I've been meaning to link to this for the last couple days and misplaced it. Thanks to the reader who sent and re-sent Michael Pettis' China Financial Markets:
To address the first of the four reasons I expect hard commodity
prices to drop, excess growth in supply, one month ago I spoke at a
conference in Sydney, after which Gerard Minack, chief economist at
Morgan Stanley Australia, gave a presentation on the world economy and,
more specifically, on commodities. His presentation was an eye-opener
for me.
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.
Production capacity has grown
He will almost certainly be wrong. But whereas my evidence for
claiming continued high growth rates in production was conceptual and
anecdotal, Minack has actually gone out and tried to measure the
potential increase in supply. Minacks’ argument is that because of
twenty years of stable or falling prices, until the early part of the
last decade there had been a minimal amount of investment globally into
commodity producing facilities. Commodities seemed to be in a permanent
slump and no one was interested in expanding supply.
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.
Changing production requires years of exploration, investment, and
upgrading, however, so the decision to increase production could only
result in higher production many years later. This is shown by a set of
cost curves, which are at the heart of Minack’s presentations, and these
curves graph the short-term relationship between price and volume. For
any given amount of demand, in other words, the graph showed the
corresponding price.
The supply curves, of course, are positively sloped – the higher the
price of copper, for example, the more copper will be produced and
sold. The slopes of the curves, furthermore, are very sensitive to
existing production capacity, and Minack lists curves for several points
in time as production capacity changes. As one would expect, when
demand for copper is less than production capacity the curves slope
gently upwards, implying that small increases in copper prices
correspond to very large increases in copper supply.
But this curve slopes gently upwards only up to a point, representing
the limits of normal production capacity, after which the slope of the
curve is almost vertical. Beyond this point – of maximum capacity – no
matter how high the price of copper, in the short term supply cannot be
substantially increased. Or to put it another way, beyond that point
small increases in demand translate into large increases in price.
In 2001, according to Minack’s numbers, this transition point for
copper was roughly 12 million tons, above which it would be extremely
difficult for copper producers to supply demand except at extremely high
prices. There was some improvement in capacity during this time but
not much. By 2004 this same inflection point had increased only
slightly, to roughly 13 million tons. This, as Minack pointed out,
reinforces the argument that copper producers were not expecting any
significant increase in demand and so had not prepared for it.
But by 2004-5 it was increasingly evident that demand was rising
quickly. Copper producers responded, and thanks to increased investment
in countries like Peru and Chile, among others, production capacity
surged. By 2018 the inflection point is projected to be at roughly 21
million tons, suggesting that between 2004 and 2018 an enormous amount
of additional copper production has become or is going to become
available. In his July 17 “Down Under” note, Minack goes on to say:
What’s notable, in my view, is the
forecast increase in supply versus the actual supply increases seen over
the past decade. For copper, the increase in global supply in each of
the next seven years will be roughly equal to the increase in supply
over the decade to 2011. Consequently, it would require a material
acceleration in demand to keep prices at current levels in the face of
this supply increase.
The same story is more or less true for iron ore, although the
expansion is supply has been more dramatic. In 2006, according to
Minack’s numbers, the inflection point was at roughly 900 million tons,
above which iron ore producers would have difficulty supplying demand.
By 2011 it was at 1,300 million tons and by 2014 and 2020 it is expected
to be1,900 million and 2,600 million tons respectively. In just over
ten years, in other words, production capacity will have nearly tripled.
This is a lot of iron that has to be absorbed by someone.
The supply considerations are exacerbated by the amount of
stockpiling taking place in China. I won’t rehash all my arguments from
earlier newsletters about stockpiling but it is enough, I think, simply
to list some of the articles I found in my daily readings last week.
Stockpiling
The first article came on Tuesday from Bloomberg:
Cotton consumption in China, the
world’s largest user, may shrink 11 percent this year as a deteriorating
economy hurts demand and causes a buildup in commodities, according to
Weiqiao Textile Co.
…Coal inventories at
Qinhuangdao port rose to 9.33 million tons on June 17, the highest since
2008, data from the China Coal Transport and Distribution Association
showed. Stockpiles were at 6.69 million tons as of Aug. 19. While
steel-product stockpiles at the nation’s 26 major markets have dropped
for five months as the end of July, they’re still 19 percent higher this
year, according to the China Iron & Steel Association.
Commodity-related companies have flagged their concern. Noble Group Ltd. (NOBL), Asia’s
biggest listed commodity supplier, expects a tough environment for the
next 12 to 24 months, Chief Executive Officer Yusuf Alireza said
yesterday. Vale SA (VALE5), the world’s largest iron-ore producer, said
this month that China’s so-called golden years are gone as economic
growth slows.
The article in Tuesday’s Financial Times talks
about excess inventory of a wide variety of products and refers to an
earlier article, from July, that claims that China’s coal inventory is
up 50% from last year:...MUCH MORE
