End of the Commodity Supercycle, or Not?

When I toured Australia a couple of years ago, I couldn’t help but notice a surprising number of fresh faced young people driving luxury Ferraris, Lamborghinis, and Porsches. I remarked to my Aussie friend that there must be a lot of indulgent parents in The Lucky Country these days. “It’s not the parents who are buying these cars,” he remarked, “It’s the kids.”

He went on to explain that the mining boom had driven wages for skilled labor to spectacular levels. Workers in their early twenties could earn as much at $200,000 a year, with generous benefits. The big resource companies flew them by private jet a thousand miles to remote locations where they toiled at four-week on, four-week off schedules. This was creating social problems, as it is tough for parents to manage offspring who make more than they do.

Sadly, the wheels have since come off the commodity boom. Since the 2011 peaks, copper (CU) had shed 35%, gold (GLD) has given back 36%, and iron ore has been cut by 40%. One research house estimates that some $150 billion in resource projects in Australia have been suspended or cancelled. Budgeted capital spending during 2012-2015 has been slashed by a blood curdling 30%. Contract negotiations for price breaks demanded by end consumers have broken out like a bad case of chicken pox.

The shellacking is reflected in the major producer shares, like BHP Billiton (BHP), Freeport McMoRan (FCX), and Rio Tinto (RIO), with prices down by half or more. Write-downs of asset values have become epidemic at many of these firms.

The selloff has been especially punishing for the gold miners, with lead firm, Barrack Gold (ABX), seeing its stock down by nearly 80% at one point, lower than the darkest days of the 2008-9 stock market crash. It is a pretty safe bet now that gold will see its first down year since 2000.

With both prices and volumes in a race to the bottom, the effect on profits has been especially traumatic. Highly leveraged, smaller, undercapitalized firms have started filing for bankruptcy, such as the Western Australia based Allmine Group (see http://www.allminegroup.com), a service provider.

You can also see the bloodshed in the currencies of commodity producing countries. The Australian dollar has led the retreat, falling 18% from early this year. The South African Rand has also taken it on the nose, off 15%. In Canada, the Loonie is getting cooked.

It was not supposed to be like this. Permabulls pointed to the China boom as a never-ending source of demand. But this dragon’s fire has recently gone out, its GDP growth shrinking from a 13.5% annual growth rate to 7.5% in three years. The most recently reported quarterly figure has been the slowest since 1990. Many analysts bet that even these modest numbers are highly suspect. The hard landing scenario is still firmly on the table.

The impact of China cannot be underestimated. In 2012, it consumed 11.7% of the planet’s oil, 40% of its copper, 46% of its iron ore, 46% of its aluminum, and 50% of its coal.

The rise of emerging market standards of living was also assumed to provide a boost to hard asset prices. But as China goes, so does its satellite trading partners, who rely on the Middle Kingdom as their largest customer. Many are also major commodity exporters themselves, like Chile (ECH), Brazil (EWZ), and Indonesia (IDX), creating a further drag on prospects.

As a result, western hedge funds have been happy to move money out of hard assets into paper ones. A US earnings boom has sent managers in search of any investment that could be created with a printing press, like bonds last year, and stocks in 2013. Look at the worst performing sectors this year and they are dominated by the commodity space.

The permabulls were at least right for a decade. What the cheerleaders failed to reckon with was the cruel arithmetic of the commodities cycle. These are your classic textbook inelastic markets. Mines often take 10-15 years to progress from conception to production. Deposits need to be mapped, plans drafted, permits obtained, infrastructure built, capital raised, and bribes paid. By the time they come on line, prices have peaked, drowning investors in red ink.

So a 1% rise in demand can trigger a price rise of 50% or more. There are not a lot of substitutes for iron ore. Hedge funds then throw gasoline on the fire with excess leverage and high frequency trading. That gives us higher highs, to be followed by lower lows.

I am old enough to have lived through a couple of these cycles now, so it is all old news for me. The previous bull legs of supercycles ran from 1870-1913 and 1945-1973. The current one started for the whole range of commodities in 2000. Before that, it was down from 20 years. While the present one is short in terms of years, no one can deny how business cycles have been greatly accelerated by globalization and the Internet.

Some new factors are weighing on miners that didn’t plague them in the past. Reregulation of the US banking system is forcing several large players, like JP Morgan (JPM) and Goldman Sachs (GS) to pull out of the industry. That impairs trading liquidity and widens spreads—not developments welcomed by falling markets.

The prospect of rising US interest rates is also scaring away capital. That raises the opportunity cost of staying in raw metals, which pay neither interest nor dividends.

My pet theory, which no one else seems to recognize, is that the evolving makeup of the Chinese economy will permanently slow demand for commodities. As the country moves from an export led manufacturing based economy to a domestic, services driven one, the need for expensive foreign resources declines. Much of the metal intensive infrastructure in China, like railroads, freeways, shipping, and housing has already been built out. The new frontiers require only brainpower, silicon chips, and a decent broadband connection to boost GDP.

The future is not entirely grim for the resource industry. While the gains in Chinese demand are smaller than they have been in the past, they are off of a much larger base. In ten years, Chinese GDP has soared from $1 trillion to $6 trillion.

Some 20 million people a year are still moving from the countryside to the coastal cities in search of a better standard of living and improved prospects for their children.

So unlike past commodity busts, I don’t believe that prices are going to near zero. They may only see half the declines in prices that we saw before.

What we may in fact be seeing is a 3-4 year mini down cycle within a longer-term secular bull cycle that is still alive and well and could have another 10-15 years to run. That implies that we may be closer to the end of this down move than the beginning.

To survive, many traders have dumped the “buy and hold strategy that served them so well for a decade. They have adopted a much more trading oriented approach, which is increasing volatility. I certainly would not be initiating any new shorts down here, as some of the more aggressive hedge funds are doing.

That is the good news. The bad news is that it looks like the headaches of Australian parents of juvenile high earners may persist for a lot longer than they wish.

COPPER 8-9-13

ABX 8-9-13

FCS 8-9-13

FXA 8-9-13

car The Wheels Have Come Off the Commodity Boom

John Thomas