The jig is up for Australia. The crash is underway. It’s not like anything we’ve seen before and so it is kind of disguised but it’s happening nonetheless.
Mining and energy are being destroyed before our very eyes. It’s a structural adjustment that is eating up all of our policy support before we can even get to the next broader cyclical shakeout. When that hit comes, and it will arrive some time in the next year or two, the next phase will be housing and the services economy following mining into the abyss.
The contemporary Australian economy is basically the story of three booms: iron ore, LNG and house prices. Through the millennium we enjoyed a housing boom that filled out consumer spending. It was ready to crash in 2003 with historically high household debt ratios and would have done so had not the second boom arrived in time to save it.
The iron ore boom that began in 2003 was one of the most extraordinary dumps of unexpected cash on any economy in history. From 2003 to 2011 the iron ore price rose 1300% while the cost of producing it only tripled.
We went from making a slim margin on iron ore at $14 to eight years later selling the stuff for $180 per tonne at margins around 500%. It flooded Australia with cash, flooded households with income, flooded governments with tax receipts and flooded stock markets with profits.
The iron ore boom back-filled the national housing bubble through high immigration, huge income and rental gains. In effect, it inflated away high house prices. Except the iron ore income boom was so big that the housing bubble itself re-inflated before long accompanied by a massive share market boom.
That all hit a brick wall in the GFC but only momentarily. Iron ore quickly took off again and, more importantly for the future, the LNG boom arrived. It was the export boom we needed to fill an iron ore boom that couldn’t last forever. As iron ore topped out and income began to drain away, an enormous round of gas investment filled the gap and promised another future income boom. This one was an entirely new industry that would offer the external support to our now addicted habit of borrowing offshore to fund large house price increases.
The triple boom has been a nearly unbelievable run of good fortune; consecutive, feeding and supporting one another in perfect synergy.
But. Such a long boom, let alone three of them, always ends with the mother of all hangovers as malinvestment accumulates. We’re well into the hangover for iron ore and that is now quickly spreading to LNG.
Iron ore may be stable around $50, with RIO and BHP still making ludicrous mark-ups of 60-70%, but it is on its way back to $25 and low margins in the next 18 months. Many uneconomic miners and mines are yet to close. All share prices are going to be gutted. Everyone above FMG on the cost curve is doomed. FMG itself will be restructured and probably cease to exist in the long run. Inevitably, volume cuts will move down the cost curve with the price, denuding Australia of GDP. The job losses will be very large. Already impressive share market losses will turn huge as low cost producers are inexorably drawn into the rout. Tax revenue will disappear into thin air forever.
The iron ore story is well understood and, although not yet fully priced, is well on its way. What is new and less well understood is that the LNG boom, the nation’s future, is now swiftly going the same way.
In some ways the accelerating shakeout for LNG is better than iron ore because its plants won’t close like mines. But the malinvestment is, if anything, even larger. The entire QLD LNG boom should never have happened. With all-in break even costs upwards of $13mmBtu (Brent oil $86) the firms that own them will never see a return on capital invested. Marginal or cash costs are much lower owing to the up front capital expense, downwards from $7mmBtu, but these still place the projects at the top of the global cost curve.
The marine projects in WA and NT are cheaper and better place but not by much. The inside word is that they are far more over budget than acknowledged, pushing them up towards the QLD projects on the cost curve. Australia’s largest foreign investor, Chevron, is being bled dry by Gorgon and Wheatstone. It is rationalising projects all over the world in part to finish these monster projects before they wreck its financials. Partners on the projects are rumoured to be fire-walling it.
The oil price upon which these firms depend to set selling prices appears on its way to $40. The oil glut is very large and will take years not months to work off. Moreover, the US shale revolution has capped any sustained rebound at $60 for now. Forward curves now have oil at $65 out to 2020 and that will fall further. Shale will deplete but not until the mid 2020s and by then the broader energy revolution in renewables for electricity grids and the rise of electric cars will combine to overrun oil demand.
As well and perhaps even worse long term, the LNG price will only remain linked to oil so long as its price remains suppressed. The LNG glut is itself is even bigger than in the oil market. If the oil price rebounds pressure will immediately mount from customers to renegotiate LNG contract terms. There’ll be face-saving agreements but the terms will break. That’s capitalism, especially Chinese capitalism, which is where much of the new demand for the projects is supposed to come from. Woodside is currently projecting 14% annual demand growth in Chinese demand for LNG, yet this year it is down 5%. A much more realistic outlook is 5% annual growth as China rebalances away from, and reduces the energy intensity of, its GDP.
In short, the price assumptions upon which the Australian and especially QLD LNG booms were built are collapsing.
A massive restructuring of the Gladstone LNG miracle is needed, indeed has started, with first Arrow cancelled then QCLNG sold off with British Gas. The next shoe is dropping as we speak with weak balance sheet firms seeing their equity destroyed. STO will cease to exist. ORG may as well but at minimum will require restructuring. New owners will eventually emerge but with prices lower for longer there’s no income ahead for Australia and less volume growth as well a lower than expected net exports contribution to GDP. The job losses are already enormous and only one third through. There will be no new projects and tax revenues will eventuate only far into future.
So, our past commodities boom in iron ore is reverting to mean. Our future commodities boom in LNG is turning to ash. Yet so far we’ve held up more generally. Australia’s unusually high interest rate price deck has fallen to historic lows and unleashed the last great leg in the Australian house price inflation. Even as our external sectors crash, domestic sectors are booming.
But don’t be comforted. The boom is only happening because we’ve nearly exhausted the primary support to the high household debt that makes housing inflation possible. Interest rates are at just 2%. They will keep falling as the twin mining booms implode and will be near or under 1% before we even reach the next cyclical shock. Thus there will be next-to-nothing left in the can to support crushed household sentiment when the next global shock comes.
Fiscal policy is slightly better but not much. Australia will never see a Budget surplus again (or for so long that it might as well be). Iron ore revenue is on its way to zero for several years. LNG revenue will only arrive far into the future and at far lower levels than projected. Net debt-to-GDP is sliding inexorably towards the 30% threshold that will trigger sovereign downgrades. They will likely come at the worst possible time, during the next global shock, preventing the meager rate cuts left from be passed on to households as bank funding spreads rise.
And so it is time to go to cash. It is time to sit back and watch the final months of Australia’s good fortune drain away. We never know when the end-of-cycle shock comes. It could be tomorrow or it could be two years away yet. It’s obvious enough that it will come through some combination of US monetary tightening and a share market bust, a Chinese and emerging markets crash and a European recession but the exact course of events and when we can’t know.
But, given the huge structural impairments now obvious in Australia’s commodity producing sectors, which constitute two thirds of Australia’s export income, aiming to be precise about it is foolish. When it does come it will be such a monumental reset for Australian assets that there is no upside in playing brinkmanship with it. This is what hedge funds call asymmetric risk.
When the next shock comes it will rewrite our economy, our politics, our social assumptions and self-image. It will re-write our history in a seemingly interminable reckoning that will be as deep as 1991 but as long as the 1980’s malaise. Our dreams of exceptionalism will burn until we’re finally able to compete with the world again. The earning’s season failure of industrial dollar-exposed firms to capitalise on currency weakness is a hint of hard this is going to be.
This is not the cycle to be caught long at the death, even if that means missing out on some gains for a little while. Sell rallies on stocks. Sell excess properties. Get long, long duration fixed interest. Set your medium term shorts. Get money out of Australian dollars.
Build your war chest. The opportunities will be historic.
