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Unintended consequences: Thank cheap central bank cash for the depth and duration of the commodities slump

posted on April 5, 2013 at 8:30 am
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There is no free lunch.

So, yes, the flood of cash from the world’s central banks has prevented the crash of the world financial system in the dark days after the collapse of Lehman Bros. and the near collapse of America International (AIG) and Citigroup. And, yes, Mario Draghi’s promise to do anything necessary to save the euro has headed off the collapse of the market for Italian and Spanish government bonds. And yes, the huge stimulus thrown at China’s economy prevented a hard landing where the growth rate might have slipped below 7%. And, yes, the Federal Reserve’s promise to keep interest rates at essentially 0% has revived, finally, the U.S. housing sector.

But we’re still counting up the costs.

Sometimes the price is obvious: In China it produced a real estate bubble that has left the landscape littered with ghost cities of apartments owned by speculators.

Sometimes the price is obvious but delayed: Someday the bill will come due in higher inflation, higher interest rates, and weaker currencies.

And sometimes the price is just not all that obvious. That’s the case right now in the commodities sector where a global policy of cheap money has turned a modest slump into what looks likely to be a long, deep, depression in the worst hit sectors such as natural gas, coal, and maybe even iron ore.

How is cheap money related to what is already a punishing recession for major commodity sectors? Let me explain. If you buy my explanation of the cheap money/commodity recession connection, I think you’ll wind up rethinking your strategy and timetable for investing in commodity stocks.

Let’s begin with the mismatch between what I’m calling the commodity depression and the slowdown in global growth. Certainly the slowdown in China’s economy–the driver for the global market in commodities from thermal coal to copper to iron ore—should lead to a drop in commodity prices from their peaks. A China growing at 10.4% in 2010 thanks to the country’s post-global financial crisis stimulus efforts (let alone a China growing at the 12% or 14% annual rate before the financial crisis) would consume more coal, iron ore, copper, oil, you name it than a China growing at 7.8%, as the country’s economy did in 2012.

Take a look at iron ore, for example. China’s steel mills are the world’s largest consumer of iron ore (accounting for 60% of global iron ore imports) and it makes sense that demand from China would slow as China’s growth rate hovers near 8% rather 10% or 12%. In fact, Goldman Sachs projects that China’s imports of iron ore in 2013 will growth at the slowest rate in the last three years.

But do note that China’s demand for imports of iron ore is still projected to grow in 2013—by 4%. And global demand for iron ore imports is expected to growth by 8% in 2013.

Iron ore prices, however, have already retreated 6% in 2013. And the consensus among analysts surveyed by Bloomberg projects that iron ore prices will fall another 34% by the end of 2013 to finish the year near $90 a metric ton. (Iron ore sold for about $155 a metric ton at its local peak at the end of February 2013.)

That may not even be the worst news. Iron ore prices could continue to retreat through 2014 and perhaps until 2018, according to Morgan Stanley. That would produce a slump that mirrors the nine-year boom in iron ore prices that saw the ore climb seven-fold in price for the days in the late nineties when the price was $15 to $20 a metric ton.

Projections for a huge decline in price by the end of 2013 and in the years following don’t make much sense if you look just at the demand side of the market, however. Demand from China for imports will climb 4% in 2013 and yet the price of iron ore will not just slide lower, but plunge? Global demand will climb by 8% but prices will fall another 34% in 2013?

Ahh, take a look at the supply side. Those same projections that say global demand will rise by 8% in 2013 also call for a 9.1% increase in seaborne supply (that’s the standard term for global iron ore imports since iron ore travels from mine to customer by sea.) And that’s just the beginning of a trend that has supply growth outstripping demand growth as new iron ore capacity comes on line. Morgan Stanley projects that the global iron ore market will move into surplus in 2014 and that the surplus will continue to grow through 2018. That’s won’t be good for prices.

This basic story—slowing but still solid growth in demand overwhelmed by a big increase in supply—isn’t limited to iron ore either. The same story holds—with individual wrinkles for specific commodity markets—for commodities that are as different as natural gas, thermal coal, and copper. Copper, for example, is projected to move into a global surplus in 2013 as demand rises by 5.3%, but supply rises by 6.8% to 8%, according to analysts. That will take copper to a projected surplus of supply over demand of 330,000 tons in 2013 from a deficit of 95,000 tons in 2012 and 132,000 tons in 2011. Copper for delivery in three months closed at $7,958 a ton on April 3. The average price for 2013, according to Goldman Sachs, will be $8,458 a ton before falling to $7,250 a ton in 2014.

This kind of boom to bust and, then back, commodity investors hope, to boom is typical of the commodities sector. High prices lead producers to increase their capital budgets and invest in new capacity. But it takes so long to find and develop these commodity resources that the result is often over-investment in new capacity as every mining company invests in new capacity that then yields a temporary surplus in the sector, driving down prices.

The capital markets play a key role in regulating this boom/bust cycle. If money is expensive, mining companies will invest in only the best resources, thus putting limits on how big the temporary glut will be and how long it will last.

If money is too expensive (in relation to commodity prices,) mining companies won’t invest enough (or at all.) That’s part of the story of the 1990s. Under investment in that decade provided a good part of the fuel for the boom in commodity prices after 2002.

If money is too cheap, mining companies won’t do enough self-editing, and they’ll invest in marginal projects that will add the potential supply surplus.

Commodity markets will eventually adjust to that supply surplus, of course. Some marginal projects will get delayed or canceled. And we’re seeing that now in cuts to capital spending plans at miners such as BHP Billiton (BHP) and Rio Tinto (RIO) and at natural gas producers such as ExxonMobil (XOM.)

But the price of money affects the speed of that adjustment. When money is cheap—as it is now for global mining giants thanks to the Federal Reserve, the European Central Bank and the Bank of Japan, companies can borrow to keep projects going that might have otherwise been canceled. They can borrow to keep mines in operation that are actually producing a loss in hope that the turn-around is just about the corner. And they can sell off assets in deals funded by cheap money that simply shift capacity around a sector rather than reducing it.

Take the thermal coal sector, for example. The deal between producers and Japanese consumers of coal that serves as a benchmark set the price for coal at $115.20 per metric ton in 2012-2013. (That’s below the record high of $129.85 a ton set in 2011-2012.) This year negotiations are pointing to a benchmark price that might be as low as $94 a metric ton as Japanese utilities, under pressure from the Japanese government to reduce soaring electricity prices, aggressively try to drive down prices.

At current Australian port prices of $90 a ton about 25% of Australia’s coal miners are losing money, commodity trader Glencore estimates. But a drop below $100 a ton in the Japanese delivered price (higher than the Australian port price) might well not be enough to reduce supply. Coal producers with long-term contracts may chose to operate at a loss and simply borrow to make up the difference. (Once you’ve broken a contract, it can be tough to re-enter the market.) It might take a drop to $72 to $74 a ton (Australian port price) to lead to a significant reduction in supply, Deutsche Bank estimates.

In the U.S. market for natural gas the cheap money mechanism works through asset sales. Chesapeake Energy (CHK) has kept its drilling and completion spending budget for 2013 at $6 billion, even though U.S. natural gas continues to sell at less than $4 per million BTUs. That has left the company with a $3.6 billon funding gap for 2013, which Chesapeake plans on filling by selling off more assets. The likelihood, of course, is that the buyers of these assets, almost certainly deep-pocketed majors that want to increase their exposure to the U.S. natural gas boom, will keep the assets they’ve purchased in production.

Which is why, even though natural gas prices are well below costs for many producers, there hasn’t been much change in capital spending in the sector. Of the 44 oil and gas producers surveyed by Bloomberg, 21 companies plan to increase their capital spending in 2013 over 2012 (by an average of 13%) and 17 plan to cut their spending (by an average of 22%.)

What’s all this mean to an investor?

First, that the bottoms in commodity prices in recently depressed sectors such as coal, iron ore, natural gas, and copper are further out than you might think. Cheap money, thanks to global central banks, is slowing the normal reduction of capacity. I don’t thin 2013 will mark a bottom for thermal coal, for example. 2014 is more likely.

Second, that the movement of assets from weakly-funded to well-funded hands is likely to continue in 2013. I think that will give the major producers in sectors such as coal and natural gas a chance to stock pile capacity against the eventual swing from bust to boom. For example, ExxonMobil’s latest strategy talks of increasing production from oil and gas shale in the timeframe of 2020 and beyond on the 180 million acres it has stockpiled in the Russian Arctic (first well planned for 2014) and in the western Black Sea and the Gulf of Mexico. In the long-term I think you want to own the majors that are adding assets now or that have the potential to add assets. In coal that means Peabody Energy (BTU.) In oil and natural gas ExxonMobil, Statoil (STO) and Apache (APA) are worth a look. But there’s no need to buy these today. (Producers that pay dividends of 5% or so are worth a look, though, since cash flows in many commodity sectors are healthy enough to keep dividend payouts at current levels, especially if the company is adding new reserves as Eni (E), ConocoPhillips (COP), and Chevron (CVX) are.)

Third, in the nearer term, the best plays among commodity stocks might not be producers but instead commodity infrastructure companies that get paid for bringing commodities to market. Remember demand isn’t falling; it’s simply not growing as quickly as supply. Here a liquefied natural gas exporter such as Cheniere Energy (LNG) or a well-located refinery such as Marathon Petroleum (MPC) look like good bets.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own positions in Cheniere Energy and Statoil as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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  • itsnotlifeasweknowit on 5 April 2013

    brilliant analysis Mr. Jubak

  • eremmell on 5 April 2013

    I agree, very useful analysis. Thanks!

  • BigBlueFan on 5 April 2013

    Great article, Jim. But whatever happened to the relationship between increasing printed money and increasing hard asset prices? Is it simply too weak as long as rates are this low?

  • johnresearch on 6 April 2013

    Thanks for the careful analysis, Jim.
    I eventually found your talk on the MoneyShow website:
    Click on VIDEO to pull down a pop-up, containing
    LATEST FROM JIM JUBAK at top left, and
    View All from Jim below that-CLICK
    On the web-page that appears (after a long delay):
    See video thumbnails at middle left.
    Top right one is “The Commodity Supercycle…”
    Again, no dates are provided!

    Whew! That was a search.

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