Steel prices falling? ... Ospraie shuts flagship fund ... how far can commodites fall - what's Chinese for White Elephant?

Its Matthew's first day at school today - a big day indeed. Time just flies - is it really four years ago since he was born?! It could be worse ... one of my friend's friends recently became a grandpa. He's the first member of my cohort to be called that ...

... anyway, Arcelor cut Steel prices in South Africa. They stressed this wasn't a company wide policy and is only related to domestic mkt conditions in SA. But the international cycle is correlated indeed. Behavioural psychologists call it cognitive dissonance - when things are going well it's because you're great, when they're not, it's someone elses fault. So when the UK economy was booming it was because Gordon Brown was the iron chancellor. Now it's falling apart, it's because the economy is being buffeted by overwhelming global forces. When steel prices were rising, it was because the steel companies had consolidated and more disciplined at managing the cycle. Steel entrepeneurs said things like this:

“I can say with considerable certainty that the volatile years of boom and bust are now relegated to the past."  Lakshmi Mittal

Now we see signs that its started to turn there is instant denial that it can be anything other than one off and temporary factors ...

Needless to say, the widespread assumption is that the commodities "bubble" has now burst. Yesterday I was asked if I was still a believer in oil. In today's Bloomberg, there is an article looking at the five next bubble candidates (including banking!!). Meanwhile, GS are at the other end, and looking for an entry point into oil.

Would further falls mean the end of the secular boom? Posssibly, but I doubt it. Gold, for example, can fall another 30%, which would take close to $500/oz and be a roughly 50% correction from its recent all time high. But it did this in the mod 70s as it ran from $34 in 1971 to $850 in 1981. Was its 50% correction then an end to its secular move? No. Was the stock market crash of 1987 an end to the secular bull market in equities which peaked in 2000? No. And was the bond market rout of spring 1994 and end to the secular decline in yields which started in 1982? Again no. Can commodities fall any further and remain in a secular bull market? Oh yes.

How much further? Well, Nickel prices now look to be trading below marginal cost. We already saw XTA shutting down production on cost considerations. Now Asia's biggest producer, Jinchuan Group is considering soing the same, cutting production by 4% on weaker prices. We've seen similar shut downs  in zinc. So on "value" grounds (whatever "value" is for a commodity) there are signs that we're approaching. 

It's important to understand that there has been a step change in pricing for all commodtities. The marginal cost of US natural gas has risen to around $8 recently with extraction of expensive shale gas, that for oil around $75 with the increasing importance of unconventional oil like that from the tar sands. Meanwhile, farmers aren't making anything like the money you'd expect at current levels because of record fertiliser prices, themselves influenced by higher energy costs. 

During recessions, prices fall to below marginal cost. This one is unlikely to be any different. So be ready to buy at those prices, not the prices of previous recessions. Be prepared also, for everyone to have given up on the commodities story when you buy.

The problem though is that marginal costs can go down as well as up - there is always a high cost producer ready to shut down if demand and therefore prices fall below levels which are economic to that producer. And here, the big uncertainity is China. Its just not a case of if it hits the skids. Its a case of when. FAI of 50% is neither balanced or sustainable. Indeed, its very difficult to imagine investment at those levels representing anything like an efficient allocation of resources ... here is a disturbing annecdote on how ugly things might look in a downturn (because they always look great in an upturn).

http://www.thenational.ae/article/20080612/REVIEW/206990272/1042

Only a few years ago (2005) the South China Mall opened up as the world's biggest " ... a seven-million-square-foot retail-and-entertainment behemoth in the heart of China’s southern Pearl River Delta, the wealthiest region in a nation that boasts the world’s biggest population and its fastest-growing major economy." Today it is empty. 

Presumably, that mall was financed to some degree by bank debt. It's collateral for a loan sitting on a bank's book somewhere. But as the US/UK are reminding us, the ability of a bank to lend is only as good as the quality of its collateral. And from what we can see annecdotally, the South China Mall is hardly unique in its ostentatious wastefulness. I strongly recommend watching Paul Merton's tour of China for umpteen examples of how not to "invest" capital.

The commodities story, certainly on the metals, has been in large part one of Chinese industrialisation. But how much copper, alluminium, iron ore etc has been used to build White Elephants destined for the banking system's future NPL problem? I don't know. No one does. But that's how much of the surging metals demand we've seen is unsustainable and an investment to GDP ratio of 50% suggests it's quite a lot. That demand will disappear when the wheels fall off, which they inevitable will because they inevitably do. It won't be the end of the China story, or of the commodity story (largely because it won't be the end of the energy story). But it will be a painful few years indeed.