higher commodity prices as well. I think this particular story is driven by a demand shift that is driven by the growth story and the growth in value-added based on commodities.

SB: Is this a story that can continue indefinitely or is there a natural point at which the cycle will turn?

VT: If you look in the past, every time price has gone up – and again, it differs from commodity to commodity – they’ve come down over about two years, back to something like we would imagine being along the lines of equilibrium. So two years has been about the average cycle for base metals for example. It’s been a bit longer for iron ore because of the lags associated with the supply response, but for base metals it’s been about two years and we have a lot of history on that. Now, what we’re observing is that prices are still going up about four years into this particular price rise so it really is quite different. It was expected that prices would go back down in 2006 but they didn’t, they just kept going up or stayed very high, so there will be inevitably a supply response here. The high prices are required in order to induce that supply response, but the very fact that prices are so high and the supply response hasn’t yet come through, just shows you how much of a supply response you’re going to need.

SB: In your modelling, what does today’s supply demand picture look like and is there a point in the foreseeable future where supply is materially greater than demand?

VT: Look, that will happen one day. These are cyclical markets and there will be periods of over-supply and under-supply. I think that what we could be looking at though is a period of tight markets. In some instances, that could extend well beyond a decade and I think that from a company valuation perspective, the long-run price is really quite important. Long-run margin is quite important and in all our modelling we obtain a much higher long-run price and also higher margins than might have been obtainable in the past or that is consistent with the historical record. So what we find is (a) higher short run prices (b) they’re going to stay much higher for much longer than has been the case historically and (c) the long-run equilibrium price is probably going to be higher than historically as well, because you’ve got a higher marginal cost structure in place.

RG: Vivek, how big is the ore production pipeline in copper, iron ore and bauxite? When will it come on stream and how important is China’s investment in Africa on this front.

VT: Again, it differs substantially from commodity to commodity but the over-arching picture is that it is taking much longer for supply to come on than would otherwise be the case. In one of the graphs I’ve been using in my presentations, it shows the lead time for obtaining mining equipment. Now, it’s our own data so I imagine that smaller producers will be facing even greater difficulty, but the lead time for obtaining key equipment has doubled compared to what would have been the case in the past. That’s essentially because it’s taken the suppliers of that key equipment much longer to see that there’s been a commodity boom and make their own investments.

So on the supply front, the generic story is that we’re seeing input constraints to mining constraining the supply side. I think a big long-term supply constraint relates to the availability of skilled project management. These people aren’t built overnight, they’re built over a 10 or 15 year period. I think that as we need to see more and more supply come on stream in more and more complex places, including in Africa, we’ll need to see higher quality project management.

Africa in particular is always held out as a promised land for commodities. Unfortunately it hasn’t come through to date and I think that it really should if we want to help meet the aspirations of the African people. But Africa faces problems as well. We saw this on the supply side in the case of aluminium very recently, where we have power shortages in South Africa constraining aluminium supply. There are all sorts of problems and issues that will need to be handled in Africa before we see a good surge of commodities from there.

AK: How powerful is the economic incentive on China to own the suppliers of raw materials?

VT: I’ve been asked this question a lot and I think the generic answer is that commodities are a good investment. Funds need to be drawn into the industry to get supply that’s required to meet the demand that’s out there. And so you’re seeing lots of different people from everywhere from China to New York to London to Sydney investing in commodities, because they see it as a good play on the future of developing economies. I think the Chinese investors see that as clearly as anyone – probably more clearly.

AK: Yeah, but there’s obviously another incentive on the part of the Chinese buyers of raw materials to attempt to control and perhaps keep the price down. Do you think that they think that there is any possibility of doing that? That if they buy shares in raw materials companies such as Rio and BHP that they will be able to in some way influence the price?

VT: I must say that the issues around Rio and BHP and China are really not my area. I’m really principally focussed much more on the supply and demand dynamics that affect these markets, but your question I suppose is: is it possible for somebody to get in there and drive prices down by producing excessive supply.

AK: That’s right.

VT: And I think the answer to that is that it’s very hard and it will cost a hell of a lot. It’s not necessarily rational to attempt to do it and the scale of what would be required is enormous. But I think we do need to see much, much more investment in mining companies and to induce that I think you do need to see higher prices for a sustained period. Certainly higher than we’ve seen historically, so I think that the era of high prices will induce additional supply. It will induce greater investment from all sorts of sources and in the long run, the market will reach a new equilibrium.

RG: Do you think the big rise in coal demand which fuelled the latest price rises is sustainable in the carbon-constrained greenhouse world?

VT: There are a range of really fundamental issues that we come up against in facing rapid growth. I think climate change is one of those and responses to climate change are in that set of issues that companies and governments need to be concerned about. What we do know is that the Chinese don’t appear to be taking on board binding emission constraints at this stage and I think that the Chinese energy use is going to rise very dramatically and that will add considerably to Chinese greenhouse gas emissions. Now, in that context, I think that all countries are going to end up facing pressures to participate in emission reduction and I think what that does is push up the price of electricity really, and that could be a constraint on some commodities. Greenhouse gas constraints are going to be a double edged sword in terms of commodity supply and demand but I think that they’re inevitable. I just don’t know when they’re going to come through in the case of China.

SB: You’re a pretty ardent believer in the view that China’s economy has decoupled from the US economy. What kind of impact would a severe recession in the US have and why should commodity producers be unaffected by it?

VT: We’ve analysed this issue in very great depth and we’ve been doing it now for a little while, even before it became popular to think about a US recession. We in fact modelled and looked at from all sorts of different angles the effects of a very sharp US slowdown on commodities, and therefore obviously on the driver of commodity markets which is China. Every which way we tried to model it, it’s very hard to come up with an impact on Chinese GDP growth of more than about 1 percentage point. Now, in the context of an economy that’s growing at about 10 or 11 per cent, a 1 percentage point reduction in GDP growth isn’t an awful lot. It still allows for quite a lot of growth in commodities markets.

We observed in our work that the sectors that would be most affected – and there’ll be differential impacts – would be on the export side, rather than on the infrastructure development side within China. If anything, the modelling showed that there would be a move of funds from the United States into emerging markets, fuelling potentially a little more investment. In fact, I think what we’re observing of late is a shift of funds toward emerging markets and sectors that are levered towards emerging markets in the wake of an expected and actual slowdown in the United States. So our modelling at least – and we pushed it very hard for a risk assessment perspective – didn’t show a very big effect on China from a US recession and even less effect on commodities. The US just isn’t very important for commodities anymore these days.

SB: What about if there’s a problem that is internal to China, like higher inflation.

VT: Yeah, inflation has obviously accelerated in China and it’s principally a function of food and energy at this stage. The question that we ask, or we’re thinking about Chinese inflation and developing country inflation, is what the best way for Governments to address it is? And what will be the effect of those policy responses on commodity demand? What we are observing is in the initial instance at least, with food and energy price-related inflation, it’s almost certainly the wrong policy response for developing country Governments to constrain investment.

What you want to see is more investment and more capacity development, so that you avoid setting capacity constraints and fuelling more inflation. So paradoxically, the observation was that given the current inflation, we might in fact see small benefits to commodity demand. Certainly no negatives, because addressing inflation requires the development of infrastructure which is commodity intensive.

RG: Would you say that the greenhouse and carbon constraint is the biggest threat to commodity demand in the next five years?

VT: No. I think the climate change equation is tremendously important but I think will play out over decades rather than over years.

AK: Thanks very much, Vivek.

Follow @AlanKohler on Twitter

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