A Worst-Case Commodity Scenario

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The task of today’s Daily Reckoning is to ponder what could cause the All Ords and the ASX/200 to make a new low in the first quarter of 2009. A warning, today’s issue is longer than normal. But the stakes are higher than normal too. So we hope you’ll bear with us.

By the way, by new low, we mean could the indices take out the March 2003 lows? For example, in the week of March 10th, 2003, the All Ords settled at 2,716. It would a nearly 23% fall to there from today’s trading level.

This is not an exercise in fear mongering, by the way. For most of this week, we’ve been focussed on a scenario where an increase in the global money supply causes widespread consumer price inflation and at least some inflation in commodity prices. But we need to take a closer look at another possibility today-a staggering earnings depression in resource stocks.

And be warned, it is not pretty. The only good news is that there are at least two businesses we can think of that will do well in an otherwise abysmal situation. More on them further below.

Here is the problem in brief: we know that financial earnings will suck for the fourth quarter. While Aussie financials may be relatively better off than their U.S. and European counterparts, their ability to increase earnings (especially when they are so reluctant to loan to begin with) is suspect. Either way, with Bernanke talking about another effort to re-capitalise banks, it doesn’t appear the supply of credit to the real economy is going to increase any time soon-at least not via traditional bank lending.

Next is the real economy. Last night we learned that industrial production in the Eurozone’s 15-member bloc fell by 7.7% year-over-year. Couple this with falling industrial production data from China, Japan and North America and you have nearly irrefutable evidence that the first-half slowdown in the global economy is going to be a lot more severe than any of the official estimates by the likes of the IMF, the World Bank, and the Fed.

None of this is good for Aussie commodity demand. Even though commodity prices are already down by large amounts, we now have the possibility of an ugly earnings shock for Aussie resource producers in the first and second quarters of this year. Whether this is already priced into resource shares is a question we’ll deal with in a moment.

But it would be wise to not underestimate the possibility of a massive, earnings-crushing double whammy for resources. First, is rapidly contracting global industrial production. This could lead to an unpleasant (and not priced-in) decline in Australia’s export earnings. Financial earnings have already been decimated by the credit crisis. Now that the crisis is storming into the real economy, are resource earnings next?

According to the RBA, “Australia’s export earnings make up around 20 per cent of total domestic income on average, and thus have a significant influence on economic activity.” Two of the biggest contributors to those earnings over the last few years were coal and iron ore. Both saw huge increases in annual contract prices as pre-Olympic Chinese steel production soared.

But now the reverse is happening. The Chinese are working down stockpiles and inventories. And waiting. But waiting for what? They are not just waiting for a resumption in global growth, at which point they will resume production and demand for Aussie raw materials. No. They are waiting for March and April

March and April are the looming deadlines for the annual contract price negotiations for bulk commodities like coal and iron ore. Right now, spot prices are well under contract prices-a reversal from last year when Indian iron ore traded at a premium in the spot market to Australian contract ore. Indian spot ores traded as low as $65/tonne late last year. That’s well below the $90/tonne price negotiated for 2008, and a lot further below the spot price of $200/tonne achieved earlier in 2008.

So what can you expect? Contract prices are going to come down, probably by as much as 40%. The steel producers could ask for an even bigger price cut, but that would ultimately affect the number of viable projects in the Aussie and Brazilian markets (and sow the seeds for a shortage and higher prices in 2010).

Before then, though, you can be sure the decline in contract prices is going to combine with a plunging global economy to punish Australian export earnings. Putting aside the effect this will have on national income (along with job losses to accommodate the lower demand for raw materials), you now have a situation where the earnings recession could lead the Aussie market could take out the 2003 lows.

Just to repeat: the proximate cause of a 22% decline from today’s levels on the All Ords would be a brutal double smack down of much lower global industrial production in the real economy (lower resource demand) and a huge reduction in contract prices for Australia’s two main export earners (coal and iron ore).

But what would all this mean for resource shares? That is the question. Well, as hard as it is to believe, we reckon it would lead to new lows. Despite their gut-wrenching falls from last year, there could be even worse ahead. Perhaps that is why today’s Australian Financial Review leads with the story that “$60bn projects under threat.”

The Fin reports that falling resource prices and the lack of access to credit could shelve $60 billion in new Aussie resource projects. And that’s on top of the $11 billion in projects that have already been deferred or cancelled altogether. ABARE still reckons there are 85 advanced projects valued t $67 billion that will proceed. But what about the 347 less advanced projects, valued at $220 billion? Who is going to fund those in this climate?

And more important, what would be the best investment strategy in a situation where there is a final, blow-off contraction in the resource patch? Well, as a thought experiment, one way to avoid another massive fall in the ASX and All Ords is to simply liquidate everything now and keep your head low. Such a strategy acknowledges that the bottom of the cycle in commodities has not yet been reached, and that it is not prudent to hang on for grim death. Rallies would be sold.

However, that is not to say that the bottom of this cycle is going to leave you wandering in the equity desert for 20 years. Earlier this week, we published Dr. Marc Faber’s analysis that commodities may be the one asset class for whom the current situation most resembles stocks in 1987-the big correction/crash was an interval in the cycle, not the end of it. What would that mean in this case?

It would mean that the real economic consequences of the credit crunch are going to accelerate in the first two quarters of this year, leading to much lower global trade, industrial production, and export earnings for Aussie producers. Already you see this with plunging freight rates. This economic slowdown, along with the seemingly inevitable contract prices for coal and iron in March of this year, mean a steep drop in Aussie resource stocks in the next four months.

And then?

It’s important to remember that commodities are heaving perfectly naturally and cyclically at the moment. “We know that this is a perfect economic storm,” says Mitch Hooke, the CEO of the Minerals Council of Australian in today’s AFR. “There is going to be some wreckage, there is going to be some damage and there will be a drop in supply. But demand will come back and then outstrip supply, and when that happens there will be a rapid recovery in prices and then production.”

He’s right, of course. This is basic cyclical economics. Its how things worked in the first stage of the resource bull. The increase in prices and the availability of finance led to surge in publicly listed explorers. Mind you with the exception of the base metals, you did not see a huge increase in new commodity supply come from all these new explorers (that’s important later).

But now, the cycle has reasserted itself on the downside. Boom gives way to liquidating bust in the commodity sector, where free market economics still functions (unlike in finance). Slower final demand and tighter credit are pushing non-producers and those resource companies without cash or lines of credit right to the wall. There’s nowhere left to go for many of them except out of business or into the hands of larger acquirers.

This too, is part of the cycle. When small would-be miners with quality resource projects and ore bodies lack the financing to produce those ore bodies (and can’t live off the production of another working mine) they don’t survive, at least not without help from a larger, cashed-up producer. This has an obvious effect (and also represents an opportunity for investors). Supply of commodities and minerals falls as the small firms disappear and the big ones mothball capacity. “Pebbles” get scooped up.

But when will the cycle bottom? This year? Not that we’re a big believe in equilibrium, but the fall in supply will eventually get more in line with current demand (which itself may fall for awhile). And so you get a consolidation and contraction for a few quarters. Equity prices would react to all this much sooner, of course.

But what is the general, long-term trend for commodity prices? If we accept Marc Faber’s analysis last week, the commodity cycle is not dead. It is merely resting. After a 20-year bear market and a eight year bull market, the cycle must now work through effects of a credit contraction and slower global growth.

Some analysts, like those at UCI say that the long term is good, even if the short term could be very gad. “The secular trend remains upward due to tight supply/demand fundamentals. In medium term, focus will be on global slowdown, easing inflationary pressures, dollar recovery, monetary tightening – all bearish for commodities.”

Mind you, even in such a bearish argument for commodities, you might find an exception in gold producers, although not the explorers. The junior gold explorers are fast, like everyone else, running out of finance. Our forecast? Gold production is going to fall this year at the same time gold prices rise.

We’ve focused so much on the demand side for gold as an inflation-hedge that it’s easy to forget gold is a mining business. You have to find it and dig it up. It is hard to increase the mine supply of gold.

True, there are large above-ground hoards of gold held by central banks. But in terms of mine supply, you can probably expect lower production this year, meaning those gold producers without debt might make attractive investments, even in the first six months of this year-and especially if the gold price reacts to the increase in global money supply.

Another exception might be LNG. Our man Kris Sayce at the Australian Small Cap Investigator has been all over this story. In fact, his two LNG share tips from the last two months are each up over 100% already. Kris was able to spot the bull within the bear. LNG is rapidly emerging as a substitute for oil as a transportation fuel (see the Pickens Plan by U.S. billionaire T. Boone Pickens).

LNG is also an infant industry in Australia. But it’s already attracting the interest of large foreign firms who want in on an energy source coveted by Asian economies like Korea, Japan, and of course, China. So even amidst the general bearishness in oil prices, a punter could find some nice little earners in the Aussie energy patch.

LNG and precious metals are the promising exceptions to the bearish general trend of commodities. It’s what our analysts are working on full time at the moment. And there may be others. But we thought it important to at least explore a scenario in which things get much worse for commodities. It’s hard to believe that’s possible.

However, we simply don’t know-and no one does-how markets will react to increasingly large sums of money injected in the global banking system, or what direct Fed purchases of assets might to world’s economy. In the long-term, as we’ve said before, the high saving emerging market nations are going to cease funding U.S. deficits and develop their own economies-focused more on domestic demand export growth.

That scenario-growth of consumption in the emerging world-is commodity intensive and favours Aussie producers. But getting to that that next stage in the global economy is easier said than done. Will it happen this year? Next year? In five years? Nobody knows.

Tomorrow, we’ll return to the subjects of banks, the alchemy of turning debt into equity, and what it all means!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Dan. Concerning gold juniors with a clear production pathway, my limited and anecdotal observation is that shareholder consolidations are now underway. Every time there is a share issue, the underwriter (along with other major shareholders who oversubscibe) take a firmer grip. Major shareholders who can’t hold on are jumping off but they are being replaced. The “listed” nature of these companies is becomes a burden to major holders who just want to get on with it but can’t easily do so while stock is being sold for pennies in $400 trades.

    OK there is money coming in via new and existing major shareholders. There seems to be taking 5%-10 incremental consolidation with each round. One key question (and risk) is the depth of their pockets. They won’t tell me so I don’t know. Another key question is whether the standard industry 25% residual share deal (eg. ALK’s arrangemnt with Newmont on one prospect) will provide sufficient cash flow to see through some other prospects. The wiser debt free companies are also slashing their costs with the view to holding on for a very long time.

    Coffee Addict
    January 15, 2009
    Reply
  2. What does any of this mean for the Aussie dollar?????

    Reply
  3. CA: I like your observations. I was quite surprised when CGT didn’t drop below the 3c level after the share redist. And it is nice to see people holding on to the shares.

    I am expecting that sooner or later (if the companies have any means to) some of the larger companies may consider buying out the juniors. Perhaps even the likes of Rio or BHP as they attempt to hedge themselves for the future?

    A thought occurred to me the other night…was BHP’s 07/08 Rio takeover partially deliberate to set Rio up for a fall?

    I very much doubt they had that foresight, but consider:
    – BHP launches takeover bid
    – Rio has to invest further to bolster its companies ‘value’ (reckless debt?)
    – Rio seeks to increase production hastily (reckless debt?)
    – BHP can consider its future options with less debt
    – BHP cancels bid, kills Rio share price
    – Rio suffers, has too much debt
    – Rio cuts back big time, has to sell assets, sack workers
    – BHP considers buying old Rio assets if it wants
    – Rio is weak for a considerable time
    – BHP waits for recovery of resource prices, considers another takeover bid whilst Rio is very weak

    Okay, so I strongly doubt it, but maybe by change BHP gets Rio after all?

    Probably should have posted this on another page…

    Reply
  4. Of course the big assumption here is that the market has not already factored in a major global recession. I would suggest that a 50% or so correction in the ASX All Ords since the peak in 2007 pretty much takes into account a pretty bleak outlook for 2009. As for LNG. I see Woodside are stopping work on the LNG project off the coast of California…so maybe that tells us something?

    Reply
  5. […] A Worst-Case Commodity Scenario Even though commodity prices are already down by large amounts, we now have the possibility of an ugly earnings shock for Aussie resource producers in the first and second quarters of this year. Whether this is already priced into resource shares is a question we’ll deal with in a moment. […]

    Reply
  6. Dear Dan,
    After doing a google search, i found that about 25% of gold is owned by central banks and about 75% is owned privately. I believe that with a recesssion/depression that we may see a huge influx of gold from this privately held source onto the market. Just to survive a lot of people will liquidate their gold positions to get cash. Just a couple of weeks ago i was checking to see if AGR Matthey was still in existence in melbourne (it is not – it has been taken over by Australian Gold Bullion company) and saw an indian woman at the counter having a pile of jewelery analysed for gold content. Have you considered this source of supply, the 75% of privately held gold?

    Reply
  7. […] A Worst-Case Commodity Scenario Even though commodity prices are already down by large amounts, we now have the possibility of an ugly earnings shock for Aussie resource producers in the first and second quarters of this year. Whether this is already priced into resource shares is a question we’ll deal with in a moment. But it would be wise to not underestimate the possibility of a massive, earnings-crushing double whammy for resources. First, is rapidly contracting global industrial production. This could lead to an unpleasant (and not priced-in) decline in Australia’s export earnings. Financial earnings have already been decimated by the credit crisis. Now that the crisis is storming into the real economy, are resource earnings next? […]

    Reply

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