Commodities | Jun 21 2006
By Greg Peel
Uncertainty is the mother of volatility and recent volatility in base metal markets (and subsequently in resources stocks) only goes to prove there is little consensus of opinion on the "where to from here?" question. Even if opinions are held one way or another, they are clearly on stand-by to be reversed at a moment’s notice.
Merrill Lynch analysts have sought to tackle this debate by at least offering up some scenarios and ascribing their own levels of perceived probability to each. As to whether this will comfort befuddled investors is another matter. It comes down to whether or not you like the odds.
Firstly, let’s look at the bull side of things – the positive indicators of upside in metal prices.
Has the supply/demand situation really changed at all? From about two years ago, resources analysts were entertaining the idea of a super cycle but continuing to warn of a reversion in prices at least towards a longer term average. Debate then ensued as to whether we had made a secular jump such that a new average price would be established, higher than the previous long term average, or whether markets would revert to the mean just as they always have.
Driving the demand side, of course, was China – certainly a new player on the block. But ever since every resource analyst had been in short pants, or pigtails, metals markets had moved in cycles. What goes up must come down. The cyclical basis is that mining and smelting are time-consuming and costly ventures that cannot be approached flippantly. If you’re going to invest a lot of time and money into production, you’d want to be confident prices are attainable to economically justify your venture.
Before China took off, prices were low – too low. For years they were too low, so for years metal production and associated infrastructure investment was neglected. When China did take off, there was a rapid realisation that the supply side was inadequate, and that things had better happen fast.
The usual, historical response to rising metal prices is subsequent investment in the supply-side, which leads to supply eventually catching up to demand after a lag. During the lag, prices keep rising until balance is reached, and then they fall back again as supply outweighs demand. After a lap of the board we have come back to "Go".
Slowly but surely, analysts came to realise two important aspects of the China story. (1) Demand was astronomical – far greater than initially forecast. (2) Supply was going to take a helluva lot longer to catch up than would normally be the case. Not only were there not enough mines and smelters, there weren’t enough ports, ships, trains, trucks, railway lines and even qualified people to restore a demand/supply balance in a hurry. The super cycle theory was cemented, and the time frame was stretched out to distant years. Analysts were forced to acknowledge a new world.
In 2005-06 a new problem emerged on the supply side – hold ups. If you drive things to hard too fast they tend to break down and need to be fixed. If you become all optimistic about the production capabilities of your new mine chances are you’re in for disappointment. And if you make too much money from mining, it won’t be long until your lowly workers start exercising collective power in order to participate in the spoils as well.
Shut-downs and strikes have beset the metals markets, and while shutdowns are hard to predict, strikes are sure to continue as large mines across the world hit predetermined wage negotiation points over the next year or more. The supply side will continue to be restrained.
Metal inventories are still at 10-year lows. Restocking has been occurring lately, which takes metal out of the consumable market and into a hoarding phase. This phase is, however, expected to end soon after what Merrill Lynch describes as "an aggressive six months".
Now consider the demand side. It is a logical assumption that prices cannot go up ad infinitum, and that eventually demand will drop when the marginal benefit of acquiring a commodity is less than the price required to be paid. Analysts have been predicting a slowing of Chinese demand for a while now, but signs of a slowdown have been few. It’s not that hard to consider why this is the case. As China’s economic development continues, that which the Western world takes for granted becomes affordable to more and more of China’s masses. Phones, computers, fridges, cars, houses.
Take cars as an example. There are presently 14 million cars in China. That figure is expected to double in four years. Add trucks, buses et al, and there should be 55 million cars on the road by 2010. How much metal goes into a car? (Let’s not worry about oil or pollution at this point). How much copper goes into wiring a fridge, a building, or a telecommunications system? It is hard to contemplate there being anything other than ongoing demand coming out of China, and its cohorts, India, Russia, Brazil…
Such are the demand and supply "fundamentals". Now, turning to the bear argument, consider the negative indicators.
The world is concerned about inflation. Metals prices have gone up, so the price of anything made from metal has gone up. The oil price has gone up, and this is the most fundamental factor behind inflation fear. Higher oil/energy prices simply mean higher prices for everything, from petrol to plastics to food transported across countries or oceans.
Inflation has been slow to appear. Everyone has been expecting a sudden jump in inflation, but to date there has been an offsetting factor. As China has become the production centre of the world, low wages and high productivity have meant the price of many household goods, from clothes to computers to cars, have fallen.
While inflation appeared to be under control, central banks were not in a hurry to raise interest rates and jeopardise economic growth. From the US to Europe to Japan. This meant capital was cheap, and this allowed investment in assets producing a healthy return – such as metals. The US was the first major economic power out of the blocks to raise rates, and just when everyone thought the tightening phase was over, Ben Bernanke came along to scare everyone into believing it wasn’t.
Supporting Bernanke’s strategy were US inflation data, particularly the CPI that set the whole market correction ball rolling.
Now central banks across the world are raising rates. Europe is into the swing of it, Japan has rediscovered the need for it, and even China has succumbed to the inevitable. What do higher global rates mean?
Firstly, a credit scare – if easy money is no longer easy then speculative investments like metals are no longer as attractive. Time to get out. Secondly, a slowdown in global economic growth, including growth in the world’s largest economy (US) and fastest growing (China). If investment capital costs more, investments will not be entered into at the same pace. Business confidence falls (as it has already) and demand falls as a result. If demand falls, prices fall.
China has been publicly discussing the need to slow its economy. The hard part is slowing it without killing it off. But China’s commodity consumption is out of control, and the growth of its industry is so frenetic that it can only end in tears. There just cannot be so many steelmakers, for example, before there’s just too much steel.
China is trying to avoid a "hard landing", but either way, some slowing is required. This works against further astronomic surges in commodity prices.
Weighing up the bull and bear arguments, Merrill Lynch has come up with three scenarios.
(1) The "Peak Bull Case". We overcome the present correction/slowdown in about six month’s time. Global growth then rebounds in 2007 and we’re back on track, with demand continuing to run above supply and supply being constrained by ongoing interruptions. Metal prices surge to new highs.
(2) The "Bull Trend Case". We overcome the present correction/slowdown in about six month’s time and growth returns in 2007, albeit at a more subdued pace, some 1.00-1.25% below levels experienced in 2006. G7 economies are softer and although inventories are tight, destocking keeps a rein on things.
(3) The "Bear Case". We’ve had our fun and now it’s all over. We won’t see such highs in metal prices again. Demand will begin to disappoint and supply will begin to catch up. Prices will start heading back to those aforementioned long term averages.
Which do you see transpiring? Merrills ascribes a 10% probability to the Peak Bull Case, a 60% probability to the Bull Trend Case, and a 30% probability to the Bear Case. If this seems like an each-way bet to some extent then think about it this way: it’s highly unlikely we’ll see the same level of upside pandemonium again, but a healthy bull trend is twice as likely as a depressing bear trend.
Merrills believes in 2-3 more months of pain. By pain we’re talking volatility, and the only way for volatility to be shaken out of the market is for prices to fall further to levels where benched investors begin to feel comfortable about returning back to the game. Within 6-12 months the bull trend will have re-emerged, provided China can slow its economy gently. If not, the bear case will increase in likelihood.
From the resources stock perspective, Merrills is tipping another 10-20% downside, driven by further falls in metal prices towards "reasonable" levels. Diversified resources stocks will suffer less, pure-plays will suffer more.
For Australian pin-up stocks this means further falls of around 10% for the giants – BHP Billiton (BHP) and Rio Tinto (RIO) – moving out to 12% for the likes of Alumina Ltd (AWC), and 20-30% for the Zinifexes (ZFX) of this world.
Merrills advice is if you’re long pure-play stocks (and they’re not major takeover targets), be prepared to wear 20% downside or get out now. If you’re long diversifieds, best to hang on, and perhaps build at lower levels. If you’re underweight resources altogether, wait. You will have a better buying opportunity soon.
If you want something to buy now, Merrills suggests the bulk commodities, steel and uranium. As BHP and Rio are the big bulks, and they’re set for a fall, iron ore fans may need to look elsewhere. Coal-wise, Merrills likes Excel (EXL) and suggests the outlook for thermal coal remains robust for three years. ERA (ERA) looks cheap in the uranium stakes.