Poor prospects

In August, mining giant BHP Billiton halted its planned expansion of Australia’s massive Olympic Dam copper mine, its largest of at least US$50 billion in cuts and delays this year. In October, Brazil’s Vale SA, the world’s largest iron ore producer, slashed its projected annual output of the metal by 18%. Australia’s Fortescue Metals Group went so far as to suspend company barbecues, lock stationary cabinets and take away free coffee machines this fall. Rio Tinto, Anglo American and Xstrata have also tightened their belts.

In a few months, the boom metals industry – in which even truck drivers have made more than six figures – was suddenly at risk of a bust as hard commodity prices fell. The cutbacks are occurring around the globe, but they can all be traced back to one source: China.

China drove a boom in global commodities during the last decade, lifting generally volatile and uncertain metals markets to unprecedented heights. The price of many key metals shot up fivefold or more, as China’s consumption grew to at least 40% of the global supply of dozens of metals and minerals. But analysts say that the country’s recent economic slowdown has brought the end of this so-called “super-cycle” of growth.

China’s GDP growth slowed to 7.4% in the third quarter, the seventh consecutive quarter of deceleration, and economists widely predict that future growth will not exceed 10%. Sluggish trade globally, as well as rising wages, an aging population and lower returns on fixed-asset investment within China, all indicate that the country’s era of investment- and manufacturing-led expansion may be nearing an end. Instead, China will need to shift its economy toward consumption and services, areas that are inherently less metals intensive, or risk a potential economic crash.

This slowdown is set to reshape the global economy, and hard commodities are among the first markets being remade. As prices of commodities such as iron, aluminum and copper retreat, the balance of worldwide economic growth will shift away from commodity-producing economies, such as Australia and Brazil. Analysts disagree on the extent of this slowdown, but most agree that metals prices are likely to keep declining as the world realigns around a changing China.

“The peak that we saw in 2009 was the highest peak we’ve seen since 1870,” said Gerard Minack, global cross-asset strategist at Morgan Stanley Australia.“It’s a once in a century peak ... I doubt you’ll see those levels ever again.”

once in a century boom

The beginning of the metals super-cycle surprised miners as much as its end has. Following a 20-year down market, metals prices began rising in the early 2000s when Chinese demand started to push miners worldwide to the limit of what they could produce. Flush with cash from decades of miraculous growth but short on domestic resources, China imported massive amounts of metal. As metals prices shot up – copper prices increased nearly 10-fold – commodity-rich countries like Australia, Brazil and Indonesia saw their incomes, their standards of living and the values of their currencies rise.

Metals companies were initially skeptical that such a surge in demand could be sustained. Most waited roughly five years into the super-cycle before deciding to increase production, said Paul Robinson, a metals analyst at independent research firm CRU Group.

After that, actually expanding capacity took years. Processing facilities such as aluminum smelters typically take 18 months or more to build, while underground mines require far longer to develop. “To take a copper mine from a twinkle in a developer’s eye to actually producing is probably 10-15 years,”Minack said.

That extra capacity has only begun to come online in the last few years and is set to increase substantially by the end of the decade. Global iron ore capacity should roughly double to 2.6 billion tons by 2020, according to a recent note by Minack. The supply glut will persist well into the next decade, with mainland production of non-ferrous metals (metals other than iron) estimated to peak around 2030, said Guo Chaoxian, an industrial economics analyst at the China Academy of Social Science.

shocking the system

This rising supply of iron, aluminum and copper is colliding with the slowing growth of Chinese demand. Iron ore prices fell 26% this year as of midOctober, while the prices of copper, lead and aluminum are all trading below the historic price peaks they reached in the last decade.

These decreases have pushed global metals companies into defense mode. They are now scrambling to boost efficiency by cutting staff, delaying planned capacity expansions and shutting down some higher-cost operations.

But those measures will not likely be enough to prevent declines in profits. Following a year of record profits for the mining sector in 2011, Britain’s Rio Tinto and Switzerland-based Xstrata have reported more than 30% declines in first-half earnings, while BHP reported a 35% drop in profits for the fiscal year ending June 30.

Profits are likely to fall more sharply in roughly one year, when long-term fixed-price contracts begin to expire, said one analyst, who spoke on condition of anonymity since he is not authorized to speak to the media. “Most of the miners can still be profitable but less profitable than they’ve been previously,” he said. Other analysts predict earnings per share for the sector in 2013 to show doubledigit declines.

Metals companies will also find it more difficult to secure financing, adding to pressure to shut down less profitable operations. Lenders are wary of financing any miners when even majors like BHP Billiton are delaying giant projects like Olympic Dam, said Mike Elliott, head of global metals and mining at accountancy Ernst & Young.

Financing pressure is likely to be more severe within China, which is experiencing an oversupply of coal, iron ore and aluminum. According to Craig Charney, research director at consulting firm CBB International, in the third quarter “interest rates for the [mining] firms that were fortunate enough to get loans shot up like rockets. And this was true whether they were state or private.” Chinese firms that turn to the domestic shadow banking system to keep projects afloat may find that the usurious lending rates only compound their troubles.

Indeed, Chinese miners are likely to be among the first pushed out of the market as prices fall. With a few exceptions, Chinese miners generally operate at higher costs, since the country is relatively resource poor and those resources it does have are more costly to access. Domestic iron ore mining is already being scaled back, and Chinese output may fall from 330 million tons in 2011 to about 250 million tons this year due to price declines, according to data from investment bank CLSA.

“It’s for sure that many [Chinese] companies will eventually be forced to exit,” said Guo of CASS. “In a market economy, as the industrialization process continues and market regulations are further improved, the competition will intensify.”

Many Chinese miners, as well as metals processors and some provincial governments, are likely to suffer because they have bought into metals during the boom years, a practice that Michael Pettis, a Peking University finance professor, terms “pro-cyclical investment.” Companies have a short-term incentive to stockpile hard commodities in a bull market because, as metals prices rise, the value of stockpiles on balance sheets increases, which can then be reported as profit, Pettis argues. But this same principle will hit many Chinese firms with outsized losses when price declines drag down the value of their stockpiles.

world of woe

With metals accounting for 6% of global trade in 2010 according to research firm Capital Economics, a decline in the market will weigh on already flagging trade levels. The WTO has cut its estimate for 2012 trade growth to 2.5%, down from an expected 3.7%. Knock-on industries dependent on trade will also face weaker business, with the already sluggish shipping industry chief among them.

Some economists, including Pettis of Peking University, predict a reordering of global economies. Global growth darlings including Australia, Brazil, Indonesia and Chile will no longer outperform, while the price decrease will be “like a huge tax cut for the commodity-importing countries” such as the US and Mexico, Pettis told China Economic Review. “He who is first shall be last, and he who is last shall be first.”

Jayant Menon, lead economist at the Asian Development Bank, argues for a more moderate view. Menon predicts that countries like Australia and Brazil will fall back on well-developed service sectors and on agriculture as food commodity prices continue to rise. With the US and European economies shaky, money will still flow into Australia and Brazil in search of high yields and low risk.

However, GDP growth, living standards and currency valuation will nevertheless fall in tandem with exports, Menon said.“There’s just been a party with them, if you like, with champagne flowing over the brim. That will all go away.”

consumption or bust

In the longer term, analysts have drastically different views on China’s growth and expected demand for commodities. Investment bank economists generally predict that China’s GDP growth will bottom out in the fourth quarter or early next year and hold steady at around 7% – perhaps the best-case scenario miners can hope for. Guo at CASS expects growth to stabilize at a more moderate 5-6%. Pettis, among the most bearish observers, predicts that growth will average 3-4% or lower during the next decade.

Pettis’ prediction rests on the assumption that Chinese policy makers get serious about rebalancing. Investment growth needs to fall below consumption growth for the economy to rebalance, he wrote in a recent note. But with investment being such a large economic driver, any slowing in investment will necessitate a slowdown in overall GDP growth, likely to around 3%.

“Under these conditions I don’t see how we can avoid a very nasty two or three years ahead for commodity producers,” he wrote, predicting that prices of certain hard commodities could fall by 50% or more in that time.

But rebalancing may still be a long way off for China, said Guo of CASS. Consumption outgrew investment in the first three quarters of the year, but government policies continue to favor investment. Beijing is also relying on investment to drive growth in China’s less developed west and to lessen regional economic imbalances.

With such wide disagreement, the safest bet for long-term commodities investors is to wait out this transition in hope that China’s economy will stabilize, Beijing will set a clear course toward rebalancing and the economic outlook of the US and Europe will improve.

The timing of rebalancing may not be clear, but its long-run consequences are. Commodity prices would be unlikely to rebound beyond historic peaks for decades, as no large economies are poised to grow fast enough to take China’s place driving demand. For commodity investors, rebalancing is still better than the potential alternative: a China that racks up debt to the point where it destabilizes the economy and sends the country into decades of stagnation like Japan.

Even if metals prices come down, Chinese firms will continue to buy up metals assets worldwide, analysts said. From a market standpoint, “[Beijing] shouldn’t really need to worry about it,”said Ian Roper, a commodities strategist at CLSA. “It’s really more from a security or supply aspect – it makes them feel comfortable that they own it.” Chinese companies conducted roughly 13% of global mining mergers and acquisitions in the first half of the year, jumping from 7% in the same period a year prior, according to PwC.

China is buying in at a time when the market is declining, but the rollercoaster of volatile commodity prices lumbers on.“Commodities prices never move in a straight line, of course,” said Minack of Morgan Stanley. “For me, the super-cycle was a sequence of a decade where we had higher highs, higher lows, so the trend was up … This adjustment that I envisage is once again not a straight-line move. It might be a series of five or 10 years when we have lower lows, lower highs,” he said.

Unlike a rollercoaster, the way down will be far less thrilling. But in its bid for self-sufficiency, China ensures that wherever the market goes, it is strapped in and along for the ride.