My endless boom

It’s playing out as expected with the Pascometer leading off a chorus of nay-saying insiders yesterday afternoon and today. The boom isn’t over. Oh no! This is the endless boom, don’t you know. It’s entering a new phase, a third, fourth,fifth…twelfth stage. The AFR is wall-to-wall miner drivel this morning. The consensus now is that supply is catching up. We’re simply being out-competed for our markets. And yes, this is true. Mike Komesaroff, an old contributor for me at The Diplomat, has the pick of the pieces at the SMH with a precise description of how China’s local sources are taking over coking coal market share:

In coking coal, an essential ingredient for the production of steel, Mongolia has already grabbed market share from Australian producers who once dominated the sector. Only three years ago, Mongolia supplied 11 per cent of China’s demand compared with 65 per cent for Australian competitors. But as production at new mines has increased, positions have been reversed, with Mongolia now supplying 45 per cent of China’s needs compared with Australia’s 23 per cent. With mines yet to be commissioned and improvements in infrastructure, Mongolia’s market share can only further increase.

Low cost is a feature of most of Mongolia’s coalmines and is attributable to favourable geology, principally shallow, relatively thick, uniform seams of high-quality ore. Close to the border with China, the mines can deliver coking coal to Chinese steel mills for significantly less than Australian competitors.

Competition from Mongolia has driven down the price of coking coal, which 12 months ago traded for as much as $320 a tonne and now sells for less than $180. The collapse in the price has affected the profitability of Australia’s coking coal producers, with BHP reporting a drop of 41 per cent in the earnings of its metallurgical coal division. This was certainly a factor in the company’s decision to shelve expansion of its Peak Downs coking coal project in Queensland.

This is now the refrain across the mining firms and media. We need greater flexibility for the endless boom to continue. Again, there is an element of truth in this.

But there are four issues here. The first is that we are seeing a coordinated slump in bulk exports that goes well beyond new supply. The assumption behind the slow decline of commodity prices embedded in everyone’s forecasts is seamless demand growth in China. Yet Chinese consumption of our bulk exports is clearly slowing. There is also a clear reticence in China to repeat the reckless stimulus of 2008/9. It may have to come, but there is no guarantee. Indeed, the most impressive part of the Chinese response to their economic slowdown to date is the slowness of officials to respond. Besides, it is now widely accepted that healing the Chinese economy demands rebalancing towards consumption and away from the bridges to nowhere that have underpinned commodity demand until now. The rebalancing will not happen overnight but it will happen. Endless Chinese demand growth cannot be relied upon at all. Yet I cannot find a single reference to this in the business media today.

Which brings us to point two. The lack of accountability at large is breathtaking. The rising competition meme enables the continuation of the magical thinking that prices will enjoy a commodious decline offset entirely by rising volumes. Treasury captured this line of thought recently with a chart of terms of trade projections:

That’s a genteel halving of the ToT over twenty years.

Now, as I’ve argued lot’s of times before, I reckon there is plenty in the argument that we’re entering a new era of consistently higher prices on emerging market development. And in that sense Australia is well placed, as evidenced by the gas boom, which will provide lot’s of economic support for many years. But it’s all about timing and degree. And sadly, the history of commodity booms is not friendly to the endless boom thesis:

There are a couple of periods of a decade long decline but no twenty year declines from peak. And I think you’ll agree, on balance, the evidence is that booms go bust! I don’t see this happening overnight either. There is a rebound in ore price coming and it’s fair to think that we could back to the $120 level and above. But it will be brief in my view. And each rebound, henceforth, is increasingly likely to be to a lower high. That is unless ore production growth is cut, which is the end anyway, or China does push the panic button, which delays the end a little while but ultimately makes the crash worse.

Which brings us to point three. Perhaps the greatest wonder of all of this magical thinking about commodities is that it flies in the face of basic economics. As the Unconventional Economist and I have been arguing for several years, demand shocks in inelastic markets do not result in endless boom prices. They result in volatility. From eighteen months ago:

Like housing supply in Australia, commodity supply is inelastic. That is, it cannot respond quickly to a sudden surge in demand. The chart offered below (and mentioned above) shows the effects on any given market if supply cannot respond quickly. Don’t be scared of it, it is easier than it looks:

Q0 and P0 represent the initial equilibrium situation in any market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted).

Following an increase in demand, such as a surge of emerging markets looking to engineer an historically swift catch-up in living standards through mass urbanisation, the demand curve shifts outwards from D0 to D1. When commodity supply is restricted, prices rise sharply from P0 to PR. By contrast, when supply is unrestricted, prices rise more gradually from P0 to PU.

The situation works the same way in reverse. For example, if there was a sharp fall in demand following a contraction like that of the GFC or an inflationary bust causing commodity demand to fall from D1 to D0, then prices fall much further when commodity supply is constrained.

The graph illustrates that demand shocks combined with inelastic supply do not result in a one way bet of upwards price movements. Rather, such economic settings produce volatility, with steeper price rises and spectacular collapses.

In short, the supply curve steepens and you get booms and busts.

My final point is that if all of this common sense has been ignored by the government, sell-side research, miners and media, why should endless boom arguments be believed now? I mean, come on! The projections made by these folk have determined where we are today, with a grossly inflated cost-base, spending levels that are unsustainable and a radically depleting non-resource export base. The Budget is one fine example. David Uren from The Australian looks at the damage via Brian Redican at Macquarie:

“We think there will be a $10bn shortfall compared to the budget brought down in May from these kinds of factors.”

When the budget was being finalised in late April, the iron ore price was still at $US150 a tonne. Treasury had forecast that Australia’s terms of trade (export prices compared with import prices) would rise by 3.25 per cent in 2011-12 before falling by 5.75 per cent in 2012-13.

…Mr Redican said the severity of the price falls since May…were facing a fall of about 11 per cent this year, provided there was no further deterioration in prices.

The budget papers include Treasury’s estimate of what would happen to the budget bottom line if the terms of trade were weaker than expected, showing a four percentage point fall would take $3.4bn from the bottom line. If there were no recovery in prices, this suggests the revenue shortfall would be about $7bn.

Add to that a big miss for resources profits and the black hole is up to $10 billion.

None of this will be very surprising to regular readers because I’ve reasoned and calculated most of it over the past few years. But you have ask yourself, if an isolated upstart can do it, why the frack can’t these billion dollar entities do the same?