Tarnished - Part Two:
From the February 12, 2015 HRA Journal: Issue 227-228
This last of three issues covering my thoughts about 2015 will focus on base metals and a couple of bulk materials with some guesses on major markets. The editorial was a long one and has been split into two parts of which this is the second. This final installment of the early year market overview deals with bulk minerals, oil and major equity indices.
Iron Ore and Coal: Just Ugly.
The chart below shows the slow motion collapse of the iron ore market through 2014. The price is off 45% from the start of the year and hovering at lows not seen since the modern era of open market (rather than negotiated) iron ore pricing started in 2009.
I didn't include coal charts but those markets don’t look much better. Iron ore is the prime suspect for those making a case for the commodities being dead, especially those who are China bears. It’s a reasonable position but an oversimplified one. Both iron ore and coal are victims of “murder suicides” by the world’s major mining houses.
Iron ore and coal are very large markets. The world’s major mining houses have focused on these bulk commodities for that very reason. When you are the size of a BHP or Rio Tinto it takes something huge to move the needle on company valuation. Iron ore especially is one of those things. The largest iron ore operations have top line revenue of $10 billion plus per annum.
The big boys had these markets to themselves for decades. That changed ten years ago when iron ore prices took off to the extent that juniors and private producers were drawn into the space and high prices allowed smaller miners to finance development.
New iron ore mines got built by new juniors and intermediate producers and there was an explosion of “mom and pop” operations in China in particular. Many large steel producers either took interests in or built iron mining operations to assure supply.
The world’s big three mining houses (BHP, RTZ and Vale) are also the dominant iron ore producers and they didn’t like the new competition. All three planned and have largely pushed forward on huge expansions of their operations that have added 200 million tonnes of production capacity.
This is classic miner behavior in a bull market. It’s been disparaged by many but it wasn’t a blind decision. The operations of these three companies in Brazil and Australia have huge economies of scale. The Aussie operations in particular have cash costs in the $30-40/tonne range.
A lot of the smaller competitors arrived on the scene after prices crested $100/tonne. Many are located in those same regions but a lot of the marginal production comes from end user nations, namely China and India. Smaller operations are exploiting much lower quality deposits but cheap labour and little or no shipping costs are keeping them alive for now. So too are end users that don’t trust the big three not to jack up prices later.
They are right not to trust them. All three major producers have made a conscious decision to flood the market. It’s expected to take 2-3 years (assuming decent growth in China particularly) for the market to absorb the new production they are bringing online. In the meantime the iron ore price will get trashed. The big guys are ok with that. It’s not a conspiracy because it’s no secret. Essentially, they are trying the same thing that OPEC is attempting in the oil market. Drive the new and marginal producers out to maximize their own market share.
Will it work? Probably, but not as quickly as they might hope. Local producers do have a big shipping advantage. Steel producers in China and India often own part or all of these less efficient mines or have long term purchase contracts with them.
End users worry that once the small fry are cleared out the big three will slow expansion again so prices can melt up. That sounds about right. That could provide a good buying opportunity at the right time. Unfortunately, I think the right time is two or three years off at least.
Coal is a bit different and a more fragmented market but the essentials are the same. Big producers hoped to drive some of the newer competition in places like Indonesia out of business but local support and shipping advantages help keep them alive. Coal also has to compete against oil and natural gas that are at multi year lows too in many regions. Like iron ore, I think the comeback for coal will be a long time in coming. I would stay away from both for the foreseeable future.
I’ve added an updated chart of US crude oil stocks on this page. I’m putting this just after the iron ore/coal section because the situation is similar. While many use the price of these “bread and butter” commodities to prove big slowdowns in the world economy the issues are largely supply side. The world economy has slowed but most of the damage in these markets is self-inflicted.
You can see the increase in crude oil inventories is accelerating and is way above normal. There is no reason to expect this to change in the near term. With storage filling and a refinery strike broadening this situation will get worse before it gets better.
Traders are excited about falling rig counts in the US and bidding oil up but don’t be surprised if the low is still ahead of us. I think it is. Production is still rising and isn’t likely to top out before Q3. We haven’t even entered the spring “shoulder season” yet when oil demand has a seasonal fall. I think the bottom will come in Q2 but I still expect the ultimate low to be lower than $40. Bad for oil and gas stocks but good for the world economy.
Major Markets: Another Bull Year if Other Markets Normalize?
That brings us to the final section of this long editorial. Major markets had a good year by and large. I’d expected 10% gains from the big boards at most. Most did a bit better than that, exemplified by the S&P that clocked a 12% gain. I was hoping for a turnaround in the resource sector and a 30% move in the Venture exchange. I got a 30% move alright. But it was in the wrong direction.
When 2014 started markets expected to see the Fed raising rates before the year was out. Things moved decisively in the opposite direction there too, thanks to the deflationary forces I’ve been talking about for a few months.
As we start 2015 traders are again on a Fed watch of sorts, with couple of rate increases by year end priced into the market. That seems like a reasonable target and would in fact be a pretty dovish stance if we were looking at the US to the exclusion of everything else. That’s not how it works though.
Deflation has been raising real (inflation adjusted) interest rates across several markets. Central banks in Japan and the EU are printing money and several (12 at last count) smaller central banks have started cutting rates in an effort to ease deflationary pressure and weaken their currencies.
All of this has been adding upward pressure to the US dollar. That, in effect, leads the US to import deflation as the price of imports drops. It also makes it tougher for US exporters to maintain margins because they get priced out of foreign markets. The pressure to cut prices in some regions will be intense. Even off shoring, as many US corporations have done, is not a real solution. Those foreign profits get depreciated right along with the foreign currencies they were earned in.
All this adds up to a tougher environment for US multinationals. Most have put out conservative guidance for this year’s sales and profits. Bulls have made much of the “profit beats” during the current earnings season. Given how much guidance has come down that wasn’t impressive.
Falling inflation means real yields are rising in the US even if the Fed does nothing. If job creation stays strong and wage increases accelerate the US consumer may be able to generate 3%+ growth but we’re not there yet.
I’d like to see interest rates start to normalize but raising rates is only one way a central bank can create wiggle room for the next recession. The other is to let inflation rise and generate increasingly negative real rates. If there is a need to cool inflation that can be done with rate increases later.
Whenever you get to the zero bound in macro economics the cost of policy mistakes gets magnified. The US and world economies are in just such a period. There is a real danger of a bad outcome with even modest interest rate increases until inflation bottoms out and starts rising. Things are too close to a tipping point to get this wrong. I think the Fed plans to start raising rates in 2-3 months. I hope that isn’t a mistake but it will be if inflation hasn’t bottomed ahead of that move.
Given current valuation levels, impending rate increases, Greece and whatever other surprises may be in store I don’t see much room for gains in the major indices. We got 10% last year on the S&P. We’ll be lucky to get a repeat of that. So far this year New York has been flat and I suspect that is how the year will end, flat or slightly negative.
The TSX and TSXV are both slaves to the oil and gold price, particularly the former. Both performed terribly in Q4 thanks to oil but both are seeing some renewed buying as oil traders get more bullish. That’s good to see but as noted above I think oil may have one more dip ahead of it. That will be hard on the Canadian indices and even tougher on the Alberta economy that has been such a driver the past few years.
Even if there is another dip I think the bottom should be in during Q2 of this year, Q3 at the latest. After that the TSX could put in a strong move and drag the Venture along with it. The TSXV would have the 30% move I hoped for last year though it would come off a lower base. We need oil to bottom for it to happen though.
For gold to do the same we need some easing of the safety trade in the USD.
That’s not happening yet and may not until there is a resolution to the Greece issue. I don’t see that taking long if only because the money will run out soon if Greece sticks to its current negotiating posture. It will have to do something soon.
As I expected, physical demand in Asia has been strong with January buying up 4% from last year’s record. There is talk of India cutting its gold tariff in the next budget update at month end. Both of these price conscious markets will provide some bid support but we need the currency drama to settle down for renewed gains.
Farewell to a good friend.
One reason for the lateness of this issue was an unplanned and unfortunate trip to Houston to attend and speak at the funeral of my good friend Gene Arensberg. Some of you know Gene as the publisher of the Got Gold Report. Gene was among the first to produce meaningful analysis of the often confusing Commitment of Traders reports that Comex produces each week. He was quoted often by Brien Lundin and I and several others.
More than that Gene was a true southern gentleman. He had a big heart and was always an engaging and supportive friend. We spoke often. Even when he became ill his main concern was others. His good humor, selflessness and bravery under such trying circumstances was an inspiration.
I urge you to visit Gene’s site www.gotgoldreport.com. You can learn more about Gene, leave a supportive comment for his family and find a link to his chosen cause for donations.
Join me at our annual Toronto Subscriber Investment Summit on February 28, 2015. For more details or to register for this limited seating event, go to: www.subscribersummit.com or watch the video now.
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