I have been calling for a base metals bust for some time, fueled by a slowdown in China. Michael Pettis at China Financial Markets has been saying the same thing. Indeed, it is analysis from Pettis that influenced my views in the first place.
Pettis now believes commodity prices will collapse by as much as 50% over the next few years. His rationale is solid.
Here are a few snips from a recent Michael Pettis email in which he outlines the case.
By 2015 Hard Commodity Prices Will Collapse
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% 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% or more in the next two to three years.
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.
He will almost certainly be wrong.
Production capacity has grown
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% a year, with most of that coming in the past decade. If you exclude China, however, global demand for steel grew by only 2% 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% a year on average.
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.
What about demand?
China currently is the leading consumer of a wide variety of commodities wholly disproportionate to its share of global GDP. The country represents roughly 11% of global GDP if you accept the stated numbers, and substantially less if you believe, as I do, that growth has been overstated because of the difference over many years between reported investment, i.e. its input value, and the actual economic value of output. China nonetheless accounts for between 30% and 40% of total global demand for commodities like copper and nearly 60% of total global demand for commodities like cement and iron ore.
The only reason China has provided such an extraordinarily disproportionate share of global demand for hard commodities has been the nature of China’s growth model. While China may represent only 11% or less of the global economy, it represents a far, far greater share of the world’s building of bridges, railroad lines, subway systems, skyscrapers, port facilities, dams, shipbuilding facilities, highways, and so on.
Over the next decade, two things are going to change. The first is increasingly recognized, and that is that Chinese growth rates will drop sharply. The second is that China will rebalance its economic growth away from its appetite for commodities.
Which Way Can Prices Go?
For these reasons I am very pessimistic about hard commodity prices and expect them to drop substantially further in the next two to three years.
- Production capacity for hard commodities is rising much too quickly, in a belated response to the unexpected surge in demand just under a decade ago.
- Expected economic growth rates in the country that has been biggest source of new demand – virtually the only source – have fallen sharply and commodity prices have fallen with them. Historical precedents and the arithmetic of rebalancing suggest, however, that the current consensus for medium-term Chinese growth is still too optimistic. Expected growth rates will almost certainly fall further in the next two years.
- Beijing has finally become serious about rebalancing China’s economy, and rebalancing means shifting Chinese growth away from being disproportionately commodity intensive. Instead of representing 30-60% of global demand for most hard commodities, Chinese demand will shift to a more “normal” level. Remember that even a very limited shift – from 50% of global demand, for example, to a still high 40% of global demand – represents a sharp drop in global demand.
- There has been so much stockpiling of commodities and finished goods with implicit commodity content in China that the country could well become a net seller, and not net a buyer, of a wide variety of commodities in the next few years.
This is going to come as a shock to many people. In my discussions with senior officials in the commodity sectors in Brazil, Australia, Peru, Chile and even Indonesia, it seems to me that many analysts have been insufficiently skeptical about the Chinese growth model and are unaware of how dramatically the consensus has changed in the past two years.
They have failed to understand how deep China’s structural problems are and how worried Beijing has become (this worry may be best exemplified by the extraordinary growth in flight capital from China since early 2010).
Under these conditions I don’t see how we can avoid a very nasty two or three years ahead for commodity producers. This isn’t all bad news, of course. What will be a disaster for hard commodity producers will be great news for companies and countries that are commodity users or importers. One way or the other, however, we are going see a big change in the distribution of winners and losers.
Given that iron ore prices have already fallen by more than 50% perhaps iron does not see another 50% decline. Regardless, there is certainly room for many commodities to plunge that much, and copper is a prime example.
The price of copper at the beginning of 2005 was $1.50 and it fell below that price in late 2008 and early 2009.
Pray tell why can’t (and shouldn’t) copper see that price again if Pettis’ view of Chinese growth is accurate (and I am quite confident in his view).
Official Denial from Australia Prime Minister
Please consider an official denial regarding Australia’s mining sector : Boom Isn’t Over Says Prime Minister
AUSTRALIA’S mining boom is not over and its ‘death’ has been exaggerated according to Prime Minister Julia Gillard.
Ms Gillard said she understood there was growing uncertainty due to economic problems in Europe and America, rising competition and a softening of China’s growth.
“Let’s be clear,” she said, “reports of the mining boom’s death are exaggerated.”
Ms Gillard said the boom had three distinct phases – a prices boom, which was passing; an investment boom, yet to reach its peak, and a production boom “as all that effort comes to fruition in the years and decades ahead”.
Her comments come as iron ore prices drop and Australia’s third largest iron ore producer, Fortescue Metals Group, today added its name to the list of companies pulling back expansion plans.
Question? What Question?
“There is no question about whether we have a boom, the issue is whether we make it last” said Prime Minister Gillard.
Note the sheer foolishness of Gillard’s statement. It is not up to Australia at all whether the boom is over or not. The boom is entirely dependent on what China does or doesn’t do.
Moreover, there is no question the boom is over. The real question is “How big is the bust?“
Mike “Mish” Shedlock
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