Extent of commodity prices collapse is the big unknown

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30 Nov 2008

The Australian government's biggest concern about the economy is that commodity prices will fall further and faster than expected. The run-up in commodity prices has been so dramatic over the last five years that there is little precedent to guide forecasters about how big the reversal in prices might be. Treasury's budget update last month tipped that the terms of trade (the ratio of export prices to import prices) would show a rise of 10.75 per cent this year, reflecting the boom-time iron ore and coal contracts won last April. It forecast a partial reversal of 8.5 per cent in 2009-10.
In his report on the economy to parliament last week, Kevin Rudd warned the outlook for the terms of trade was weakening. "A sharper fall (in the terms of trade) cannot be ruled out if the global downturn intensifies, and this would further reduce national income growth," he said.
He noted that since Treasury had ruled off its update of the budget forecasts, there had been further sharp falls in commodity prices and the outlook for growth of Australia's biggest customer, China, had weakened.
The last really big commodities boom was in 1973-4. This included the quadrupling of oil prices following the OPEC embargo, but metals and soft commodities also leapt in response to a period of inflationary growth.
Like the latest boom, it was also brought to an end by a global recession, which caused a 15.6 per cent fall in Australia's terms of trade in the following 12 months. The terms of trade then kept falling for the next three years, dropping a further 14.9 per cent.
However, the 1973-4 boom is dwarfed by the increase in commodity prices that ran from 2003 to June 2008. The terms of trade reached a peak in 1974 that was 31 per cent above the long-term average. By contrast, in June this year, the peak in the terms of trade was 60 per cent above the long-term average.
The Reserve Bank has been keeping an index of Australia's commodity prices since 1982. For a 15 year period, from 1985 to 2000, the index hovered around 80 points, rising at most 10 per cent above that level during the mini-commodities boom in 1989-90.
In the eight years since then, the RBA commodity index has risen threefold to 234 index points. It doubled in the last three years alone.
The only commodity boom of similar dimensions was in 1950 and that was a flash in the pan, with the gains caused by Korean war shortages entirely undone in the following year.
For a while, Treasury dared to dream that commodity prices might remain aloft forever.
"It is worth exploring what might happen to the Australian economy if it turns out to be the case that the terms-of-trade are permanently higher, even if not quite as high as at present," Treasury secretary Ken Henry said in a 2006 speech.
He said government should consider the possibility of a long term contraction in manufacturing, a shift of people and capital to the resource states and a rise in consumption.
The idea of an ever-lasting boom was based on what was thought to be the tectonic force driving China's industrialisation.
China's industrial take-off was plotted against those in earlier decades from Japan, ASEAN and the "newly industrialising countries": South Korea, Taiwan, Singapore and Hong Kong. China's rapid expansion was seen to have another decade or more to run, with India coming up fast behind it. This would propel demand for commodities and their prices to ever greater heights.
The industrialisation of China and India will doubtless resume once the financial crisis has passed, but in the meantime, mining companies are digging more rock out of the ground than anyone wants.
The behaviour of commodity prices in bear markets follows a well established pattern. Prices that over-shot at the peak of the boom also over-shoot at the bottom of the cycle. The rule of thumb is that they fall below the cash costs of the highest quartile of producers.
The bottom price in each cycle is usually lower than the one before, because technology means the break-even costs of mining are generally falling. The exceptions to this are commodities such as copper, where an increasing percentage of output is being extracted from underground mines.
Commodity prices have already fallen a long way. Steel, for example, is down from its peak of $US1020 a tonne to $US295. Copper, which peaked at just under $US9000 a tonne, is selling for $3740.
The spot price for iron ore has come down from a peak of $US200 a tonne in February this year to about $US70 now. The current spot price is less than half the benchmark price for Australian iron ore of $US144.70 a tonne.
The spot price is at the level that would render the most expensive producers uneconomic, but it is far from clear how the price negotiations for the 2009 contracts will work out.
The most expensive production is China's own, mainly because of its low grade. But China's mills are used to dealing with it and may give it preference in a downturn.
Australia's big iron ore mines still have cash costs of little more than $US40 a tonne and will remain profitable, although not sinfully so, under any likely scenario.
In recent years, the pace-setting deal for global iron ore prices has been concluded by Brazil's Vale with the European steel mills, which are all squeezed by recession.
As an industry with high sunk costs, miners face a great incentive to maximise the volume of their sales, and this will make it easy for steel mills to play one miner off against the other, offering higher tonnage as a trade-off for lower prices. The same logic holds for the coal contract negotiations, although Australia faces less global competition in coking coal.
Treasury was aware, when it compiled its mid-year budget update that commodity prices were the greatest vulnerability. It included a useful ready reckoner, with modelling showing that a 4 per cent fall in the terms of trade would, given constant exchange rates, result in a 1 per cent fall in nominal GDP and a $1.5 billion drop in budget revenue in the first year and a $3.8 billion fall in the second year.
Given the precedent of 1974 and the stratospheric height commodity prices reached earlier this year, it is possible the fall in the terms of trade in 2009-10 could be at least double the 8.5 per cent projected by Treasury last month.

Source: The Australian