Opinion: Dangerous dis-investment in commodities

In my last column, I suggested that the oil-producing firms were being extremely myopic in abruptly cutting back on investment. My point was that vast investment was needed annually to keep oil flowing. I am delighted to add that The Economist has subsequently filed its major economics article covering precisely the same point. I am in good company. The problem is readily explained. Producer's short term interest when prices are falling and overall receipts are down, are to cut expenditure, even capital investment, to minimize expenditure and thereby try to balance receipts with expenditure. I want to develop that idea further in relation to commodities, especially mining where capital expenditure has been frozen. It means that when inventory is cleared, prices must rise again. That is one reason why I am bullish medium to long term about commodities as an asset class. Mining Credit Suisse UK has estimate that two-thirds of the US$75 billion of mining capital expenditure planned for 2009 may be delayed, and a further planned US$150 billion planned for 2010-12 will be postponed. This means that about 300 million tons of iron ore may be delayed (about 35% of sea-bourne market) and similar declines in production of copper, aluminum and even platinum. Mining went through a similar freeze in 1998, and that took the wind out of the sails of the industry for about five years. It could take a similar period to restore confidence and raise more capital. The present time is not conducive to capital raising, the banks are cutting lending as their funding dries up and it would be difficult, if not impossible, for most companies to raise money on share markets through new issues or rights issues. Most of the growth planned in mining after this year will not occur. Some capacity will also be lost. This will encourage a spike in future years because vast quantities of minerals are used by global business, even when growth is subdued. Iron ore Iron ore extraction is essentially the one area where there has been a significant addition to capacity in recent years. Leaders of the industry now fear over-production has occurred in a frenzy of activity in Western Australia and Brazil. Vale in Brazil has cut production by 10%. In Australia it is estimates that the smaller producers will decrease their capital expenditure sharply from US$15 billion to US$2 billion. Mount Gibson is in grave difficulties because three Chinese buyers have reneged on contracts, saying the price is too high. Fortescue Metals also announced it would delay its US$2 billion expansion, and reduce supply by 10% though reducing its number of contractors. It intends to be "first out of the starting blocks when the market returns". The spot price of ore has fallen from US$100 to US$60, and steel has halved too. Analysts believe greater fall will occur in iron ore prices next year. Other analysts have explained that a massive investment had increased capacity to about one billion tons in Australia, but the market could not absorb that. Rio has also cut output by 10% ( 20 million tons). Rio will not say if it will slow capital expenditure. The matter is important because Rio is spending US$2.4 billion to build two new mines in Pilbarra, Western Australia, by 2010. Rio will not sell into the spot market when it is lower than the contract price of US$100, It has responded to China's changed delivery requirements by realigning production. BHP has a different philosophy. It has continued to sell on the spot market, which could be a risky strategy when steel-makers are cutting production by about 30% to meet a collapse in world demand. About 90% of BHP production is contracted, and it is flooding the spot market, perhaps because it will ease the approval of the European Commission to proceed with its bid for Rio. It is trying to remove the fear that a BHP-Rio merger would not have too much market power. Fortescue's and Rio's cuts alone will reduce Australia's exports by US$2.2 billion p.a. Exports to China have fallen, but not all is gloom as South Korea and Japan have increased their demand over the year, although that is now weakening. Contracts next year will be lower. Other metals Nickel has been hard hit, falling in the year from US$30,000 to US$10,000 a ton. Producers are also lowering output, especially Australian leader, Mincor which is lowering production on two of its five mines. Copper has been very volatile in the months of October, over-all losing about 30%. But it has been recovering. It is considerably higher this month on the back of China's stimulus package. Nevertheless investment is falling sharply. Credit Suisse has identified 15 of 70 future projects which will not go ahead, and some will be deferred. Xstrata of Australia, the fourth biggest miner in the world, is over extended with a net debt of AU$16.5 billion but will be unable to progress its eight projects until it gets funding. Zinc and Copper miner Kagara is even reviewing its AU$37 million expenditure to finalise its Mungana base metal treatment plant in Queensland. Outlook The Australian Reserve Bank has cut it forecasts twice in a few days, for economic growth over the next two years. It cites fragile world financial markets and concern about the China market. It acknowledges that the economy will be slowed by falling commodity prices. The gloom has lifted slightly because China has announced a near US$600 billion stimulus package of infrastructure spending and tax reforms which is expected to strengthen demand for commodities. Commodity prices surged and UK, EU, Japan and Chinese stock markets rallied strongly. Wall Street could not shake off its gloom. Some US commentators said part of the package had already been announced, other doomsters said there were concerns that China needed to take such drastic action. I believe commodities are a relatively strong asset class. Stocks, property etc will be weaker. A massive deleveraging is taking place in all assets (except gold, so far). Another column will explain that deflation will extend to retail prices and labour. *Neville Bennett is a long-time Senior Lecturer in History at the University of Canterbury, where he has taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.