Monday, October 19, 2015

Glencore suffers hit from commodity prices

As commodity prices continue to fall, bankruptcies among producers and industry consolidation will no doubt accelerate.  Suppliers of farm, mining and construction equipment are already troubled. With this onslaught, it's no surprise that Glencore, the huge Swiss company that dominates global commodities markets, lost a third of its value in a single day last week.   

Glencore was founded in 1974 by Marc Rich, the commodity trader and U.S. tax fugitive who died in 2013. Initially the firm, called Marc Rich & Co., didn’t own mining assets because Rich believed they were too volatile. He focused instead on commodity trading and eventually turned the company into the world’s largest trading house. Rich tried and failed to corner the zinc market in 1993-94 and was forced to sell 51 percent of the company in a management buyout to a team that included Glencore's current chief executive officer, Ivan Glasenberg.  

The new company became directly involved in mining operations, yet continued to stress the stability of its trading profits. Glencore's 2011 initial public offering prospectus stated that its trading business is “less correlated to commodity prices than its industrial operations, making Glencore’s earnings generally less volatile than those of pure producers of metals, mining and energy products.” 

It hasn't turned out that way. The nosedive in commodity prices and $30 billion in debt have put Glencore on the ropes, at least in the eyes of investors and possibly credit-rating companies. Despite measures announced in early September to reduce debt by $10 billion through stock sales, dividend cuts, asset sales and cost reductions, the yield on its U.S. dollar-denominated bond maturing in 2022 leaped from 4.6 percent at the end of July to 11 percent recently. Glencore's stock plummeted 29 percent on Sept. 28 and is down 90 percent since its 2011 public offering, done at the peak in commodity prices. 

If Glencore’s huge trading operation can’t protect its mining business, what’s in store for giant, concentrated mining companies like BHP Billiton, Vale, Rio Tinto and Anglo American? Or mining-equipment companies like Caterpillar? And how about smaller, less financially secure firms? Alcoa just threw in the towel on basic aluminum production and split those operations from its downstream, higher-value-added aluminum businesses. 

Investors who are much less knowledgeable about commodities than Glencore will probably continue to be forced into agonizing reappraisals. This includes pension funds that got swept up in the commodity craze a decade ago and hoped further rapid price rises would help them achieve their investment goals in an era of low interest rates. Many elevated commodities into an investment class alongside stocks and bonds. 

I’ve always insisted, however, that commodities aren’t an investment class, but a speculation. Sure, I use such commodities as crude oil, copper and sugar in the aggressive portfolios I manage, but on the short side. Since the mid-1800's, commodity prices, adjusted for inflation, have been in a steady downward trend. The price spikes due to demand surges in the Civil War and both world wars were soon retraced, as were the effects of the oil-supply curtailments in the 1970's. 

Sure, there’s only so much oil in the ground. Devotees of the Hubbert peak theory -- geophysicist M. King Hubbert's idea that world oil production had peaked in the 1970's -- thought that crude oil supplies would have been fully exploited by now, with surging prices as the result. Then came fracking technology and huge new supplies of relatively cheap shale oil. 

I can recall when serious economists predicted that the telecommunications expansion would come to a grinding halt because there wasn’t enough copper in the earth’s crust to make the needed wires. Fiber optics obviously eliminated that problem. 

Human ingenuity and free-market prices have always eliminated commodity shortages, and probably always will. Commodity investments may continue to be rewarding -- as long as they’re based on further price declines.

Monday, October 5, 2015

Many reasons why we could see further commodity price declines ahead

It's hard not to notice that commodity prices have been plummeting. It seems the price of everything that is grown or pulled out of the ground -- from oil and gas to sugar and copper -- has declined 46 percent since early 2011, causing bankruptcies and industry consolidation.

Prepare for further big declines. 

Directly or indirectly, developed countries consume most commodities. Yet economic growth and demand for commodity-based products remain weak as North America and Europe continue to unwind their financial excesses. The earlier rapid expansion of debt, which helped fuel robust growth, is being reversed. 

U.S. real gross domestic product has risen at just a 2.2 percent annual rate since the business recovery began in mid-2009 -- about half the rate you’d expect after a recession. The euro area is limping along at a 1.2 percent annual growth rate, with recovery from the 2007-2009 recession interrupted by a mild downturn in 2011-2013.  Economic gains in Japan’s stop-go economy have averaged only 1 percent.

The world is now eight years into a deleveraging cycle. At this rate, it will probably take more than the historical average of 10 years to complete. 

Meanwhile, supplies of almost every commodity are huge and growing. China joined the World Trade Organization in late 2001 and, not by coincidence, commodity prices took off in early 2002. As manufacturing shifted from North America and Europe to China, it sucked up global commodity output. From 2000 to 2014, China’s share of global copper consumption leaped to 43 percent from 12 percent. China's portion of iron ore purchases similarly zoomed to 43 percent from 16 percent, while aluminum went to 47 percent from 13 percent. 

By the mid-2000's, industrial commodity producers were dazzled by China’s seemingly insatiable demand and made the same big mistake that always occurs in every economic cycle:  They assumed surging demand from China would last indefinitely. 

Producers embarked on massive projects that often take a decade to complete. These included digging copper mines in Latin America, removing iron ore in Brazil and producing coal in Australia. All that new capacity began to come onstream in 2011, just as it became clear that the hoped-for post-recession return to rapid global economic growth wasn’t occurring. 

The downward pressure on commodity prices has been magnified in recent months by the realization that economic growth in China is slowing. This is nothing new, really. China doesn’t grow independently, but has an export-driven economy. It imports raw materials and equipment that it uses to produce manufactured goods, largely for export. 

But muted demand in North America and Europe for Chinese exports has slowed economic growth in China.  Meanwhile, over-investment in ghost cities and building of excess infrastructure, in which China engaged to create jobs, has spawned huge debts. I estimate that the true rate of inflation-adjusted growth in China is about 3 percent to 4 percent, half the 7 percent official number. 

Few investors and most of the media were unaware of China’s dependence on the West and its slowing growth until stocks went off the cliff in June. The Shanghai index is now down 40 percent despite Beijing’s clumsy and heavy-handed efforts to support equities. Devaluation of the yuan soon followed.

With most other currencies also devaluing against the dollar, the trade-weighted yuan is down 30 percent from May 2011, and China wants it to go even lower to spur exports in a softening economy. To prevent the pegged yuan from collapsing -- and accommodate the rush of money out of China -- the government has sold about $400 billion of its nearly $4 trillion in foreign currency reserves to buy yuan. 

Additional forces are depressing commodity prices beyond the general surplus of supply relative to demand. A number of hard-rock miners are so deep into new projects that they are compelled to complete them. Closing down the ventures would be more expensive than the losses they'd incur from selling production at today's prices.

The world’s biggest iron ore producers - Rio Tinto, BHP Billiton and Vale -- continue to produce huge quantities of ore even as prices drop 70 percent to $57 a ton, from $189 in February 2011. The companies believe they can squeeze out less-efficient producers, such as those in India, that may lack staying power. 

Some commodities, especially aluminum, are produced in developed countries like the U.S. and Canada. In textbook fashion, once demand falls and profits nosedive, owners shut down smelters. The drop in supply offsets some of the downward pressure on prices.

But copper, used in numerous manufactured products ranging from autos to plumbing fixtures to computers, is mostly mined in developing nations like Peru, Zambia and Chile.  They need the revenue from copper exports to service their hard-currency debts. So the lower the copper price, the more physical copper they must produce and export to earn the same dollars. And the more they export, the lower the price, in a self-feeding downward spiral. 

Similarly, Brazil subsidized the export of sugar, which is down 67 percent in price since February 2011, and no doubt will be forced to pour more money into the industry. Already, 80 of 300 sugar mills in the South Central region, where 90 percent of Brazilian sugar is produced, are closed. Stockpiles are at a 35-year high. Insolvent mills are trying to sell as much sugar as possible to generate cash, which has depressed world sugar prices. 

Meanwhile, sugar imports in China were down 25 percent in August from a year earlier. Adding to the pressure, the Brazilian real is down 33 percent so far this year. Standard & Poor’s cut the country’s debt rating to junk in September. The dollar-denominated debts of Brazilian sugar producers are becoming next to impossible to service, as a result. 

As with iron ore, the Saudis are trying to use low prices to squeeze out other major crude-oil producers. I previously explained why that could result in per-barrel oil prices of $10 to $20.

As long as market prices exceed marginal cost, more (not less) production is encouraged to make up for lost revenue. Some producers will raise output even when prices fall below marginal costs. 

Russia depends on energy exports to cover import costs and government spending. With the collapse in oil prices and Western sanctions, Russia is desperate to earn foreign exchange.