Citi has joined the recent debate about whether the commodity super cycle is finished (or nearly so) with an argument in the affirmative. Bulls like to point to the fact that the apparent intensity of use for steel (in terms of kg per capita) for China is still well below some other countries at their peak. However, Citi reckons that in terms of “value in use”, China is already above most of the developed world. In other words, while consumption of commodities in terms of volume still lags behind many countries, the value of the commodities China is consuming has already been higher than most countries:
The structural story — The bulls on the sector point to intensity of use charts for commodities on a kg/capita basis and extrapolate this into the future. This ignores one vital component which is price, as it assumes that developing economies will continue to consume ever increasing quantities of commodities regardless of the price. If we look at value in use rather than intensity of use this changes the argument and suggests China has already overtaken most of the developed world. Arguably for commodity consumption to increase globally then prices need to come down.
Margins have peaked — Mining margins peaked around 2007 and since then the industry has faced higher depreciation costs, higher operating costs, higher oil prices, higher exchange rates, higher capex costs and higher salaries – all these factors are continuing and margins will continue to come under pressure.
Returns have peaked —On an EVA basis (ROIC – WACC) the peak returns for the sector occurred in 2006, yet earnings momentum peaked two years later in 2008 and has subsequently moved higher. In our view the mining sector bought earnings momentum through M&A, and the mining sector is now buying earnings momentum through unprecedented capex spend. Importantly ROIIC is falling.
And arguably, China’s investment boom in the recent years have been getting less and less efficient:
Arguably the investment boom in China is already becoming less efficient due to higher input costs. In the past decade, China’s GDP grew at an average rate of 10.5%. Investment expanded at an average rate of 13.5% during the period, the main contributor of growth. As a result, share of investment in GDP increased from 36.5% in 2001 to 48.5% in 2010.
The efficiency of investment appears to be falling – In the absence of a more reliable metric for assessing the productivity of investment, we employ the Incremental Capital Output Ratio (ICOR) as an indicator of marginal product of investment. During 2001-2010, China’s average ICOR topped 4. More recently, the ratio rose to around 5, with a big jump in investment/GDP ratio—associated with stimulus measures introduced to tackle the global financial crisis—producing a relatively small output response.
ICOR is obtained by dividing the ratio of investment to GDP with real economic growth. The ratio shows the amount of capital investment incurred per extra unit of output. The higher the ratio, the lower the productivity of capital.