What's going on with bulk commodity prices?
In recent months we have seen a quite astounding recovery in the prices of many commodities.
The focus of today's Investment Matters will be the bulk commodities - coal and iron ore.
What the charts tell us
Hard Coking Coal: Price spike this year
Thermal Coal: Also a strong recovery this year
Iron Ore: Price increase this year, followed by a dip
These graphs show the rapid and significant increase in prices over this calendar year:
- The price of hard coking coal (used in making steel) is up 307% since its late Jan-16 low
- The price of thermal coal (used in generating electricity) is up 122% since its early Feb-16 low
- The price of iron ore (also used in making steel) is up 50% since its mid Dec-15 low (and it was up 80% at its late Apr-16 peak)
Implications for the miners
They are good. Obviously higher commodity prices translates to increased revenues.
But this also needs to be put into the context of the mining investment collapse. This led to miners dramatically reducing their production costs. For miners such as BHP Billiton and Rio Tinto, they also have part of their cost base in AUD. Together this results in higher margins. Whilst we expect some turnaround in investment spending to occur (see edition 14, 30-Sep-16), the increased revenue (from higher prices) will be further supported by higher margins, leading to quite large profit leverage.
The market, though, has basically built this into share prices. For instance, BHP's share price has increased 69% since its late Jan-16 low.
The impact of Trump
Analysts and commentators had predicted that, should Trump win the election, there would a collapse in markets broadly (including commodities), and there would be a strong bounce in the gold price - as investors shifted their investments to the "safety" of gold.
Well, Trump did win, and the markets did the opposite of those predictions. Just as there wasn't a rout on the equity markets around the world, commodity prices have also proven resilient in the subsequent week.
By our assessment, the commodities futures market is effectively calling a top on the current price run, with hard coking coal 6-month futures at US$240/t (vs US$309.80/t current), and thermal 6-month futures at US$69/t (vs US$108.11/t current).
Some qualitative factors are also pointing to a peak in the market. For instance, this week it has been mooted that Wesfarmers are putting at least some of their coal assets up for sale. Wesfarmers aren't silly - they will have made a judgement as to when it is in their best interest to sell.
There may be some price support associated with demand from infrastructure and building activity in the US, driven by the Trump regime. However, we see such demand as more marginal, than likely to have any meaningful impact on prices. This is because the main driver of demand has been, and will continue to be China.
Speculation vs underlying demand
The driver of some of the price increase this year is undoubtedly due to supply cuts in China, driven by government decree to reduce overcapacity in coal production (and steel manufacture). The Chinese government ordered 500m tonnes of coal production cuts over three to five years, including a 250m tonnes cut in CY-16. It has also cut the number of days a coal mine can be in production to 276, from the usual ~330.
However, the degree of the price increases also points to at least some speculative activity in the market. Some factors which collaborate this are that contract prices are quite a bit lower than spot, there is a question as to how much progress is actually being made in relation to the Chinese cuts to overcapacity, stockpiles at Chinese ports and power plants have reportedly been increasing, and there is reportedly active trading by Chinese futures traders (on their Dalian exchange). The bottom line is that it certainly does not appear that fundamentals have improved to the extent we have seen prices rally.
Conclusion - caution
After a strong rally in bulk commodity prices, we look to the future with increased caution.