Australian Resources Sector: Caught in the Inflationary Vice

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While the Australian resource sector has already endured nasty selling, perhaps there’s more to come. It’s no secret that investors don’t like the sector at the moment. It’s not quite reminiscent of 2008, but it’s not far off either. A few years ago, it was the bursting of the global credit bubble that caused the carnage. This time, it’s China’s credit bust.

Capital intensive industries with long life assets always take the brunt of credit busts. That’s why resource stocks are so volatile. Plentiful credit causes a momentary boom. Long term demand, along with prices, look robust, so producers plan big investments to satisfy that future demand.

But when things turn pear-shaped, investors run for the hills. Weaker credit growth lowers demand and commodity prices. Previously robust resource projects now look marginal and can’t obtain further funding. Share prices collapse.

Some resource projects turn bad in other, sneakier ways. Take Santos’ Gladstone LNG project. It’s suffering from cost blowouts. Yesterday the company upped its total cost estimate for the project from $16 billion to $18.5 billion.

This is a feature of all major resources projects, especially in Australia. To explain why, have a think about this Ludwig Von Mises’ quote from Human Action:

‘…changes in the structure of prices brought about by changes in the supply of money available in the economic system never affect the prices of the various commodities and services to the same extent and at the same date.’

China’s deflating credit boom first held out the carrot of higher prices and greater demand. Then, as the credit boom dissipated throughout the Aussie economy (via the terms of trade link), came the stick that led to higher prices of wages, materials and services.

So inflation lures you in…and then it bites you on the arse. Call it the inflationary vice. That wasn’t precisely Santos’ issue. It needed to find more gas for its project and so had to increase its budget. But looking for more gas costs money and uses more resources. These types of hiccups lower return on capital and lead to lower share prices.

The big gas, coal and iron ore projects in WA and QLD have pumped up wages and prices in those areas. Some mates of ours recently headed to QLD to work on a new coal project. They’re getting paid stupidly good money. They know it too. They also know it won’t last for long.

That makes us wonder…does everyone else know it, too?

Regards,

Greg Canavan
for The Daily Reckoning Australia

From the Archives…

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In Praise of the Eureka Rebellion
2012-06-19 – Dan Denning

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2012-06-18 – Dan Denning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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