As every good miner and economist knows, commodity producers are price takers (you can count most recent Australians out on that). The iron law of the resources business over the long term is the lowest marginal tonne of production sets the price.
That truth is steadily returning to various commodity markets as the Chinese demand shock of the past decade subsides. That process is the first of the three forces that are driving the commodity super cycle to bust: the fundamentals of supply and demand as China slows and inelastic supply arrives too late. For iron ore, that is made worse by this, from The Australian:
J.P. Morgan equity strategist Paul Brunker notes that while the latest official data from China shows that over 20% of “iron mining and dressing” companies in China are loss-making, the discouraging part is that a substantial proportion of firms have been in the red all this year, underlining the slow reaction time of marginal capacity.
“For the major Australian miners, the exit of higher-cost Chinese production is the key to a stabilisation of the iron ore price – assuming that demand is at least a neutral factor,” he says. “With further supply growth coming from the low-cost producers, requiring even more withdrawal of inefficient players, it looks like a long slog for the iron ore price.”
The second force is the secular turn in the US dollar, which adds a monetary downside to commodity prices.
The third is shifts in commodity financialisation, in both greater and lesser ways. The first is the definaincialistion of commodities that I have described at length previously, picked up by Bartho today:
One of the developments in markets over the past decade and a half — but particularly in the post-crisis period since 2008 — has been the emergence of purely financial players in commodity markets, fuelled by the extraordinary availability of extremely cheap credit as a result of the unconventional monetary policies pursued by the US, Europe and Japan since 2008.
Whether it is hedge funds establishing carry trades, exchange-traded commodity funds offering investors direct exposures to commodities they might otherwise not be able to obtain, or Chinese businesses using commodity inventories as collateral to get access to finance, there’s been a major increase in financial and speculative activity in commodity markets.
…If there is an implosion occurring within the financial overlay in the market that causes prices to over-shoot, that’s also likely to contribute to the bringing forward of the point at which those prices begin to stabilise at their new, much lower, post-boom levels as the speculative froth is blown away and the fundamentals reassert themselves through a better balance of supply and demand.
That’s exactly right. Most of these finaincailisaed plays were nothing more than sophisticated hoarding.
But for iron ore, it has actually been the reverse, with a shift towards financialisation that has brought it undone. Reuters picks a up theme of my own today in examining the link between Dalian iron ore futures and falling prices:
A halving in the price of iron ore this year has been fuelled in part by Chinese speculators who built up huge short positions on the one-year-old futures contract on the Dalian exchange, in the process giving China the pricing power it has long craved.
…”Many short positions were built up as a hedging strategy between the equity index and iron ore or rebar (a steel product), which is also new to me,” said an iron ore trader in Singapore, adding that the funds had tended to buy equity index futures and short one or two other futures contracts.
…To cement Dalian’s influence, Chinese authorities may have to let foreign players participate.
“If China wants to be a price maker, clearly they would need producers to support Dalian futures and the contract dollar-denominated to attract international investors,” said Hynes.
The Dalian exchange seems to be aware of this.
In a bid to develop a futures product with global pricing power, it said in a recent statement, it “will introduce qualified foreign investors to increase its global influence through bonded delivery of iron ore”.
This is classic futures market in action, allowing buyers and sellers to hedge positions well in advance of what are obvious further price falls. Dalian is currently pricing iron ore for physical delivery in May in the low $60s. I expect by May, it’ll be $50. Physical prices are now fastened to its movements daily.
Although it hurts Australia this time, in terms of market dynamics, this is a market clearing just as it should. If only China would let go its iron ore mines as well!
