Could a Commodity Market Crash be Imminent?: Michael Pettis

September 19, 2012Commoditiesby Michael Pettis

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Could a Commodity Market Crash be Imminent?: Michael Pettis

Commodity prices swelled in the last decade – mostly on the back of insatiable demand from China. Yet, if you exclude China, global demand for commodities like steel, for example, grew only 2 percent per year in the last twenty years, implying that China accounted for almost all the increase in global demand in the last two decades. With a China slowdown and rebalancing on the cards, could a subsequent commodity market crash be imminent?  

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 twenty 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 recognize, 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 10-11 percent 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 percent or more in the next two to three years.

Not everyone agrees. In July, I made a reference to a book by Dambisa Moyo, a former investment banker turned economic writer, called Winner Take All, in which the author argues that the world is facing a crisis in the form of a commodity shortage, and she expects prices to surge. Unlike her, however, I expect the price of hard commodities and certain industry-related soft commodities (like rubber) to drop sharply in the next three years, and to stay low for many years thereafter.

To address the first of the four reasons I expect hard commodity prices to drop, excess growth in supply, one month ago I spoke at a conference in Sydney, after which Gerard Minack, chief economist at Morgan Stanley Australia, gave a presentation on the world economy and, more specifically, on commodities. His presentation was an eye-opener for me.

Based on my many trips in recent years to places like Australia, Peru and Brazil, I had plenty of anecdotal reasons to believe that commodity producers had significantly overestimated the sustainability of the Chinese growth model (or, perhaps more accurately, had not really thought about whether or not it was sustainable). I was worried that they were expanding production very quickly. Everywhere I went I heard stories of large-scale investments to expand production.

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 Mr 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, Minack 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 percent a year, with most of that coming in the past decade. If you exclude China, however, global demand for steel grew by only 2 percent 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 percent a year on average.

Related News: Lower Demand, Prices Send China's Steel Profits Tumbling 96%

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.

Changing production requires years of exploration, investment, and upgrading, however, so the decision to increase production could only result in higher production many years later. This is shown by a set of cost curves, which are at the heart of Minack’s presentations, and these curves graph the short-term relationship between price and volume. For any given amount of demand, in other words, the graph showed the corresponding price.

The supply curves, of course, are positively sloped – the higher the price of copper, for example, the more copper will be produced and sold. The slopes of the curves, furthermore, are very sensitive to existing production capacity, and Minack lists curves for several points in time as production capacity changes. As one would expect, when demand for copper is less than production capacity the curves slope gently upwards, implying that small increases in copper prices correspond to very large increases in copper supply.

But this curve slopes gently upwards only up to a point, representing the limits of normal production capacity, after which the slope of the curve is almost vertical. Beyond this point – of maximum capacity – no matter how high the price of copper, in the short term supply cannot be substantially increased.  Or to put it another way, beyond that point small increases in demand translate into large increases in price.

In 2001, according to Minack’s numbers, this transition point for copper was roughly 12 million tons, 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 tons. 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 tons, 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 tons, above which iron ore producers would have difficulty supplying demand. By 2011 it was at 1,300 million tons and by 2014 and 2020 it is expected to be 1,900 million and 2,600 million tons 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. I won’t rehash all my arguments from earlier articles about stockpiling but it is enough, I think, simply to list some of the articles I found in my daily readings last week.

Click to continue reading... Stockpiling