The Ups and Downs of Commodities
Economist John Kenneth Galbraith once quite appropriately stated: “We have two classes of forecasters: Those who don’t know and those who don’t know they don’t know”. While he was most likely referencing economists (apologies to my economics colleagues), it is a comment that applies just as aptly to the field of commodities.
In the commodities market, the last two years have been a rollercoaster ride, mostly due to the large Covid-induced dislocations. After a brief but brutal correction at the onset of the global lockdown, the bounce back in commodity prices was nothing short of spectacular (Figure 1). The confluence of ultra-loose monetary policy, coordinated fiscal stimulus, supply cuts, and lockdown-induced logistical challenges drove one of the most rapid commodity price rallies in the last 30 years. China’s fiscal response was noteworthy – at RMB8.5 trillion, it was double the injection in 2009. As a result, 2021 began with a level of excitement similar to that displayed in 2008 at the peak of the proverbial supercycle. At the start of this year, market comments were dominated by speculation as to whether we were in the early stages of the next supercycle or whether the previous supercycle had, in fact, even ended (in this respect Figure 1 suggests a clear bottom of that cycle).
A boon for commodity exporters, such as SA
Two commodities that performed spectacularly well in the latest cycle were iron ore and platinum group metals (PGM’s), with both making all-time nominal highs and with thermal coal subsequently following suit. Fortuitously, iron ore, PGM’s and coal represent South Africa’s primary mineral exports, with recent heady prices resulting in an unprecedented windfall for the country’s terms of trade, current account, and fiscal position.
In the seven months to July, South Africa exported precious metals to the value of R295bn – 93% higher than the same period last year – and mineral products (including iron ore and coal) totalling R256bn – 43% higher than the same period last year (Figure 2). According to the IDC, the first five months of the year delivered a R100bn windfall to the fiscus, courtesy of the better-than-expected mining royalties and corporate income tax collections.
But it may not last
Unfortunately, expectations for the next supercycle are proving to be premature. In aggregate, commodity prices are beginning to top out at levels well below those of the 2008 – 2011 peaks, with the correction being led by the recent top performers. As of writing, iron ore has declined by approximately 50% from its peak, while a US dollar basket of PGM’s is down by 43%. The transitory windfalls for mining companies and commodity-exporting countries look set to normalise.
Tighter credit policies in China, slowing global growth, the fading reflation trade, and easing Covid-induced bottlenecks creating meaningful headwinds for the commodity complex. However, there are exceptions. Coal prices continue to perform remarkably well. Structural barriers to production, partly related to policies to address climate change, and a confluence of geopolitical and idiosyncratic events have driven coal prices towards new highs, where they are likely to stay for some time.
All three of these commodity markets are, to some extent, being driven by distinctive factors. A perfect storm is causing a spike in energy prices, while a semi-conductor shortage is curtailing automotive production and attendant demand for PGMs. It is beyond the scope of this article to expound on all three key commodities. As such, it focusses on the unfolding developments in the iron ore market, taking into account the current interest in escalating property regulation and dynamics in China.
Iron Ore: It is still all about China
Notwithstanding the coordinated policy stimulus across the world, what happens in the iron ore market remains entirely a China story. China accounts for more than 75% of the global seaborne iron ore market, in comparison to 50% of the global steel and base metals market, and 20% of the seaborne coal market (Figure 3).
Since the trough in the iron ore price in 2016, China’s stimulus measures and attendant demand recovery resulted in strong growth in steel production, which averaged a little over 7% per year. As a result, an increasing amount of iron ore had to be sourced from higher cost domestic Chinese production, as well as other non-traditional markets. This situation was exacerbated by the collapse of Vale’s Brumadinho tailings dam in January 2019.
By the beginning of 2021, additional stimulus and the V-shaped recovery in China’s economy directly impacted the two primary drivers of steel production: property and infrastructure. Steel production growth rose sharply to 11.5% per month, on average, for 1H21. The net effect was that even more iron ore needed to be sourced from the extreme high end of the cost curve. Nominal seaborne prices rose above $200/t for the first time (Figure 4).
By August, the story was materially different and the iron ore price corrected faster than most expectations. The roots of this can be found in China’s mounting commitment to regulatory change that dominated headlines in the tech and education sectors earlier in this year, but which were also playing out in the property and steel sectors.
Throughout the year, China has displayed an increasing commitment to social and environmental issues, encapsulated in the mantra of common prosperity (including the reduction of wealth inequality), affordable housing (with a strong belief that houses are for living in and not speculation) and high-quality growth. This includes firm decarbonisation and emissions control goals, as well as expectations of deleveraging across the property sector.
Although these were raised some time ago, many believed they would be deferred in favour of the stimulus playbook China has brought out frequently in the past when threatened with growth slowing below mandated levels. The last two months have disavowed the market of this notion and stressed China’s firm commitment to reform.
This time is different. We have heard this statement many times in the past with respect to China and, to date, each time it has proven to be incorrect. Property cycles are governed by policies that oscillate between easing and tightening and China has proven to be no different. However, this time certainly feels different.
Whereas China has been emphasising that housing is for living and not speculation for a few years now, this year Beijing has stressed its concern that the extended housing boom is one of the primary causes of the widening wealth gap that it is resolute to close. The result has been an unprecedented clampdown at both the central and local government levels. The clearest manifestation has been the Evergrande drama that has recently gripped the market.
This tightening cycle began in mid-2020 when China targeted the supply side of property with the now infamous ‘Three Red Lines’ that were aimed at regulating property developers’ leverage. While land sales were negative affected, property sales remained robust. Towards the end of the year, this was followed by the Peoples Bank of China (PBOC) and the China Banking and Insurance Regulatory Commission (CBIRC) issuing new rules governing banks’ loan exposure to the sector, which subsequently affected the demand for mortgages and reduced the number of approvals.
At the central government level, the CBIRC pledged to moderate growth in property-related loans, financial regulators clamped down on shadow banking loopholes used by developers for financing, and the land auctions were centralised across a number of cities. Running parallel to these measures, local governments have been introducing price ceilings in some instances and price floors in others, as well as introducing or reinforcing purchase restrictions.
Given the ‘Three Red Lines’, declining margins, high leverage (exacerbated by off-balance sheet debt), and the concentration of debt maturities, it is unsurprising that Evergrande, the $300bn-indebted developer behemoth, continues to face imminent default. It has become the poster child for everything Beijing aims to remedy. To date, Beijing appears to be relaxed about the Evergrande situation, committing to ongoing policy tightening in the property sector. Fears of broad-based contagion are residing, with Evergrande having recently narrowly avoided an onshore bond default. Consensus appears to be increasingly migrating to a scenario of an orderly breakup of the business, with local governments and developers taking on work in progress. However, an offshore bond default still cannot be ruled out.
Media attention has been almost squarely on Evergrande, but it is by no means the only developer being affected by the slowdown. Beijing is walking a tightrope between promoting high-quality growth and reducing moral hazard on the one hand, and facilitating a policy error and over-correction on the other. The impact on the sector has been severe: growth in new starts is again negative (Figures 5 and 6), as is the value of residential units sold (-7%). Although land sales continue to expand, for now, the percentage of failed land auctions is on the rise.
China’s Decarbonisation Agenda
In September last year, President Xi Jinping somewhat optimistically pledged that China will reach peak GHG emissions by 2030 and would take this to zero by 2050. This mere 30-year target to achieve net-zero stands in stark contrast to the average 60-year pledges by the United Kingdom, France, and Germany. According to the Centre for Research on Energy and Clean Air (CREA), the draft version of the widely anticipated 14th Five-Year Plan already sets out an ambitious target of peaking CO2 from the steel sector by 2025 and the cutting of emission by 30% from the peak by 2030. The Plan requires a reduction of 13.5% in energy intensity and an 18% cut in CO2 intensity. It was with this target in mind that China’s Ministry of Industry and Information Technology (MIT) mandated at the end of last year that China’s crude steel production in 2021 should not exceed that of 2020.
The very strong start to the year, together with expectations of China’s growth slowing by the middle of the year, prompted many analysts to opine that the steel production growth target of 0% would be quietly swept under the carpet. This was not the case. Not only was this target apparently cast in stone, but according to Mysteel, government regulators also started pushing for it to be met a month early.
In August, crude steel production fell by 4% month on month and 13% year on year. Expectations have rapidly reset with most analysts now expecting a 10% fall in crude steel production during the rest of the year. This would still imply levels slightly above that of last year, which means more downgrades may yet come. Even so, this takes a further 40mt of demand out of the seaborne market. Throw in the production cuts mandated for the Winter Olympics, which are scheduled to take place in Beijing in February 2022, and it is difficult to be anything other than bearish iron ore demand in the short term.
Where to from here?
As alluded to at the beginning of the article, forecasting spot commodity prices is largely an exercise in futility. Yet we can certainly consider broader trends and higher probability outcomes.
On the demand side, calls for peak steel production in China have been premature in the past and China is certainly going to require a great deal of steel in the longer term. However, the current decarbonisation drive and pivot to higher quality growth look genuine. According to both Mysteel and the CREA, a future transition from emissions intensive blast furnace production to somewhat cleaner electric arc furnaces (EAFs) is being strongly incentivised. Although there is insufficient scrap available for a large-scale transition, such a transition could result in a decline in pig iron production of 30mt by 2025 and a further 150mt by 2030, according to the CREA. This implies lower demand for iron ore in the short term.
On the supply side, there is no shortage of iron ore in the world, with low-cost iron ore majors having in excess of 160mt latent capacity (while junior miners can add more). Together with the potential loss in demand from increasing EAF investment, this implies a 310mt long-term drag on the iron ore demand/supply balance, which is equivalent to 17% of estimated iron ore demand in 2022 from China. This is before taking the possible Guinea Simandou project into consideration that could add up to 200mt to supply before the end of the decade, which would further weaken the demand/supply balance.
The longer-term dynamics strongly imply a well-supplied iron ore market and point to longer-term prices being well below current levels.
In the near term, an oligopolistic industry is unlikely to add significant volumes in a bid to support prices. However, the recovery from South America’s Vale, China’s emission targeting, and the expected protracted property slowdown in China should remove tons from high-cost Chinese domestic producers as well as other non-traditional suppliers to keeping prices in check.
Some may fear a protracted decline in iron ore prices, such as we experienced in 2015 – 2016. We think this is unlikely in the shorter term. China’s property inventories have been stable at levels below that seen in 2016, when excess inventories and oversupply were facing rapidly falling demand. As such, a decline in prices to the previous lows of $50/t would be an overly bearish outcome.
That said, the only thing we can bank on with commodity prices is uncomfortable volatility.