Two tests for commodities

Here’s what commodity markets need before a convincing recovery is possible.

Summary: An estimated half the world’s minerals and fuels are being produced at a loss. More material needs to leave the market and a bout of full-blown capitulation is needed before the recovery phase. Two tests to measure this include an investment bank survey and any entry by private-equity funds.

Key take-out: Before commodity prices can regain some of their lost ground, they need more mine closures to help reduce stockpiles, a pick-up in global growth and a clearer view of the new normal.

Key beneficiaries: General investors. Category: Commodities.

There’s no harm in considering commodities, which is what the US magazine Barron’s suggests in its latest cover story (see The view from Wall Street: Bottom for commodity stocks?), but there is still a risk that the great unwinding of the commodities boom has further to go before recovery can take hold.

Fresh overnight falls in most commodity prices, other than gold, were a reminder that the world is struggling to adjust to a new set of rules and values which include the return of the US as the global economic driver, and the slowdown of China.

For Australia’s hard-hit resources sector there is unlikely to be a sudden revival of fortune while fundamental changes are made to a number of critical factors, including US interest rates which help determine the value of the US dollar, the currency in which most commodities are traded.

In time, most probably over the next six to 12 months, a bottom in commodity prices will become obvious and a revival will start, if only because an estimated half of the world’s minerals and fuels are currently being produced at a loss.

The spate of closures in the coal and iron ore industries is a guide to how the culling of the losers works but more material needs to leave the market because the once-promised “stronger for longer” commodities boom has morphed into a “lower for longer” phase.

Like the over-supply of any asset class, from high-rise apartments to oil or diamonds, a glut eventually leads to lower prices which stick until the glut is absorbed.

What Barron’s has done is alert readers to the fact that commodity prices are 50 per cent (and more) below their China-driven peaks and that eventually they will recover, while skirting around the critical question of when.

My view is that we are close to the price-bottom but we need a bout of full-blown capitulation before it’s possible to see the recovery phase.

Two tests demonstrate that point, with one of them easy to measure.

The first test is subjective and comes in the form of a survey by the investment bank Citi which last week asked clients whether commodity prices would reach a bottom in the current quarter (to September 30). The vote was 54 per cent no v 46 per cent yes. Close, but we’re not there, yet.

The second more objective test is to watch for an entry into the commodities sector by the private-equity funds sitting on the sidelines, especially the $5 billion X2 fund assembled by former Xstrata boss, Mick Davis.

A man with a well-honed nose for knowing when to buy (and when to sell) Davis has been hovering in the background waiting for the time to snap up some of the distressed assets being offered by over-burdened miners.

The fact that Davis has not yet deployed his capital is a sign that he reckons prices are more likely to be lower in the near future, and that there’s no need to rush because the recovery (when it starts) will be longer. There’s also the problem that only second-class assets are currently being offered for sale.

Perhaps the most important part of the Barron’s report on commodities is that which covers the “three Ds” which another investment bank, Goldman Sachs, watches: Deflation (of costs) which is keeping mines in production, De-leveraging as emerging economies (such as China) become less commodity-heavy, and Divergence of growth as the US grows at a faster rate than the rest of the world.

The final D is of immediate importance because it is being reflected in the rising value of the US dollar, and the corresponding decline in the Australian dollar.

A lower local currency is helping Australian miners on conversion but as China demonstrated yesterday currency moves are a double edged sword delivering good and bad news. A worldwide race to the currency bottom helps no-one and certainly confuses investors.

Gold, which doubles as a commodity and a currency, is a useful tool to gauge the struggle underway in a variety of markets with China’s modest, but unexpected currency devaluation, sending shockwaves through industrial metals and oil while delivering a surprise bonus for gold investors.

Copper led the industrial metals down, shedding 4 per cent overnight to a new six-year low of $5114 a tonne. Oil lost 3 per cent to drop below $US50 a barrel. Nickel lost 3.5 per cent to $US4.86 and zinc lost 4 per cent to US81.4c.

Of the commodities gold was the eye-catcher. Not only did it rise in US dollars immediately after the 1.9 per cent devaluation of the yuan to more than $US1100 an ounce but in Australia there was a double win delivered in the form of a fresh fall in Australian dollar to less than US73c.

The overall effect of gold rising and the Australian dollar falling was to produce a reasonable rise in the Australian gold price which moves back over the $A1500/oz mark to around $A1518/oz.

Interesting as the gold-price moves are, the more important signal being sent by the gold market is that most financial markets, including commodities, remain in the grip of competing forces with the net result being a continuation of the uncertainty seen over the past few years.

No commodity can match gold as a measure of economy uncertainty. It is the financial world’s equivalent of a canary in a coal mine, there to detect noxious gasses.

What commodities need before prices can regain some of their lost ground is for more mine (and oilfield) closures to help reduce stockpiles, for global growth to pick up with China’s commodity demand critical for Australia, and for a clearer view of the new normal which is expected after the US starts raising interest rates.

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