No soft landing for hard commodities

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 20 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 recognise, 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 to 11 per cent 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 per cent or more in the next two to three years.

...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 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, Gerard Minack, chief economist at Morgan Stanley Australia, 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 per cent a year, with most of that coming in the past decade. If you exclude China, however, global demand for steel grew by only 2 per cent 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 per cent 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.

In 2001, according to Minack’s numbers, this transition point for copper was roughly 12 million tonnes, 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 tonnes. 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 tonnes, 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 tonnes, above which iron ore producers would have difficulty supplying demand. By 2011 it was at 1,300 million tonnes and by 2014 and 2020 it is expected to be 1,900 million and 2,600 million tonnes 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.
...

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 per cent 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 per cent and 40 per cent of total global demand for commodities like copper and nearly 60 per cent 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 per cent 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 recognised, 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 to 10 per cent just two years ago, the consensus for average growth rates in China over the next decade has dropped to 5 to 7 per cent... 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 per cent.

This 3 per cent average will not be distributed evenly, of course, and we should expect higher growth rates at the beginning of the period (perhaps 5 to 6 per cent 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 to 7 per cent growth rates over the next decade, which I think is almost impossible, this implies that consumption growth will rise to 7 to 10 per cent annually, and so from 25 per cent growth in the last few years Beijing will be able to allow investment to grow no more than 2 to 4 per cent annually, and much less if GDP growth rates are as low as I expect.

...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 sceptical 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.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management.

He blogs at China Financial Markets.