Excerpted exclusively from Michael Pettis latest newsletter:
For the past two years, as regular readers know, I have been bearish on hard commodities. Prices may have dropped substantially from their peaks during this time, but I don’t think the bear market is over. I think we still have a very long way to go.
There are four reasons why I expect prices to drop a lot more. First, during the last decade commodity producers were caught by surprise by the surge in demand. Their belated response was to ramp up production dramatically, but since there is a long lead-time between intention and supply, for the next several years we will continue to experience rapid growth in supply. As an aside, in my many talks to different groups of investors and boards of directors it has been my impression that commodity producers have been the slowest at understanding the full implications of a Chinese rebalancing, and I would suggest that in many cases they still have not caught on.
Second, almost all the increase in demand in the past twenty years, which in practice occurred mostly in the past decade, can be explained as the consequence of the incredibly unbalanced growth process in China. But as even the most exuberant of China bulls now recognize, China’s economic growth is slowing and I expect it to decline a lot more in the next few years.
Third, and more importantly, as China’s economy rebalances towards a much more sustainable form of growth, this will automatically make Chinese growth much less commodity intensive. It doesn’t matter whether you agree or disagree with my expectations of further economic slowing. Even if China is miraculously able to regain growth rates of 10-11% annually, a rebalancing economy will demand much less in the way of hard commodities.
And fourth, surging Chinese hard commodity purchases in the past few years supplied not just growing domestic needs but also rapidly growing inventory. The result is that inventory levels in China are much too high to support what growth in demand there will be over the next few years, and I expect Chinese in some cases to be net sellers, not net buyers, of a number of commodities.
This combination of factors – rising supply, dropping demand, and lots of inventory to work off – all but guarantee that the prices of hard commodities will collapse. I expect that certain commodities, like copper, will drop by 50% or more in the next two to three years.
Not everyone agrees. In the July 2 issue of this newsletter I made a reference to a book by Dambisa Moyo, a former investment banker turned economic writer, called Winner Take All, in which the author argues that the world is facing a crisis in the form of a commodity shortage. According to a recent review in the Guardian,
If Moyo’s calculations are correct, we are in big trouble – which makes the central premise of her book, Winner Takes All, all the more arresting. Governments across the world, she writes, have singularly failed to grasp what’s coming – with one sensational exception. “Simply put, the Chinese are on a global shopping spree.” State-sponsored Chinese corporations are busy buying up commodities across Africa, North America, the Middle East, South America – anywhere they can – in a concerted strategy to seize control of resources before the rest of the world wakes up to the looming crisis.
They’re striking deals with what she calls the “axis of the unloved” – developing countries rich in commodities but poor in political and economic capital – in return for much needed investment, employment and infrastructure. Extravagant shoppers, the Chinese are happy to pay over the odds, treating their trading partners not as poverty-ridden charity cases nor political pariahs but valued commercial equals.
But when the resources begin to run dry, the consequences will be catastrophic. Already, since 1990 at least 18 violent conflicts worldwide have been triggered by competition for resources. If nothing is done now, warns Moyo, commodity wars on a terrifying scale are all but inevitable.
As I have written before, whatever you might think about the argument that commodity prices are headed up, stockpiling commodities and buying commodity-production facilities abroad is nonetheless a poor liability management strategy for China. Chinese growth and global commodity prices are driven by the same set of factors – high commodity prices are the result primarily of high levels of Chinese investment, which have also been the source of high Chinese growth – and when China stockpiles commodities it automatically exacerbates volatility in an already-very-volatile economy.
When China is doing well and growing quickly, commodity prices are likely to rise on surging Chinese demand, and so the value of long commodity positions will rise. This will reinforce an already strong domestic economy by giving Chinese manufacturers relatively “cheap” commodities. When China slows down, however, commodity prices will tend to drop, forcing losses onto manufacturers and speculators just when the country has less ability to absorb them.
Large-scale Chinese stockpiling, in other words, is highly pro-cyclical, and in my reading of economic history (I discuss this extensively in my book, The Volatility Machine) it is high debt and highly pro-cyclical mechanisms embedded into a developing country’s balance sheet that condemn most developing countries to long-term poverty. They do better than expected during the boom, of course, thanks to these pro-cyclical mechanisms, but when the inevitable slow-down occurs, the economy necessarily does much worse than expected, and financial distress costs typically soar. These financial distress costs can affect the economy for years after the crisis has resolved itself.
Are rising commodity prices inevitable?
If Moyo is right, however, and the world over the next few decades is characterized by steadily rising commodity prices and geopolitical maneuvering to gain greater access to production, the liability management issues will be viewed by most analysts as irrelevant (it is hard to tell someone who has won the lottery, after all, that buying lottery tickets is a bad investment). It is only if commodity prices are uncertain that the structure of the balance sheet matters – which means that it always matters, but during the global growth periods it often seems not to matter.
On the other hand if commodity prices are expected to drop, China’s stockpiling of commodities is then not only a risky balance sheet strategy, it is also a bad speculative bet, and here is where I differ sharply with Moyo. Unlike her, I expect the price of hard commodities and certain industry-related soft commodities (like rubber) to drop, not rise, in the next three years, and to stay low for many years thereafter.
I should point out that my argument relates mainly to hard commodities. I am less certain about energy-related commodities, because the dynamics there are complex and include political considerations that are hard to predict, but – especially given the potential energy explosion in the US – if I had to bet I would bet that energy prices, too, will drop sharply in the coming years.
On the other hand agricultural commodities, or more specifically food commodities, may buck the trend. If China is able to rebalance its economy in an orderly way, investment growth will slow sharply, but still-high household income and consumption growth should drop only a little. If we combine this with household income growth in other poor Asian countries, especially in India, I expect demand for food might grow for many years.
Which way can prices go?
For these reasons I am very pessimistic about hard commodity prices and expect them to drop substantially further in the next two to three years.
1. Production capacity for hard commodities is rising much too quickly, in a belated response to the unexpected surge in demand just under a decade ago.
2. Expected economic growth rates in the country that has been biggest source of new demand – virtually the only source – have fallen sharply and commodity prices have fallen with them. Historical precedents and the arithmetic of rebalancing suggest, however, that the current consensus for medium-term Chinese growth is still too optimistic. Expected growth rates will almost certainly fall further in the next two years.
3. Beijing has finally become serious about rebalancing China’s economy, and rebalancing means shifting Chinese growth away from being disproportionately commodity intensive. Instead of representing 30-60% of global demand for most hard commodities, Chinese demand will shift to a more “normal” level. Remember that even a very limited shift – from 50% of global demand, for example, to a still high 40% of global demand – represents a sharp drop in global demand.
4. There has been so much stockpiling of commodities and finished goods with implicit commodity content in China that the country could well become a net seller, and not net a buyer, of a wide variety of commodities in the next few years.
This is going to come as a shock to many people. In my discussions with senior officials in the commodity sectors in Brazil, Australia, Peru, Chile and even Indonesia, it seems to me that many analysts have been insufficiently skeptical about the Chinese growth model and are unaware of how dramatically the consensus has changed in the past two years. They have failed to understand how deep China’s structural problems are and how worried Beijing has become (this worry may be best exemplified by the extraordinary growth in flight capital from China since early 2010).
Under these conditions I don’t see how we can avoid a very nasty two or three years ahead for commodity producers. This isn’t all bad news, of course. What will be a disaster for hard commodity producers will be great news for companies and countries that are commodity users or importers. One way or the other, however, we are going see a big change in the distribution of winners and losers.