Despite the recent bounce, something largely fuelled by short covering rather than any significant improvement in fundamental supply and demand dynamics, it’s been a tough period for commodity prices.
As a consequence of a huge supply side response to previous market tightness, along with a quicker-than-expected slowdown in demand, primarily from the world’s largest largest consumer, China, commodity prices have been in one almighty funk.
Over the past five years crude, along with many base and industrial metals, have more than halved in value, placing pressure not only on balance sheets of miners but also those firms who have financed their expansion.
The chart below of CRB commodity price index tells the story.
While they believe that further pain is to come for commodity prices, Deutsche Bank’s multi-asset team, lead by Stuart Kirk, suggests that the end to the deflationary spiral that has gripped commodity markets is “finally in sight”.
Metal markets have been either well supplied or over supplied for the past five years, a combination of slowing Chinese demand growth and a surge of mined output, as many of the long gestation projects finally started to deliver tonnes. In this environment prices should fall to the marginal cost (nominally the ninetieth percentile on the industry cost curve), forcing closures and ultimately balancing the market.
In essence, a prolonged period of low prices will see high cost producers cease production, eventually seeing markets rebalance which in turn will help support prices.
Although simple supply and demand, commodity prices have been low now for several years, with many high cost miners remaining in production despite ongoing weakness in prices.
Deutsche suggest that there’s a simple explanation as to why this has occurred, delaying a rebalancing of markets: the miners have been victims of their own success when it comes to cost reduction.
“Strong deflationary forces have given management teams the misconception they can beat the decline in metals prices by reducing costs, and in so doing maintain profitability,” say Deutsche. “To a certain extent the miners have been victims of their own success; their ability to take out costs as a group has helped the fall in metals prices.”
In other words, while cost reduction has allowed many firms to stay in production, it is contributing to ongoing commodity price deflation, creating a cycle where margins are still being squeezed despite lower operating costs.
However, Deutsche suggests this phenomenon is unlikely to last.
“Management teams may be able to take out more costs, but we are at the point where these cuts would be unsustainable, ultimately leading to lower output in the future,” they argue.
With Deutsche expecting metals prices to fall further on the back of lower-than-expected oil prices and the potential for a further depreciation in the Chinese renminbi, they suggest that mine closures will likely accelerate this year. In unison with a sharp reduction in capital expenditure over recent years, potentially curtailing future output, they suggest the grounds for a recovery in crude and metals prices is building.
“It may take a little longer for capital constraints to become apparent, but as they do, metal price deflation will quickly turn to inflation,” say Deutsche.