When will the commodities rally end?

By David Taylor

This time last year BHP Billiton was trying to reassure the world that it was doing everything it could to help the people of Brazil to recover from the collapse of its tailings dam at Samarco.

It was also dealing with a collapse in the price of its key product – iron ore.

This year, the focus has shifted entirely. Early last week BHP revealed a $4.17 billion profit, and a big increase in its dividend, in its half year earnings report. There was just a small reference in the ASX release about what the company had achieved in terms of its mop-up in Brazil.

The turnaround in the price of iron ore has been remarkable and it’s taken many by surprise. Moreover, forecasting when the commodities party will end has essentially turned in to a guessing game.

Also read: Debt risks too high for rate cuts – RBA

BHP is not alone

BHP Billiton is not the only company enjoying a surprise lift in the price of its key product. Rio Tinto and Fortescue metals have also ridden the bull market.

Even a quick glance at the 5 year stock market price charts for all three companies shows a virtual U-turn over the past 12 months.

Fortescue CEO, Andrew ‘Twiggy’ Forrest, has also seen his personal wealth explode once more. He was the richest person in Australia in 2008, but then fell way back when the markets went sour. He is now (as of 2016) back in the top 10 richest, according to BRW magazine.

The increases in the prices of iron ore and coal have had real, tangible flow-on affects for both shareholders and entrepreneurs.

Great news for the government?

So let’s be clear, what we’ve seen over the past 12 months is both a lift in the prices Australian companies receive for the iron ore and coal they sell, but also a boost in how much they sell (production has been at record highs).

It’s produced a stellar run in the nation’s terms of trade performance over the summer. It’s a far cry from mid-2014. July 2014, the price of iron ore was in the middle of a worldwide sell-off. Commodities prices crashed, as did Australia’s terms of trade. Now it’s in surplus – to the tune of billions of dollars.

That’s very helpful for a government that’s currently trying to manage a structural deficit (too much money going out and not enough money coming in). The more money Australia can suck in from overseas, the more money should go into government coffers, and, ultimately, Australians’ hip pockets.

It’s not quite that straight forward though. Investment firm JP Morgan recently pointed out that many Australian mining export companies are largely foreign owned (sector around 80 per cent foreign owned). Which means any financial windfall they may have received over the summer, will ultimately go back offshore.

Also read: It’s back, the Nokia 3310

It was a different story during the height of the boom. Back then there was still plenty more upside to come, so the miners re-invested the extra cash into helping to expand their businesses. Now, it’s a case of take the extra profit and run!

To that extent, this latest boom in commodities prices will need to keep going for some time for the Australian government to benefit significantly.

China-inspired

So, what are the chances of this commodities rally running on, just a little bit longer?

I guess it entirely depends on the Chinese Communist Party. After all, they’re the ones pulling the strings.

In the past 12 months the Chinese government has thrown money at the country’s property market. That’s obviously generated demand for new houses and apartment buildings, and, of course, steel. The government has also shut down steel production, while pollution levels soar. The net result is that the price of iron ore (the main ingredient in steel) has rallied strongly.

From Australia’s perspective, there also seems to be more demand from China for higher-grade iron ore. Apparently it produces less pollution when it gets chucked into the production process.

So long as the Chinese can manipulate its steel production industry, and keep the stimulus coming, the longer the price of iron ore will rise, or at least hold its current levels.

Also read: Australia the world’s second-best equity market since 1900

Dodgy numbers

There are of course questions about the legitimacy and accuracy of the information we get from China.

In addition to that, we know that mums and dads – of all people – are driving the futures market for iron ore. That’s the market that’s meant to point to the future price of iron ore. It’s been hovering around the $100/tonne level. So even mums and dads in China are pinning their hopes on a continuation of this bull run. And, naturally, the spot (or underlying market) is actually following the futures market higher.

Outlook

I suspect, as do many investment banks, that this latest commodities rally will fizzle at some point later this year. It will coincide with slowing Chinese economic growth. There’s also the basic economic reality that you can’t just keep stimulating your economy indefinitely. At some point you have to pull back. Most analysts expect that pull-back isn’t far off.

One geopolitical issue everyone is watching is the possibility of a trade war between China and the United States. If that were to eventuate, I would expected commodities prices to crash, or correct at the very least.

A rising US dollar could hurt things too. The US dollar should be pushed up later this year by several increases in interest rates by the Federal Reserve. Commodities, including iron ore, are priced in US dollars. So if the value of the US dollar rises, commodities will be relatively more expensive, and demand may fall.

So far, though, another currency is telling the story – the Aussie dollar! Given interest rates in Australia remain at record lows, the relatively high Australian dollar (around 75 US cents), gives some credibility to the idea that the prices of iron ore and coal are going to stay elevated for at least the next little while.

The take home? The longer commodities prices stay elevated, the more beneficial for Australia… just not as beneficial as the last time around. And a time line? Literally anyone’s guess.

David Taylor