THE BIG STORY. Commodities: The fall and beyond...

Commodities are at the vortex of the ongoing turmoil in the global financial markets. Stung by the strong dollar and worries over slowing Chinese appetite, commodity prices have plummeted and investors’ losses have piled up in the last few years. The world is now into its sixth year of a bear market in commodities. Will 2016 see the dust settle down?

To answer this question, we need to understand the events that led to the current meltdown. It was the greed to make the most of a bull market in commodities that led to the creation of excessive supply in many metals in the early 2000s. Then, with a slowdown in China and rest of the world, the demand-supply mismatch in commodities increased.

While the process of adjustment of supply to the lower prices could take some time, there are three factors that you can track to gauge if commodity prices have hit a bottom. Previous bull markets in commodities show that a soft dollar, a revival in oil prices and an optimistic outlook on China are needed to pull commodities back to life.

The dollar movement and oil prices could turn conducive to commodities. But China’s prospects are still hazy and can continue to cast a shadow on the commodity market

If you feel that the crash in commodity prices now is insane, so was the rally between 2005 and 2008. In this period, the Reuters CRB Commodity index, which tracks 19 commodities, rallied 52 per cent and the LME Metals index, which tracks six metals, including copper, aluminium and lead, doubled in value. Aluminium, the white metal that goes into making home appliances and auto parts, rallied from $1,835/tonne to $3,292/tonne. Copper prices too went through the roof with spot prices on LME hitting $9,000/tonne — almost tripling from levels of $3,100/tonne in 2005.

Mines in developing countries in Latin America, Africa and Australia were producing more due to the investments in the previous decade.

The insatiable demand further spurred production. Demand for commodities in this period was driven largely by China, with India, Russia and South Korea playing a small part. China’s rapidly increasing exports and increased investment in infrastructure stoked demand for commodities. The country gobbled up 40-50 per cent of the world’s production in most metals, up from about 6 per cent in 1990-94, according to a World Bank report.

But in early 2008, as the global economy slipped into recession following the sub-prime mortgage crisis, commodity prices started to crack. Between July 2008 and April 2009, the Reuters CRB Commodity index was down 53 per cent.

However, prices didn’t remain low for long. The next leg of the rally in commodities began as early as May 2009, driven by a roaring increase in Chinese demand, spurred by the government’s stimulus plans. Supply constraints in metals and minerals due to political unrest in North Africa and West Asia and shutting down of some uncompetitive mines in China helped prices.

From 2011, however, commodity prices came under pressure again. Initially, it was the fear of another crisis stemming from the increasing debt in Europe that dragged prices, but later, it was the strong supply response to high prices that squeezed commodities.

Supply of various metals in the market rose sharply beginning 2010 as the price rally in early 2000s led to large investments in exploration and new mines. In iron ore, while it was the new low-cost capacities in Australia, Brazil and West Africa, in tin, the supply glut increased due to higher supplies from Myanmar and de-stocking by China. In copper, it was the output from new mines in Chile, Peru, Indonesia, Mongolia and the Democratic Republic of Congo and in aluminium, it was the increased smelting capacity of China that flooded the market.

Metal inventories at all major exchanges were at historic highs by the second half of 2014. World Bank data shows that in June 2014, inventories in nickel were higher over the previous year by over 60 per cent. Aluminium, lead, tin and zinc stocks were all at their 10-year peaks.

Excess supplies became a problem in the oil market too. As oil output from North America (shale) began to increase in 2014 and OPEC refused to cut its output, oil started to slide at a pace never seen before.

The end of quantitative easing by the Federal Reserve in 2014 also spelt trouble for commodities. The fear that without stimulus, the US economy may not do as well and demand for industrial commodities would wither, weighed on investor sentiment. China, which drove the multi-year bull run in commodities, too, couldn’t suck up the excess supply of commodities in the market as its policy makers were deliberately cutting investments and choosing to boost consumption. The country’s GDP growth, which was 13-14 per cent in 2007, dropped to sub-10 per cent in 2011, 7.7 per cent in 2012 and 7.2 per cent in 2014.

In August last year, the People’s Bank of China hammered the last nail in the coffin for commodities by devaluing the yuan. Commodities slipped further, fearing that a weaker yuan would see China’s imports drop further.

From the peak of 2011, the Reuters CRB Commodity index is now down 57 per cent. Oil, which hit a high of $125/barrel in 2011, is down about 77 per cent and is below the lows of 2009.

There are various reasons why supply in commodities continues to be high despite falling prices. One, because idling capacities too burn a hole in the pockets of producers. Most mines are set up on borrowed capital and miners have to keep paying interest even if mines are shut. Two, the massive layoffs result in resentment and the management would have to face the ire of workers.

What also explains the high supply is the drop in cost of production for miners over the last one year on sharp drop in crude prices.

Energy costs make up about half the cost of mining for most metals. So, other than the few high-cost miners who were forced to pull down shutters, the rest continued to mine as much as they did earlier even as spot prices of metals crashed, but still remained profitable.

It was also thanks to the stronger dollar, that mines survived. The US dollar index (which gauges the value of the greenback against six major currencies) shot up from about 75 in 2011 to 95 in 2014 (at 98 now) due to expectations of a rise in US interest rates.

With the output sold in US dollars and the costs incurred in local currency, there was a large foreign exchange benefit for miners.

Take, for instance, the Chilean copper miners. With the peso seeing a sharp 34 per cent fall vis-à-vis US dollar since 2013, their export realisations are still better, though copper prices themselves have corrected sharply.

Similar is the case with most emerging market countries that play a key role in the global trade — including Russia, Brazil and South Africa.

Mining companies are at last starting to buckle under the pressure of falling prices. In December last year, Glencore, the Swiss mining giant, announced a 30 per cent cut in its annual zinc production, which can pull out about five lakh tonnes of zinc (4-5 per cent of global supply) from the market. Brazilian mining major Votorantim Metals too announced plans to suspend operations at two of its nickel mines a few weeks ago.

Australia’s Queensland Nickel, another large miner, has announced layoffs and plans to scale back production.

What’s more, China, which is paying a big price for its meteoric economic growth of the last decade, is planning supply-side reforms. The country is reported to be planning to consolidate state-owned companies in the steel and energy-intensive sectors that will result in shutdown of loss-making capacities.

Already, many of the private copper, aluminium and nickel producers in the country have announced production cutbacks. The demand-supply balance in the metals market should, therefore, be restored sooner than later.

SNL Metals & Mining, a global source for mining information, expects the global exploration budget to have dropped about 19 per cent to $9.2 billion in 2015 (based on data collected from 3,500 mining and exploration companies) — the third consecutive year of drop in spending on exploration.

In oil, too, supply should gradually shrink. According to reports, 42 oil and gas companies in North America filed for bankruptcy in 2015 on thinning down of margins. This way, about a third of the US oil and gas companies may vanish in the next two years, say analysts.

The number of rigs drilling for oil in the US has reduced by 996 to 637 in the week ending January 22 from a year earlier, according to data from Baker Hughes, a large oil fields research company.

An analysis of the previous bear markets shows that three factors could signal a turnaround in commodities.

If history is any guide, a reversal in commodity prices will begin with the US dollar moving south. In the previous bear market in commodities, in 1997, 2001 and 2008, the revival happened with a weakening dollar.

It is not just the import-dependant emerging market countries, but the US also does not want a stronger dollar as it makes the latter’s exports uncompetitive. It is unlikely that the Federal Reserve will allow the dollar to strengthen, given that it is already overheated. The US dollar index has rallied 25 per cent in the last five years.

So, what can make the dollar lose muscle? If the Federal Reserve fails to deliver four rates hikes in 2016, the negative sentiment may hit the dollar. But that may not help much as it may only have a short-term impact on the dollar.

A more sustained downside in the US dollar could be seen when the Fed continues with rate hikes and speculators who have been long on the currency run for cover and sell it.

History shows that in the past rate cycles, the dollar has rallied only in the run-up to a rate hike. Once the first few rounds of hikes are done with, the dollar starts to plummet.

China has been maintaining that it may now not resort to large stimulus measures as it did in 2008 to stimulate the economy.

However, with already six rate cuts since November 2014, the sagging manufacturing sector may see some respite now, thanks to the flow of cheaper credit.

A McKinsey report says that China may build more infrastructure for intra-regional development in 2016. China’s ‘one belt, one road’ initiative that aims to connect Europe and Asian countries with itself through infrastructure and trade is to see a further push.

Also, given the easing of restrictions on home buying in 2015 by the Chinese government, demand for steel and other building materials may hold, if not increase, in double digits.

Markets expect a 6 per cent-plus growth from China in 2016. If the country does better, it will be viewed positively by commodity investors, but, if growth is slower, China may take the world down with it.

If some sanity returns to the oil market in 2016, it will be a big relief to the commodities market. Last year, as a reaction to the sharp price correction, the US cut its oil supply by around 1.5 lakh barrels a day over the previous year, but non-US supply reductions were not much, according to Goldman Sachs. OPEC’s output was at over 30 million barrels a day. In 2016, however, if the many small producers in West Asia close down due to financial difficulties, then sentiment will improve.

But with Iran returning to the export markets, if oil continues to record new lows, there will be more pain. Oil prices are in one way indicative of global economic health. If oil drifts down further from here, as seen during earlier bear markets, prices of other commodities too will slip.

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