I believe John Redwood recently said that it was odd that commodity prices have been falling while Chinese demand has been steadily rising as forecast. As their economy turns more to retail consumption, the demand for consumer products and energy which drive the commodity markets has been rising as China is definitely the elephant in the room in terms of its influence on global demand.
An article in the Daily Telegraph by Ian McVeigh on Friday (28/8/2015) explains this conundrum, with a particular focus on mining companies. He points out that over the period of 2003 to 2015 (that of the commodity boom or “supercycle”), mining company shares actually managed to underperform the FTSE AllShare by 39%. He calls it a “dismal outcome for investors”.
Why was that? Hubristic mergers and excessive capital investment are his answers and he is no doubt right. Commodity prices did actually rise during most of that period but the large miners geared up with high amounts of debt to develop mega projects. These drove massive increases in production capacity which resulted in the current position where there is more production than there is demand, and hence declining commodity prices. The impact on the profits of these companies has been even more severe.
Mining is a typical “boom and bust” economic market. It’s like the economics of farming we all studied at school. When prices are high, or forecast to be high, then farmers invest in more sheep, cattle or land development. Two years later there is then a bust when the investment comes into production and prices collapse. This was of course the reason given for food price stabilisation measures such as the Common Agricultural Policy to protect farmers from their own enthusiasm. Let us hope that the miners do not argue for the same.
But for investors, or the directors of mining and oil companies, what should be examined very carefully is whether capital investment projects, particularly those financed by debt, will get a decent return even in the bad times. The time delays on bringing new mines or oil wells into production are larger than those in farming so the boom and bust cycle tends to be bigger and more extended in time.
BHP Billiton, who recently announced their annual results, demonstrates exactly the problems explained above. Earnings per share down 86% and return on assets now a measly 6.4%. Debt is now over $32 billion. Needless to say they are now cutting back on capital expenditure. But they have still increased their dividend slightly so they now yield over 7%HoHow. However analysts are still forecasting a further fall in profits next year, so investors need to take a view on how long it will take for the cycle to fully unwind and production capacity to be taken out of service. Unfortunately when commodity prices fall there is a tendency to increase production to ensure the sunk costs are recovered and correction only really happens when a few producers go bust.
Roger Lawson
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