Commodity
Weakness Persists
John Mauldin
Aug 12, 2015
In
today’s Outside the Box,
good friend Gary Shilling gives us deeper insight into the global economic
trends that have led to China’s headline-making, market-shaking devaluation of
the renminbi. He reminds us that today’s currency moves and lagging growth are
the (perhaps inevitable) outcome of China massive expansion of output for many
products that started more than a decade ago. China was at the epicenter of a
commodity bubble that got underway in 2002, soon after China joined the World
Trade Organization.
As manufacturing shifted from North America and
Europe to China –with China now consuming more than 40% of annual global output
of copper, tin, lead, zinc and other nonferrous metal while stockpiling
increased quantities of iron ore, petroleum and other commodities – many
thought a permanent commodity boom was here.
Think
again, Australia; not so fast, Brazil. Copper prices, for instance, have been
cut nearly in half as world growth, and Chinese internal demand, have weakened.
Coal is another commodity that is taking a huge hit: China’s imports of coking
coal used in steel production are down almost 50% from a year ago, and of course
coal is being hammered here in the US, too.
And
the litany continues. Grain prices, sugar prices, and – the biggee – oil prices
have all cratered in a world where the spectre of deflation has persistently
loomed in the lingering shadow of the Great Recession. (They just released
grain estimates for the US, and apparently we’re going to be inundated with
corn and soybeans. The yield figures are almost staggeringly higher than the
highest previous estimates. Very bearish for grain prices.)
Also,
most major commodities are priced in dollars; and now, as the US dollar soars
and the Fed prepares to turn off the spigot, says Gary, “raw materials are more
expensive and therefore less desirable to overseas users as well as foreign
investors.” As investors flee commodities in favor of the US dollar and
treasuries, there is bound to be a profound shakeout among commodity producers
and their markets
See
the conclusion of the article for a special offer to OTB readers for Gary
Shilling’s INSIGHT. Gary’s
letter really does provide exceptional value to his readers and clients. It’s
packed with well-reasoned, outside-the-consensus analysis. He has consistently
been one of the best investors and analysts out there.
There
are times when you look at your travel schedule and realize that you just
didn’t plan quite as well as you could have. On Monday morning I was in the
Maine outback with my youngest son, Trey, and scheduled to return to Dallas and
then leave the next morning to Vancouver and Whistler to spend a few days with
Louis Gave. But I realized as Trey and I got on the plane that I no longer
needed to hold his hand to escort him back from Maine. He’s a grown man now. I
could’ve flown almost directly to Vancouver and cut out a lot of middlemen. By
the time that became apparent, it was too late and too expensive to adjust.
Camp
Kotok, as it has come to be called, was quite special this year. The fishing
sucked, but the camaraderie was exceptional. I got to spend two hours one
evening with former Philadelphia Fed president Charlie Plosser, as he went into
full-on professor mode on one topic after another. I am in the midst of
thinking about how my next book needs to be written and researched, and Charlie
was interested in the topic, which is how the world will change in the next 20
years, what it means, and how to invest in it. Like a grad student proposing a
thesis, I was forced by Charlie to apply outline and structure to what had been
only rough thinking.
There
may have been a dozen conversations like that one over the three days, some on
the boat – momentarily interrupted by fish on the line – and some over dinner
and well into the night. It is times like that when I realize my life is truly
blessed. I get to talk with so many truly fascinating and brilliant people.
And
today I find myself with Louis Gave, one of the finest economic and investment
thinkers in the world (as well as a first-class gentleman and friend), whose
research is sought after by institutions and traders everywhere. In addition to
talking about family and other important stuff, we do drift into macroeconomic
talk. Neither of us were surprised by the Chinese currency move and expect that
this is the first of many.
I
did a few interviews while I was in Maine. Here is a short one from the Street.com. They wanted to
talk about what I see happening in Europe. And below is a picture from the deck
of Leen’s Lodge at sunset. Today I find myself in the splendor of the mountains
of British Columbia. It’s been a good week and I hope you have a great one as
well.
Oops,
I’ve just been talked into going zip-trekking this afternoon with Louis and
friends. Apparently they hang you on a rope and swing you over forests and
canyons. Sounds interesting. Looks like we’ll do their latest and greatest, the Sasquatch. 2 km over a valley. Good gods.
Your
keenly aware of what a blessing his life is analyst,
John Mauldin, Editor
Outside the Box
Commodity Weakness Persists
(Excerpted from the August 2015 edition of A. Gary Shilling’s INSIGHT)
The sluggish economic growth here and abroad has
spawned three significant developments – falling commodity prices, looming
deflation and near-universal currency devaluations against the dollar. With
slowing to negative economic growth throughout the world, it’s no surprise that
commodity prices have been falling since early 2011 (Chart 1). While demand growth
for most commodities is muted, supply jumps as a result of a huge expansion of
output for many products a decade ago. China was the focus of the commodity
bubble that started in early 2002, soon after China joined the World Trade
Organization at the end of 2001.
China, The Manufacturer
As manufacturing shifted from North America and
Europe to China – with China now consuming more than 40% of annual global
output of copper, tin, lead, zinc and other nonferrous metal while stockpiling
increased quantities of iron ore, petroleum and other commodities – many
thought a permanent commodity boom was here.
So much so that many commodity producers hyped
their investments a decade ago to expand capacity that, in the case of
minerals, often take five to 10 years to reach fruition. In classic commodity
boom-bust fashion, these capacity expansions came on stream just as demand
atrophied due to slowing growth in export-dependent China, driven by slow
growth in developed country importers. Still, some miners maintain production
because shutdowns and restarts are expensive, and debts incurred to expand
still need to be serviced. Also, some mineral producers are increasing output
since they believe their low costs will squeeze competitors out. Good luck,
guys!
Copper, Our
Favorite
Copper is our favorite industrial commodity
because it's used in almost every manufactured product and because there are no
cartels on the supply or demand side to offset basic economic forces. Also,
copper is predominantly produced in developing economies that need the foreign
exchange generated by copper exports to service their foreign debts. So the
lower the price of copper, the more they must produce and export to get the
same number of dollars to service their foreign debts. And the more they
export, the more the downward pressure on copper prices, which forces them to produce
and export even more in a self-reinforcing downward spiral in copper prices.
Copper prices have dropped 48% since their February 2011 peak, and recently hit
a six-year low as heavy inventories confront subdued demand (Chart 2).
Even in 2013, after two solid years of commodity
price declines, major producers were in denial. That year, Glencore purchased
Xtrata and Glencore CEO Ivan Glasenberg called it “a big play” on coal. “To
really screw this up, the coal price has got to really tank,” he said at the
time. Since then, it’s down 41%. But back in February 2012 when the merger was
announced, coal was selling at around $100 per ton and Chinese coal demand was
still robust.
Nevertheless, Chinese coal consumption fell in
2014 for the first time in 14 years and U.S. demand is down as power plants
shift from coal to natural gas. Meanwhile, coal output is jumping in countries
such as Australia, Colombia and Russia. China’s imports of coking coal used in
steel production are down almost 50% from a year ago. Many coal miners lock in
sales at fixed prices, but at current prices, over half of global coal is being
mined at a loss. U.S. coal producers are also being hammered by
environmentalists and natural gas producers who advocate renewable energy and
natural gas vs. coal.
Losing Confidence?
Recently, major miners appear to be losing their
confidence, or at least they seem to be facing reality. Anglo-American recently
announced $4 billion in writedowns, largely on its Minas-Rio $8.8 billion iron
ore project in Brazil, but also due to weakness in metallurgical coal prices.
BHP took heavy writedowns on badly-timed investments in U.S. shale gas assets.
Rio Tinto’s $38 billion acquisition of aluminum producer Alcan right at the
market top in 2007 has become the poster boy for problems with big writeoffs
due to weak aluminum prices and cost overruns.
Glencore intends to spin off its 24% stake in
Lonmin, the world’s third largest platinum producer. Iron ore-focused Vale is
considering a separate entity in its base metals division to “unlock value.”
Meanwhile, BHP is setting up a separate company, South 32, to house losing
businesses including coal mines and aluminum refiners. That will halve its
assets and number of continents in which it operates, leaving it oriented to
iron ore, copper and oil.
Goldman Sachs coal mines suffered from falling
prices and labor problems in Colombia. It is selling all its coal mines at a
loss and has also unloaded power plants as well as aluminum warehouses. The
firm’s commodity business revenues dropped from $3.4 billion in 2009 to $1.5
billion in 2013. JP Morgan Chase last year sold its physical commodity assets,
including warehouses. Morgan Stanley has sold its oil shipping and pipeline
businesses and wants to unload its oil trading and storage operations.
Jefferies, the investment bank piece of Leucadia
National Corp., is selling its Bache commodities and financial derivatives
business that it bought from Prudential Financial in 2011 for $430 million. But
the buyer, Societe Generale, is only taking Bache’s top 300 clients by revenue
while leaving thousands of small accounts, and paying only a nominal sum. Bache
had operating losses for its four years under Jefferies ownership.
Grains and other agricultural products recently
have gone through similar but shorter cycles than basic industrial commodities.
Bad weather three years ago pushed up grain prices, which spawned supply
increases as farmers increased plantings. Then followed, as the night the day,
good weather, excess supply and price collapses. Pork and beef production and
prices have similar but longer cycles due to the longer breeding cycles of
animals.
Sugar prices have also nosedived in recent years
(Chart 3). Cane
sugar can be grown in a wide number of tropical and subtropical locations and
supply can be expanded quickly. Like other Latin American countries, Brazil –
the world's largest sugar producer – enjoyed the inflow of money generated from
the Fed’s quantitative easing. But that ended last year and in combination with
falling commodity prices, those countries’ currencies are plummeting (Chart 4). So Brazilian
producers are pushing exports to make up for lower dollar revenues as prices
fall, even though they receive more reals, the Brazilian currency that has
fallen 33% vs. the buck in the last year since sugar is globally priced in
dollars.
Oil Prices
Crude oil prices started to decline last summer,
but most observers weren’t aware that petroleum and other commodity prices were
falling until oil collapsed late in the year. With slow global economic growth
and increasing conservation measures, energy demand growth has been weak. At
the same time, output is climbing, especially due to U.S. hydraulic fracking
and horizontal drilling. So the price of West Texas Intermediate crude was
already down 31% from its peak, to $74 per barrel by late November.
Cartels are set up to keep prices above
equilibrium. That encourages cheating as cartel members exceed their quotas and
outsiders hype output. So the role of the cartel leader – in this case, the
Saudis – is to accommodate the cheaters by cutting its own output to keep
prices from falling. But the Saudis have seen their past cutbacks result in
market share losses as other OPEC and non-OPEC producers increased their
output. In the last decade, OPEC oil production has been essentially flat, with
all the global growth going to non-OPEC producers, especially American frackers
(Chart 5). As a
result, OPEC now accounts for about a third of global production, down from 50%
in 1979.
So the Saudis, backed by other Persian Gulf oil
producers with sizable financial resources – Kuwait, Qatar and the United Arab
Emirates – embarked on a game of chicken with the cheaters. On Nov. 27 of last
year, while Americans were enjoying their Thanksgiving turkeys, OPEC announced
that it would not cut output, and they have actually increased it since then.
Oil prices went off the cliff and have dropped sharply before the rebound that
appears to be temporary. On June 5, OPEC essentially reconfirmed its decision
to let its members pump all the oil they like.
The Saudis figured they can stand low prices for
longer than their financially-weaker competitors who will have to cut production
first. That list includes non-friends of the Saudis such as Iran and Iraq,
which they believe is controlled by Iran, as well as Russia, which opposes the
Saudis in Syria. Low prices will also aid their friends, including Egypt and
Pakistan, who can cut expensive domestic energy subsidies.
The Saudis and their Persian Gulf allies as well
as Iraq also don’t plan to cut output if the West's agreement with Iran over
its nuclear program lifts the embargo on Iranian oil. As much as another
million barrels per day could then enter the market on top of the current
excess supply of two million barrels a day.
The Chicken-Out
Price
What is the price at which major producers
chicken out and slash output? It isn’t the price needed to balance oil-producer
budgets, which run from $47 per barrel in Kuwait to $215 per barrel in Libya (Chart 6). Furthermore, the
chicken-out price isn’t the “full-cycle” or average cost of production, which
for 80% of new U.S. shale oil production is around $69 per barrel.
Fracker EOG Resources believes that at $40 per
barrel, it can still make a 10% profit in North Dakota as well as South and
West Texas. Conoco Phillips estimates full-cycle fracking costs at $40 per barrel.
Long-run costs in the Middle East are about $10 per barrel or less (Chart 7).
In a price war, the chicken-out point is the
marginal cost of production – the additional costs after the wells are drilled
and the pipelines laid – it’s the price at which the cash flow for an
additional barrel falls to zero. Wood Mackenzie’s survey of 2,222 oil fields
globally found that at $40 per barrel, only 1.6% had negative cash flow. Saudi
oil minister Ali al-Naimi said even $20 per barrel is “irrelevant.”
We understand the marginal cost for efficient
U.S. shale oil producers is about $10 to $20 per barrel in the Permian Basin in
Texas and about the same on average for oil produced in the Persian Gulf.
Furthermore, financially troubled countries like Russia that desperately need
the revenue from oil exports to service foreign debts and fund imports may well
produce and export oil at prices below marginal costs – the same as we
explained earlier for copper producers. And, as with copper, the lower the
price, the more physical oil they need to produce and export to earn the same
number of dollars.
Falling Costs
Elsewhere, oil output will no doubt rise in the
next several years, adding to downward pressure on prices. U.S. crude oil
output is estimated to rise over the next year from the current 9.6 million
level. Sure, the drilling rig count fell until recently, but it’s the
inefficient rigs – not the new horizontal rigs that are the backbone of
fracking – that are being sidelined. Furthermore, the efficiency of drilling
continues to leap. Texas Eagle Ford Shale now yields 719 barrels a day per well
compared to 215 barrels daily in 2011. Also, Iraq’s recent deal with the Kurds
means that 550,000 more barrels per day are entering the market. OPEC sees
non-OPEC output rising by 3.4 million barrels a day by 2020.
Even if we’re wrong in predicting further big
drops in oil prices, the upside potential is small. With all the leaping
efficiency in fracking, the full-cycle cost of new wells continues to drop.
Costs have already dropped 30% and are expected to fall another 20% in the next
five years. Some new wells are being drilled but hydraulic fracturing is
curtailed due to current prices. In effect, oil is being stored underground
that can be recovered quickly later on if prices rise Closely regulated banks
worry about sour energy loans, but private equity firms and other shadow banks
are pouring money into energy development in hopes of higher prices later.
Private equity outfits are likely to invest a record $21 billion in oil and gas
start-ups this year.
Earlier this year, many investors figured that
the drop in oil prices to about $45 per barrel for West Texas Intermediate was
the end of the selloff so they piled into new equity offerings (Chart 8), especially as oil
prices rebounded to around $60. But with the subsequent price decline, the
$15.87 billion investors paid for 47 follow-on offerings by U.S. and Canadian
exploration and production companies this year were worth $1.41 billion less as
of mid-July.
Dollar Effects
Commodity prices are dropping not only because
of excess global supply but also because most major commodities are priced in
dollars. So as the greenback leaps, raw materials are more expensive and
therefore less desirable to overseas users as well as foreign investors.
Investors worldwide rushed into commodities a decade ago as prices rose and
many thought the Fed’s outpouring of QE and other money insured soaring
inflation and leaping commodity prices as the classic hedge against it. Many
pension funds and other institutional investors came to view them as an
investment class with prices destined to rise forever. In contrast, we
continually said that commodities aren’t an investment class but a speculation,
even though we continue to use them in the aggressive portfolios we manage.
We’ve written repeatedly that anyone who thinks
that owning commodities is a great investment in the long run should study Chart 9, which traces the CRB
broad commodity index in real terms since 1774. Notice that since the mid-1800s,
it’s been steadily declining with temporary spikes caused by the Civil War,
World Wars I and II and the 1970s oil crises that were soon retraced. The
decline in the late 1800s is noteworthy in the face of huge commodity-consuming
development then: In the U.S., the Industrial Revolution and railroad-building
were in full flower while forced industrialization was paramount in Japan.
At present, however, investors are fleeing
commodities in favor of the dollar, Treasury bonds and other more profitable
investments. Gold is among the shunned investments, and hedge funds are on
balance negative on the yellow metal for the first time, according to records
going back to 2006. Meanwhile, individual investors have yanked $3 billion out
of precious metals funds.
Commodity Price Outlook
Commodity prices are under pressure from a
number of forces that seem likely to persist for some time.
1. Sluggish global demand due to continuing slow
economic growth.
2. Huge supplies of minerals and other
commodities due to robust investment a decade ago.
3. Chicken games being played by major producers
in the hope that pushing prices down with increasing supply will force weaker
producers to scale back.
This is true of the Saudis in oil and hard rock miners
in iron ore.
4. Developing country commodity exporters’ needs
for foreign exchange to service foreign debt. So the lower the prices, the more
physical commodities they export to achieve the same dollars in revenue. This
further depresses prices, leading to increased exports, etc. Copper is a prime
example.
5. Increased production to offset the effects on
revenues from lower prices, which further depresses prices, etc. This is the
case with Brazilian sugar producers.
6. The robust dollar, which pushes up prices in
foreign currency terms for the many commodities priced in dollar terms. That
reduces demand, further depressing prices.
It’s obviously next to impossible to quantify
the effects of all these negative effects on commodity prices. The aggregate
CRB index is already down 57% from its July 2008 pinnacle and 45% since the
more recent decline commenced in April 2011. To reach the February 1998 low of
the last two decades, it would need to drop 43% from the late July level, but
there’s nothing sacred about that 1998 number. In any event, ongoing declines
in global commodity prices will probably renew the deflation evidence and fears
that were prevalent throughout the world early this year. And they might prove
sufficient to deter the Fed from its plans to raise interest rates before the
end of the year.
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