Lightning risk to the Australian dollar

If terms of trade follow historic cycles, an enormous adjustment could see the dollar fall as low as 50 US cents in 2015. Meanwhile, mining investment looks increasingly shaky.

Fortunately I have never been struck by lightning. But last night at the CEDA dinner, when Reserve Bank Governor Glenn Stevens put two graphs on the screen and later declared that our dollar was "a little on the high side” it felt like a lightning strike.

Suddenly I realised what could happen to Australia in 2015 given the ominous events taking place in 2012. The dollar would fall dramatically, perhaps to 50 US cents.



We face a potential scenario that we’ve encountered only twice in our history – in the 1920s and the 1950s. I was not around in the 1920s but I was certainly there for the 1950s boom and its aftermath and I will never forget it. If I am right then the 2013 election will be one to lose because the events that will transpire in 2015 will make the 2016 election unwinnable for whoever gets to power in 2013.

Stevens, in his address, showed that actually on four occasions Australia has had a massive rise in terms of trade and capital investment. But the other two – the first decade after Federation and in the 1980s – were not as dramatic as the 1920s and 1950s. After each of the four peaks there followed an equally severe fall, taking terms of trade back to the long-term norm. But in the current boom we have risen higher than ever before and stayed up there longer than ever before.

If our terms of trade slump back anywhere near the levels of years gone by it will require enormous adjustment to the economy. The Stevens graphs show that our terms of trade and capital investment in mining have already turned down but they are still extremely high. But when Stevens confessed that "the dollar was a little on the high side,” given the minor downturn we have experienced I went onto full alert.

You see that all the Stevens projections to CEDA revolved around the next year or two. The lightning strikes Australia in 2015 or 2016. To understand this you must go to the KGB interview with Santos CEO David Knox, who says that the cost of building LNG in Australia is three times that of the US and that our costs have risen around 80 per cent in the course of this boom.

The same applies to most mining projects. (I am going to write several commentaries on why this happened and what needs to be done. The first one is Battle lines drawn for a construction cost war, November 20. In simple terms it is now completely uneconomic to build major gas, coal or iron ore facilities in Australia unless they are closely linked to an existing facility or the ore bodies, gas or oil discoveries are very rich and low cost.

Australia has $230 billion on mineral projects that might go ahead but have not been committed. My guess is that we will be lucky if $10 billion to $20 billion go ahead.

Look again at the Stevens capital investment graph. A construction decline of this magnitude is unprecedented for Australia. But it could gets worse, much worse. David Knox believes the enormous gas and oil discoveries in the US will not affect the global gas price because China will absorb the surplus capacity that is going it be created in the Middle East and elsewhere.

I am a fan of David Knox but in this case I believe that there is a high risk that he is wrong. Not only has the US discovered "a Saudi Arabia” via shale gas and liquids which will make it independent of Middle Eastern oil and gas, but in the Middle East Iraq is now producing enormous amounts of oil and gas and getting close becoming a second new Saudi Arabia (Sheikh Kloppers and BHP's 'new Saudi', November 14). Citibank says that the combination of the US and Iraq ‘Saudis’ will cause a substantial fall in oil and gas prices. Thermal coal is already depressed but could fall further and coking coal will not escape.

For what it is worth, I think Citibank is are right and Knox is wrong. And if Citibank is right then the recent LNG facilities that are being erected in Queensland and WA at inflated costs will not produce the returns that were expected of them. Australian gas and coal revenues will fall sharply.

The other ingredient of our terms of trade rise, iron ore, is not as vulnerable as gas and coal because the increase in global supply is not as dramatic. If I am right about iron ore, then while the fall in the terms of trade will be dramatic, we will not go to the pre-boom levels. But as gas and coal fall so will tax revenues and we will have substantially less money for pensions, education, health and other government expenditures.

Understandably, Glenn Stevens is not in the business of speculation on the likelihood of such events around 2015. For example an all-out Middle Eastern war would be a game changer and oil and gas prices would then rise. But if Citibank and I happen to be right, then Stevens would be the first to say that Australia would require enormous adjustment. (I will never forget the 1960s). Again Stevens would not publically speculate on how far the dollar would have to fall but his graph indicates that it would return to around 50 cents.

And of course that would mean that Australia’s operating costs would be closer to the US. And if we took out our major mining productivity impediments and inefficiencies we would again be competitive with the US. But the halving of the currency would not be a pleasant experience.

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