China creates excess supply and helps rout the market
W&D observed some months ago that China had been most successful in creating global excess supply in almost everything. A great strategy. Hint to the world that you are going to need a squillion tonnes of, for example, steel per annum. Overlay this with an opaque economic data regime so that no-one really knows what is going on. And then let the suppliers fight it out.
The most obvious outworking of this is the decline in commodity prices (e.g. iron ore, coal, oil, gas): China's economy is not growing as quickly as thought. Hence commodities are not being consumed. But mines and oil wells, by and large, keep on producing as (a) once fixed costs are paid, the marginal cost of production is still below the marginal revenue; or (b) there are long-term supply contracts in place. And, W&D mistily remembering Economics 101 (or what is Samuelson: Economics?), when supply exceeds demand, the price falls. The broadly based Bloomberg Commodity Index has halved from its April 2011 level:
Source: Financial Times
So, what does all of this mean to W&D readers?
Commodity prices are in almost everything we buy. For example, oil prices especially affect (in the long-term) the price of a mass of products from petrol to golf balls to luggage to house paint. And the Australian dollar has fallen less in value than the price of most commodities, making the price of those commodities much cheaper. Hence inputs into manufactured goods (whether imported or not) and the transport of those goods should be cheaper.
Overlay this with the efficiencies created by technology and competition and you have a benign outlook for inflation. Low inflation should mean low(er) interest rates.
Consumers should be happier.
Ah, this is where things get messier than the detritus after a teenagers' party.
BHP Billiton makes up 5.3% of the ASX 200 (cf. CBA at 8.7%); Woodside 1.7%; and Rio 1.5%.
BHP's share price has almost halved since its pre-GFC peak of $42.13 Woodside's price has also halved. Rio's is down over 60%. So what to make of these icons of Australian industry?
The answer is that these businesses are in what are called 'cyclical' industries. Their profits are significantly driven by the price of what they sell, less so by the volume. This is because it is not easy to change the volumes upwards (how long does it take to dig a mine?) and once a mine is in operation the marginal cost of production is small.
The commodity price cycle is now significantly downward, after an amazingly heady run (that many thought would last forever, because China was going to keep growing at 10% p.a. Hang on: 7% p.a. Hang on: 5% p.a.). The mistake was, of course, to believe that the 'super-cycle' would last forever - as successive Australian Treasurers have done.
But if you are a commodity trading company with inventory that is highly leveraged then you have a prarblem. Which is what caused the conniptions over the past few days. UK listed commodity trader, Glencore, has had its share price sliced by 73% since June, with 29% of that coming on Monday after a particularly negative research-analyst's report. Glencore may be in a spiral that ends in iron-ore and coal dust.
However, BHP and Rio, for example, are not in anywhere the same position. They are sound. But certainly paying out too much in dividends. Raising capital to pay dividends is faintly daft.
And the commodity cycle will return to an upward trend. Inevitably, W&D is not sure when.