Treasury changed its approach to commodity forecasts because of the huge swings in the market

Photo: John Moore/Getty Images

Australia’s Treasury has, wisely, decided to tweak how it uses commodity price movements in budget calculations following some enormous – and surprising – price gains since the federal budget in May.

“In recent years, Budget and MYEFO forecasts have used an assumption that commodity prices would remain around a recent average over the forecast period,” it said in its mid-year economic and fiscal outlook (MYEFO) released today.

“In light of the current exceptional circumstances for bulk commodities, this assumption is not considered prudent at this time.”

This chart found within the MYEFO underscored just how “exceptional” the rally in bulk commodity prices has been.

Instead of taking recent elevated prices and feeding them into the budget calculations, Treasury said an alternative assumption of a “phased reduction in prices from recent levels” has been adopted for metallurgical coal and iron ore on this occasion.

It has taken this approach because nobody really knows just how long the price surge will last, and that’s including those who work within the mining industry.

Here’s the commentary on the outlook for metallurgical coal, Australia’s second-largest goods export by dollar value:

Liaison with a range of industry contacts revealed a widespread expectation that current price levels will not be sustained. There is considerable uncertainty around the pace and timing of possible price falls. The metallurgical coal price is assumed to be US$200 per tonne Free on Board (FOB) in line with the December 2016 quarterly contract price, before declining through the September and December quarters of 2017 to reach a level of US$120 per tonne FOB in the March quarter 2018.

And here’s the commentary for iron ore, Australia’s largest export by dollar value:

Liaison with industry indicates that there is very considerable uncertainty around the drivers of the recent price movements, with the only consensus being that current elevated prices are unlikely to be sustained. That said, there is no consensus as to when prices may fall and by how far. In this MYEFO, the iron ore price is assumed to decline from its recent average of US$68 per tonne FOB through the March and June quarters of 2017 to reach a level of US$55 per tonne FOB in the September quarter 2017.

While similar to the view communicated on metallurgical coal, the one key difference is that nobody — not least those who work in the industry — know what’s behind the recent price surge that took benchmark spot rates to the highest level seen in over two years in early December.

Essentially, not only does it not know when the rally will end, but also what’s driving prices higher right now.

All that is really known is that prices are expected to go lower again.

Understandably given the view presented on the outlook for both iron ore and metallurgical coal, it says that prices remain a key uncertainty to the outlook for the terms of trade and nominal GDP.

And it’s easy to see why this remains a risk to Australia’s budget position in the future.

These tables from Treasury shows the sensitivity on the budget bottom line from an earlier and later decline in the spot price for Australia’s key commodity exports.

Here’s the analysis for metallurgical coal:

And for iron ore:

Relating to metallurgical coal, Treasury says that if prices remain elevated at $US200 per tonne for two quarters longer and then step down to US$120 per tonne, nominal GDP could be around $4.5 billion higher than forecast in 2017/18, resulting in an increase in tax receipts of around $0.5 billion in both the current and next financial years.

However, a decline in the spot price two quarters earlier than expected could reduced nominal GDP tax receipts by a similar margin over the 2016/17 and 2017/18 financial years.

It’s a similar story for iron ore with treasury analysis showing that an earlier or later fall in prices could either add or detract over $3 billion to nominal GDP in 2016/17, and reduce or add to tax receipts by around $200 million this year and around $600 million in 2017/18.

It’s all very uncertain as to what will eventuate, and most of it is concentrated on what happens in the Chinese economy and financial markets in the months ahead.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.