The long commodities grind

On-off government policies are distorting coking coal and other commodities, boosting prices but laying traps.

Summary: Many of the commodity price rises around the world are being driven by government. Some are not. Investment traps abound.

Key take-out: For most investors the commodity sector should be seen as a long game, especially as supply-demand fundamentals take a detour.

Key beneficiaries: General investors. Category: Commodities. 

Coking coal’s 120 per cent rise in less than six months has done more than anything to reignite interest in commodities as an investment class. But it is no reason to rush back to mining and oil stocks because this is not a boom, it’s the start of a long upward grind.

That means there is plenty of time to be selective, and to be careful, focusing on low-cost producers and commodities benefiting more from demand and less from price spikes, which at this stage of the recovery can be the result of government market interference.

Coking coal, the material used to make steel, could prove to be a perfect example of the trap created by government policy with today’s $US200 a tonne potentially reverting quickly to $US90, the price investment bank Citi is forecasting by the middle of next year.

Chart 1: Coking coal spot price ($US per tonne), past 12 months

Source: Bloomberg, Eureka Report

Chinese Government policy lies at the heart of the coking coal price surge, with miners ordered earlier this year to limit the number of production days to 276 annually as a means of boosting local coal prices and limiting environmental pollution. It worked too well.

Prices for all types of coal rose including thermal, which is used to generate electricity, but with coking coal doing best because China has limited supplies of that category, forcing steel mills to rush back to overseas suppliers, especially Australia.

What happens next is critical because the government policy which created the coal revival has been reversed. Chinese coal production is recovering and prices should fall. Citi is tipping coking coal to be back to $US118 in six months, and then down to $US91 by June – back to where they started.

What about oil?

Oil is perhaps an even better example of government intervention in a market, not that anyone should need reminding of that, especially if they lived through the oil embargoes of the 1970s, which drove oil through the ceiling – followed by a crash through the floor.

This time around it is the Government of Saudi Arabia which has killed the oil price by flooding the market as part of a war with the US oil-from-shale industry, with everyone in the industry suffering, including Saudi Arabia itself.

The latest government-driven attempt to manipulate the oil market is a proposed production cut which might lift the price, if it happens. But it would be a wise investor to watch and wait as all previous attempts to control output have failed, because too many governments with big oil industries cheat and the market remains flooded.

Metals mess

Nickel is another metal being buffeted by government policy flips. Last year it was the Indonesian Government which helped the nickel price by banning the export of unprocessed nickel ore. The Philippines followed this year.

But today, Indonesia is easing its ban and nickel, having reached a 12-month high of $US4.85 a pound last month is struggling at $US4.65/lb.

Gold, a commodity and currency seemingly immune from government interference, is perhaps the most exposed to policy changes with its recent weakness traced directly to the US Government’s interest-rate settings, and even to the outcome of next month’s US presidential election.

A win for Donald Trump would do wonders for the gold price whereas his opponent, Hillary Clinton, is likely to persevere with existing policy settings, and the US central bank, the Federal Reserve, is more likely to raise rates with the certainties that come with Clinton.

The best way of looking at commodities is as an investment class which was driven into a burst of gross over-investment during China’s peak construction boom, with commodity overproduction from the over-investment now being absorbed, slowly.

Copper, a bellwether metal which is seen by some economists as a proxy for global industrial production (IP), is not in good health thanks to overproduction, which is depressing the price. There are few signs of an imminent recovery despite global IP ticking over at a growth rate of around 2 per cent annually.

The main copper culprit is Chile, the South American country which produces close to 30 per cent of the world’s copper, with a government heavily dependent on tax and royalty revenue from copper to meet its budget requirements. This means it is encouraging production, which will sit on the price.

Over the past 12 months copper has been the second-worst performing metal, falling from $US2.35/lb to $US2.10 – beaten only by uranium which has fallen from $US36/lb to $US22.75.

Through this fog of government market manipulation and oversupply there is a case study of what a genuine demand recovery looks like – zinc.

Since hitting a five-year price low of US66c/lb late last year zinc has risen by 55 per cent to $US1.02, seemingly on its way back to its five-year high of $US1.10 – and perhaps on to a fresh high of more than $US1.20.

The rise of zinc can be directly linked to a fall in stockpiles of surplus metal predominantly used to galvanise steel, and while tricky to forecast because of “hidden” stockpiles in the yards of steel mills, zinc’s recovery has been remarkably predictable.

Falling supplies from mines which are in decline or, in some cases, have been closed when the ore ran out, was obvious as far back as three years ago, with the low price discouraging exploration and investment in mine development.

Night follows day in the commodities market, and it certainly has in zinc with the predictable mine closures, such as Century in Queensland, happening on cue and stockpiles declining as predicted, to reach a point where genuine demand is starting to drive the market rather than supply changes.

For at least the next year zinc should be one of the commodity world’s top performers, outgunned only by red-hot speculative metals such as lithium and graphite which look terrific today, but just wait until supply gushes over demand and the price corrects, perhaps quite sharply.

Chart 2: Zinc coal spot price ($US per tonne), past 12 months

Source: Bloomberg, Eureka Report

Investment strategy

Hot-house commodities, and those subject to government manipulation, are fun for speculators who have planned their exit and target price. They know when (and how) to get out before they even get in.

For most investors the commodity sector should be seen as a long game, especially in the aftermath of the massive boost to supply triggered by Chinese demand, which led to the false forecast of “stronger for longer” that has now morphed into “lower for longer”.

Iron ore, once a favorite of speculators, has returned to its roots as a commodity with classic long-run fundamentals as a supply surge from new mines is gradually absorbed by steel mills, a process that could take up to 15 years.

With infrastructure costs (which essentially means mines, railways and ports) being absolutely critical in all bulk commodities the winners in iron ore will be the producers with the lowest cost per tonne, and that means having the highest quality ore and the best railways and ports.

The first 10 months of 2016 have been good for commodities, with most prices up but with the increase made to look good because they’re off a low base.

The next 10 months will be a time of settling down after the initial euphoria of the first signs of a price recovery.

It is the start of a long, slow, upward grind, which will produce winners – just don’t expect too many 100 per cent price spikes, and if you get one see it as a sell sign rather than a buy.