Supply Rules In Commodity Markets

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By Rudi Filapek-Vandyck, Editor FNArena

At the start of the final week of November local stockbroker Bell Potter had some sobering news for investors counting on a turnaround in fortunes for producers of nickel: it's going to get worse first.

Surely, those investors must have thought it's about time for nickel to start making a come-back after what has been a truly horrifying 2013 calendar year. After a few years of gradual price erosion, the price of nickel simply fell by double digits this year. Virtually everybody thought in January there would be natural support not far below US$15,000/tonne, but instead the price has been below US$13,500/t and it is currently at US$13,512/t, a level at which industry experts believe up to 50% of all active production in the world right now is loss-making.

The rough ride for the sector is easily illustrated by the fall in the share price of Western Areas ((WSA)), a high quality, low cost producer in WA whose shareholders experienced prices above $10 back in mid-2008, but even in the first quarter of 2011 the price still sat above $6. Today Western Areas shares are flirting with the $2 level and if Bell Potter's projections prove correct -who knows?- they may just get there.

Is it really feasible that things might get worse?

Consider that, on Bell Potter's estimates, the global nickel market is only over-supplied by 6%. But then again, supply has been adding 10% per annum, out-muscling sluggish demand outside China since 2010 and there just doesn't seem to be any major change in industry dynamic happening. At least not yet.

Meanwhile, the industry is looking towards yet another wall of supply coming on-line with new production scheduled to start up in New Caledonia, Finland, Canada, the Philippines, Brazil and several other places. If all projects that are currently in ramp-up phase indeed do add new supply to the market, Bell Potter estimates total supply will grow by another 21%.

Something's gotta give.

With up to 50% of all production under water, and new supply still coming into the market, it is clear the present situation is not sustainable. In the absence of a major boost to global demand, seen as unlikely by just about everyone following the industry, salvation will have to come from reductions on the supply side.

Thus far, any production cut backs have been few and far between, which, of course, is the main cause behind this year's large over-supply situation. Most experts, including Bell Potter, are anticipating price increases for nickel beyond 2014. This is largely based upon widespread belief that the present situation is simply not sustainable.

Investors should thus prepare for production cuts, for potential supply to be postponed, for explorers moving into delay mode (and into hibernation) and for the large diversified resources giants to re-consider the importance and value of their assets. Bell Potter is a strong believer it is but a matter of time before BHP Billiton ((BHP)) announces the divestment of its Nickel West assets. This, speculates Bell Potter, is likely to trigger a consolidation frenzy among junior nickel producers in Western Australia.

If all this leads to a major shift in investor sentiment towards the sector, the price of nickel might well rise back to US$15,000/tonne and beyond much quicker than is currently being anticipated, but then again, how sustainable is any major lift in price likely to be without more pain first on the supply side?

In comparison with copper, iron ore and crude oil, nickel producers operate in an environment that is much more fragmented. The top four major producers supply less than 50%. This becomes a major negative when supply catches up with demand. Nobody offers voluntarily to go out of business so that others can continue to generate profits and cash flows, so the process of market rebalancing has to develop through brute force.

During this process, history shows, marginal producers often stay in business for longer than anyone expects them to, leading to lower prices than anyone expects, causing much more pain than seems feasible. Look at uranium and at the coal markets, both fine examples.

Note that global demand growth for nickel has been around 9% per annum in years past so it wouldn't have required that much in terms of production losses to keep surpluses at bay.

Thus far, the Big Three among commodities -copper, iron ore and crude oil- have fared much better and there seems to be one easy observation as to why this has been the case: all three markets enjoy a relatively high concentration on the supply side. A higher concentration among suppliers means more can be smoothed out and coordinated.

This doesn't mean that commodity markets that have a higher concentration on the supply side will forever remain immune to the same market forces that are currently creating havoc and pain for producers of nickel, thermal coal, uranium, silver and the like. As a matter of fact, copper has fallen by circa 10% this year, while iron ore (would you believe!) is also well down from its peak above US$180/tonne and from US$140+ recorded earlier in the year while crude oil (Brent, the one that matters) has pretty much remained inside a range-trading pattern for a few years now.

If you pay close attention to changes in analysts' price forecasts, as I do, you would have picked up that the underlying trend is now for lower price forecasts for all of the Big Three. In every case the underlying cause is the same: supply has caught up with demand, or is about to.

Time to repeat the ultimate truth about commodities: while everyone always seems focused on what happens on the demand side, it is what happens on the supply side that will determine where prices will end up. In other words: demand only matters in relationship to what is happening on the supply side.

Bell Potter now seems to be of the view that we have seen the peak in copper prices and that each of the next three years will see a lower annual average price than the year before. This is more downbeat than most other experts who predict a bounce in 2016 or even in 2015, but the trend in price forecasts for 2014 and 2015 is definitely negative and many an analyst will point at the wall of supply that is about to hit the market.

If current projections prove correct, copper will next year fall to its lowest price level since 2009 (below US$7000/tonne) and these forecasts are supported by the largest annual supply increase in a decade. Naturally, the few remaining bulls in the market, such as analysts at Morgan Stanley, are counting on the fact that a lot can and will go wrong on the supply side.

In similar fashion, while iron ore bulls are currently enjoying their moment in the sun, it is not Chinese demand that has proven just about every price forecast wrong this year, but delays and interruptions on the supply side, including the virtual disappearance from India as a supplier of importance to the global seaborne market.

Within this context I note analysts at Citi last week released their updated price forecasts for iron ore, essentially suggesting prices will remain well-supported over the next six to nine months, but then repercussions will lead to lower prices kicking in much quicker. Citi now predicts an average price of US$100/tonne versus US$115/t previously in 2015.

Note part of Citi's forecast is for an increase in production by India, which may not occur.

The most intriguing developments are currently taking place in the global oil market where high prices from past years have provided a solid platform for large increases in supply on the back of new technologies. This is not simply a result of the fracking revolution in the US; deep sea drilling is making a significant contribution as well.

For OPEC, and the Saudis in particular, current change in dynamics must amount to a nightmare coming true. Not only is the role of OPEC cooperation becoming less important for global oil in general, the US shale revolution is spreading across the globe, poised to make some serious impact later this decade and next.

What if the demand side will be impacted by increased popularity of natural gas, as just about everyone expects will happen?

For the first time since 2008, global predictions for oil prices are falling to lower levels. This time around they are falling for years further out. This is a new dynamic for oil. Brent prices have largely traded sideways since 2010. Now analysts are saying the price should have been higher today given the record amount in supply that has been interrupted.

But oil, just like copper and iron ore, and all other commodities, will always carry the potential for a sudden surprise. So watch the supply side. Venezuela is still governed by an ever so desperate dictator and the domestic economy seems fragile and vulnerable. Oil rich Venezuela needs a higher price. Ironically, this higher price will kick in from the moment the current regime falls or comes under serious threat.

Which again proves the obvious: supply rules in commodity markets. Investors better keep their focus where the real action is.

P.S. All of the above doesn't by definition mean there's no opportunities to be had for investors among resources stocks. Bell Potter's favourite nickel producer is the earlier mentioned Western Areas. The company is anticipated to see strong growth in the years ahead, admittedly after several years of absolute carnage, both in profits for shareholders and in the share price. But a low base and small changes in market dynamics can do wonders to a quality company's bottom line, and to its share price, once the dust of the relentless downturn has settled.

P.P.S. Indonesia can potentially throw nickel producers a lifeline soon as a large proportion of Chinese nickel pig iron production sources input from Indonesia and there's still the threat of a ban for minerals exports, but expectations about this threat actually being executed remain low.

(This story was written on Monday, 25 November 2013. It was published on that day in the form of an email to paying subscribers).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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