While bulls were looking forward to a dovish Fed statement, they seem to forget that it is based on ...
The Unintended Peril of Cheap Money
04/05/2013 10:15 am EST
Supply and demand for major commodities is out of whack thanks to the easy-money policies of the world's central banks. The imbalance creates opportunities for savvy investors, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
There is no free lunch.
So, yes, the flood of cash from the world's central banks has prevented the crash of the world financial system in the dark days after the collapse of Lehman Brothers and the near-collapse of America International (AIG) and Citigroup (C).
And, yes, Mario Draghi's promise to do anything necessary to save the euro has headed off the collapse of the market for Italian and Spanish government bonds.
And yes, the huge stimulus thrown at China's economy prevented a hard landing where the nation's growth rate might have slipped below 7%. And, yes, the Federal Reserve's promise to keep interest rates at essentially 0% has revived—finally—the US housing sector.
But we're still counting up the costs. Sometimes the price is obvious: In China, it produced a real-estate bubble that has littered the landscape with ghost cities of apartments owned by speculators.
Sometimes the price is obvious but delayed. Someday the bill will come due in higher inflation, higher interest rates, and weaker currencies.
And sometimes the price is just not all that obvious. That's the case right now in the commodities sector, where a global policy of cheap money has turned a modest slump into what looks likely to be a long, deep, depression in the worst-hit sectors, such as natural gas, coal, and maybe even iron ore.
How is cheap money related to what is already a punishing recession for major commodity sectors? Let me explain. If you buy my explanation of the cheap money/commodity recession connection, I think you'll wind up rethinking your strategy and timetable for investing in commodity stocks.
Boom and Bust
Let's begin with the mismatch between what I'm calling the commodity depression and the slowdown in global growth.
Certainly the slowdown in China's economy—the driver for the global market in commodities, from thermal coal to copper to iron ore—should lead to a drop in commodity prices from their peaks.
A China growing at 10.4% in 2010 thanks to the country's post-crisis stimulus efforts (let alone a China growing at the 12% or 14% annual rate before the financial crisis) would consume more coal, iron ore, copper, oil, you name it than a China growing at 7.8%, as the country's economy did in 2012.
Take a look at iron ore, for example. China's steel mills are the world's largest consumer of iron ore (accounting for 60% of global iron ore imports) and it makes sense that demand from China would slow as China's growth rate hovers near 8% rather 10% or 12%. In fact, Goldman Sachs projects that China's imports of iron ore in 2013 will grow at the slowest rate in the last three years.
But do note that China's demand for imported iron ore is still projected to grow in 2013, by 4%. And global demand for iron ore imports is expected to grow by 8% this year.
Iron ore prices, however, have already retreated 6% in 2013. And the consensus among analysts surveyed by Bloomberg projects that iron ore prices will fall another 34%, to finish the year near $90 a metric ton. (Iron ore sold for about $155 a metric ton at its local peak at the end of February 2013.)
That may not even be the worst news. Iron ore prices could continue to retreat through 2014 and perhaps until 2018, according to Morgan Stanley. That would produce a slump that mirrors the nine-year boom that saw iron ore prices climb sevenfold from the late 1990s, when the price was $15 to $20 a metric ton.
Prices Down, Demand Up?
Projections for a huge decline in price by the end of 2013, and in the years following, don't make much sense if you look just at the demand side of the market, however.
Demand from China for imports will climb 4% in 2013...and yet the price of iron ore will not just slide lower, but plunge? Global demand will climb by 8%...but prices will fall another 34% in 2013?
Ahh, take a look at the supply side. Those same projections that say global demand will rise by 8% in 2013 also call for a 9.1% increase in seaborne supply (that's the standard term for global iron ore imports, since iron ore travels from mine to customer by sea).
And that's just the beginning of a trend that has supply growth outstripping demand growth as new iron ore capacity comes online. Morgan Stanley projects that the global iron ore market will move into surplus in 2014, and that the surplus will continue to grow through 2018. That's won't be good for prices.
This basic story—slowing but still-solid demand growth overwhelmed by a big increase in supply—isn't limited to iron ore either. The same holds, with individual wrinkles for specific commodity markets, for commodities that are as different as natural gas, thermal coal, and copper.
Copper, for example, is projected to move into a global surplus in 2013. Demand is projected to rise by 5.3%, but supply will grow by 6.8% to 8%, according to analysts. That will take copper to a projected surplus of 330,000 tons in 2013, from a deficit of 95,000 tons in 2012 and 132,000 tons in 2011.
Copper for delivery in three months closed at $7,958 a ton on April 3. The average price for 2013, according to Goldman Sachs, will be $8,458 a ton, before falling to $7,250 a ton in 2014.
This pattern of boom to bust and then back to boom (commodity investors hope) is typical of the commodities sector. High prices lead producers to increase their capital budgets and invest in new capacity.
But it takes so long to find and develop these resources that the result is often a glut. Every mining company invests in new capacity, which then yields a temporary surplus in the sector, driving down prices.
Putting Cheap Money to Work
The capital markets play a key role in regulating this boom-bust cycle. If money is expensive, mining companies will invest in only the best resources, thus putting limits on how big the temporary glut will be and how long it will last.
If money is too expensive (in relation to commodity prices), mining companies won't invest enough—or at all. That's part of the story of the 1990s. Underinvestment in that decade provided a good part of the fuel for the boom in commodity prices after 2002.
If money is too cheap, mining companies won't do enough self-editing, and they'll invest in marginal projects that will add the potential supply surplus.
Commodity markets will eventually adjust to that supply surplus, of course. Some marginal projects will get delayed or canceled. And we're seeing that now in cuts to capital spending plans at miners such as BHP Billiton (BHP) and Rio Tinto (RIO), as well as natural gas producers such as ExxonMobil (XOM).
But the price of money affects the speed of that adjustment. When money is cheap, as it is now for global mining giants thanks to the Federal Reserve, the European Central Bank, and the Bank of Japan, companies can borrow to keep projects going that might have otherwise been canceled.
They will borrow to keep mines in operation that are actually producing a loss, in the hope that a turnaround is just about the corner. And they can sell off assets in deals funded by cheap money that simply shift capacity around a sector, rather than reducing it.
Take the thermal coal sector, for example. The deal between producers and Japanese consumers of coal that serves as a benchmark set the price for coal at $115.20 per metric ton in 2012-2013. (That's below the record high of $129.85 a ton in 2011-2012.)
This year, negotiations are pointing to a benchmark price that might be as low as $94 a metric ton, as Japanese utilities—under pressure from the Japanese government to reduce soaring electricity costs—aggressively try to drive down prices.
At current Australian port prices of $90 a ton, about 25% of Australia's coal miners are losing money, commodity trader Glencore estimates. But a drop below $100 a ton in the Japanese delivered price (higher than the Australian port price) might well be insufficient to reduce supply. Coal producers with long-term contracts may choose to operate at a loss and simply borrow to make up the difference. (Once you've broken a contract, it can be tough to reenter the market.)
It might take a drop to $72 to $74 a ton (Australian port price) to lead to a significant reduction in supply, Deutsche Bank estimates.
In the US market for natural gas, the cheap money mechanism works through asset sales.
Chesapeake Energy (CHK) is keeping its 2013 drilling and completion budget at $6 billion, even though US natural gas continues to sell at less than $4 per million BTUs. That has left the company with a $3.6 billion funding gap for 2013, which Chesapeake plans on filling by selling off more assets.
The likelihood, of course, is that the buyers of these assets—almost certainly deep-pocketed majors that want to increase their exposure to the US natural gas boom—will keep the assets they've purchased in production.
Which is why, even though natural gas prices are well below costs for many producers, there hasn't been much change in capital spending in the sector. Of the 44 oil and gas producers surveyed by Bloomberg, 21 companies plan to increase their capital spending in 2013 over 2012 (by an average of 13%), and 17 plan to cut their spending (by an average of 22%.)
What's all this mean to an investor? First, the bottoms in commodity prices in recently depressed sectors such as coal, iron ore, natural gas, and copper are further out than you might think. Cheap money, thanks to global central banks, is slowing the normal reduction of capacity.
I don't think 2013 will mark a bottom for thermal coal, for example. Next year is more likely.
Second, the movement of assets from weakly funded to well-funded hands is likely to continue in 2013. I think that will give major producers in sectors such as coal and natural gas a chance to stockpile capacity against the eventual swing from bust to boom.
For example, ExxonMobil's latest strategy talks about increasing production from oil and gas shale in the timeframe of 2020 and beyond on the 180 million acres it has stockpiled in the Russian Arctic—first planned for 2014—and in the western Black Sea and the Gulf of Mexico.
In the long term, I think you want to own the majors that are adding assets now, or that have the potential to add assets. In coal, that means Peabody Energy (BTU). In oil and natural gas, ExxonMobil, Statoil (STO), and Apache (APA) are worth a look.
But there's no need to buy these today. (Producers that pay dividends of 5% or so are worth a look, though, since cash flows in many commodity sectors are healthy enough to keep dividend payouts at current levels—especially if the company is adding new reserves, as Eni (E), ConocoPhillips (COP), and Chevron (CVX) are.)
Third, in the nearer term, the best plays among commodity stocks might not be producers, but instead commodity infrastructure companies that get paid for bringing commodities to market. Remember, demand isn't falling...it's simply not growing as quickly as supply.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. For a full list of the stocks in the fund as of the end of December, see the fund's portfolio here.
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