The Future of the Australian Resource Market, Two Ways the Boom Could End

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Australia is about the luckiest country on the planet when it comes to the resource boom. Gold to India. Coal to Korea and Japan. Iron ore to China. And windfall earnings for the Australians involved in digging up pieces of this country and shipping it off overseas.

Yesterday we mentioned the big increase in the value of Aussie exports announced by the Australian Bureau of Agricultural and Resource Economics (ABARE). But let’s take a look at the glorious details, shall we?

In total, ABARE reckons that minerals, metals, and agricultural exports will grow by $61 billion in the next year. The total export haul for the fat of this lucky land is $212.3 billion. Energy earnings will grow by 81%. Minerals and energy earnings combined will be up 48%.

Even that figure might be low, depending on the contract price for iron ore. That price, as you know, has still not been set (although Rio Tinto (ASX: RIO) seems to have reached an agreement with Baosteel…more on that below). BHP Billiton (ASX: BHP) and Rio drew their line in the red dirt of the Pilbara. They want at least an 85% increase over last year’s price. It looks like they may get it, and then some.

Iron ore isn’t even the biggest contributor to the Australian resource market. That distinction belongs to coking coal (sometimes referred to as metallurgical coal). The world’s steel boom (steel prices are soaring, along with all those new skyscrapers in China and the Middle East) is fuelling the demand for the high quality black coal from Queensland’s Bowen Basin.

ABARE estimates that the country will export $39.1 billion in coking coal in the next fiscal year. Let’s call it $40 billion. That’s a 123% increase in the value of the exports over last year.

But keep in mind the chronic infrastructure bottlenecks along the Eastern Coast mean that the volume of coal exports will only increase by 7%. The big kicker is the 206% increase in coal prices earlier this year. You can make up on price what you lose on volume. Oh to be lucky.

Iron ore will deliver nearly $36 billion into the coffers of the ore titans of the Pilbara (and some of the minnows too). Today’s Financial Review reports that Rio Tinto has secured an 85% rise in next year’s iron ore contract price. The agreement was reached with China’s Baosteel, China’s representative during eight months of entertaining and sometimes cranky negotiations.

Thermal coal-the kind you burn to generate electricity-will deliver $15.9 billion in exports, mainly on the back of a 74% increase in thermal coal prices. And thanks to the soaring oil price, Australian crude exports will generate around $15.3 billion. That should benefit Woodside Petroleum (ASX: WPL) and BHP.

Good news for Aussie gold production, too. It’s headed up after declining the year before. The rising gold price will account for most of the 14% increase in gold export earnings. But if the gold price moves higher in the next 12 months-a whole other story about money and the dollar-some new Aussie projects should benefit.

AngloGold Ashanti (NYSE: AU) and Independence Group (ASX: IGO) are set to bring their Tropicana joint venture on line by 2010. It’s considered one of the biggest gold finds in Western Australia in the last ten years. In 2009, Newmont and AngloGold will begin production at the Boddington mine expansion.

If it all seems too good to be true, well maybe it’s worth wondering what could derail the Australian resource market. What could derail the biggest export boom in Australian history? There are two answers. But only one of them can be right.

One answer is that Australia’s boom ends when America’s depression begins. This argument is based on America’s economic situation getting much, much worse as the housing bust deepens. In this argument, Australia is the first link in the global chain of consumer demand. The middle link is Chinese manufacturing, which turns Australian raw materials into finished goods. The final link is the American consumer, who buys what China builds.

If the final link is broken – if the American consumer is on the edge of his own private bear market – then eventually it will work its way back to Chinese demand for Aussie resources. No final demand, no initial demand. Bust goes the boom.

The reason this argument is bogus, in our humble opinion, is that it overstates the role of American consumption in the future demand for Australian resources. A thorough (and slightly mind-numbing) survey of the ABARE export data show that Korea, Japan, and other Asian countries are also big consumers of Aussie resources.

These are all large, developed, industrialised (or industrialising) economies. They all export to America. But they will not go in the tank of America slows down.

And in any event, if you want to know what we really think, we think the world is witnessing a slow realignment. The entire global model has favoured American consumers. Entire nations designed their economy to produce cheap things for Americans to buy. America had the world’s reserve currency. And American stocks, bonds, and real estate were considered the most attractive and safest on the planet.

All that is slowly, inexorably, but undeniably changing. By sheer weight of numbers, the markets of Asia are bigger. On a purchasing power basis, they are getting stronger year-by-year. Per capita incomes are rising. Savings rates are higher. And capital investment by the business sector sows the seeds for future income growth.

With higher incomes, Eastern consumers will drive global tastes. Producers will cater to what kind of hand bag middle class housewives in Shanghai want (hint: it will probably still be Yves St. Laurent). Maybe General Motors will become a Red Chip. China’s boom could end up swallowing a lot of global brands, or producing new ones.

That brings us to the second and more likely of the risks to Australia’s boom: an inflationary melt up. All economic cycles end with rising prices. Already we see high food and energy prices causing economic and political problems all over the world.

The real risk to Australia’s boom is that soaring energy and food prices slam the brakes on Asia’s emergence as the world’s economic engine. Growth can be awkward and destabilising too. Just watch a bunch of teenagers at the high school prom and you’ll see what we mean.

Taking 3 billion people from subsistence incomes to even a modest level of surplus in just a few generations is no easy task. It causes massive social and economic change. That change can be destabilizing. Food riots. Fuel riots. Or just riots because you have millions of young men with no jobs and no wives.

But in the big picture, it’s hard to see the role of the Australian resource market in Asia’s emergence changing or diminishing. If resource prices go too high, commodity consumers will look for cheaper substitutes. Is that a threat to Queensland’s coal and the Pilbara’s iron ore?

Even when substitution is desirable, it’s not always possible. For example, China played its own iron ore card in the last eight months. It claimed that it could feed local steel mills with local iron ore. And in terms of total production, the Chinese iron ore industry is a lot more formidable than just five years ago.

The trouble is, China’s ore industry is fragmented into dozens of smaller producers. And China’s iron ore grades are generally much lower that what Australia is endowed with in the Pilbara. BHP and Rio have enormous economies of scale on their side. There’s lot’s of high grade ore in one place. That makes it easy to produce in the volumes required by China’s steel industry. That is also why, though rocky, the marriage of Aussie ore and Chinese steel will probably be a long one.

As with ore, so with other things. There’s lots of high grade everything in this place, come to think of it. Copper, gold, LNG, lithium, tantalum, coal, molybdenum, bauxite, rare earth elements…the list is very long. If Australia ever developed the capacity to build finished goods, it would be a formidable manufacturing giant.

The labour dynamics of globalisation have set the country on a different but lucrative course. It will provide resources for the foreseeable future. For investors, it’s great news.

While the indexes (and mostly the banks) will be dragged down or sideways by ongoing credit worries, the fundamental demand for Australia’s minerals, energy, and farm products doesn’t look like it’s going to get much weaker any time soon. With earnings set to rise, the Australian resource market is a stock picker’s delight.

Dan Denning
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. Hi Dan

    You forgot to list uranium as an important mineral which would feed the nuclear power industry as oil goes ballistic and which Australia is richly endowed with.

    Keep up the good write……I find it informative & enriching.

    Cheers,

    Heng

    Reply
  2. I have reliable information from my middle aged housewive contacts in Shanghai, that their handbag preferences are more along the lines of: Prada, Burberry, then LV (except too many fakes around makes this less popular these days) followed lower down at YSL.. which is considered a bit “cheap”.

    Al the Pal
    June 25, 2008
    Reply
  3. Quote in the erureka report

    Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.
    – Sir John Templeton

    Your in there hard aren’t you.

    Reply
  4. There are more than a few potential downsides to minerals, and a rejectionist argument on a single one of them on a king hit evaluation on pricing or volume appears to me to missing the flow.

    Asian economic activity & growth has been driven by export production and the capital investment that has supported it. Locking that as a negative with any slowdown in the US an EU we can debate scale later.

    Import merchandise purchases are at the top end of discretionary consumer spending. Behind that sits Asia. Lock another one.

    The price of import merchandise is dependent on exchange rates. Demand downturn on discretionary items at inflating import prices is accentuated.

    A downturn in discretionary spending will hit services economy jobs hard & there is likely to be a significant flow-on effect in the economies that have had the steepest growth in the discretionary & financial services sectors. Can history provide a precedent or are we in uncharted waters?

    The discretionary spend component within fuel is limited in an economy that has developed like the US. US inventories have been centralised or mega-regionalised (read interstate delivery), regional distribution has been collapsed in favour of hubs and spokes, and mass transit of commuters to jobs and retail has no infrastructure and extended distances. This will mean an amplified hit on other discretionary spending sectors.

    Going back to Asia and capital investment. Right now the lever being applied by the Chinese on domestic inflation is by increasing banking liquidity requirements. The effect has yet to flow through on domestic capital investment.

    What is the affect on capital investment of the entrepeneurs losses on the Shanghai exchange?

    If China lets the Yuan float the appreciation will likely be steep and the affect on export pricing and a steep downturn in capital investment in that sector.

    The other Yuan appreciation effect is on Chinese import commodity prices. What immediately happens to them in USD terms and what happens to the USD? So what is value in a Baosteel negotiated ore price to a global reserve currency begging all corners of the world.

    India appears to be in a bad corner with little to contribute to anything but gold consumption and Japan/Korea are flatter than ….

    On the countervailing side to support minerals demand growth. Can the Chinese consumer savings? What is in the pipe on Chinese and Asian government infrastructure projects.

    So let the optimistic arguments get a little deeper than ABARE cares to go on the demand side and meantime watch the Baltic exchange to see whether I’m proved a dill http://investmenttools.com/futures/bdi_baltic_dry_index.htm

    Reply
  5. The American’s achilles heel was consumer credit and the fact that banks made it possible for people to put up their fantastical future income 20 years from now as collateral to get it. Spending was 2/3 their GDP – now its dust. When easy money became hard-a$$, the dream instantly vaporized. Good run though.

    For Australians, its resources – raw materials and energy. What’s the market cap of resources on the ASX? It was 40% in mid-2007 and that was before stimulus like the Chinese acquisition for 10% of Rio Tinto threw fat into the fire. When resource prices rationalize, our property valuations will be just about as tangible as a Saharan igloo.

    Reply
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