Rather than emerging market urbanisation and economic growth, the commodity super-cycle had its genesis in the prior under-investment in global productive capacity. The boom in emerging markets and particularly Chinese growth merely acted as the catalyst for demand exceeding supply. As investors clamoured to get a piece of the commodity action and re-allocate to an otherwise forgotten asset class, owners of productive capacity were able to finally grow the supply base. Notwithstanding this and the weakening of emerging market growth, commodity prices remain today at levels similar to those seen in 2006/2007 as they have been supported by an extremely low interest rate environment and an associated weak US dollar. Next year though the Fed will probably raise interest rates for the first time since 2006. This will have profound negative implications for the commodity markets.
To better understand the scale of investment in productive capacity we looked at samples of some of the largest listed international oil and gas producers, miners and agricultural companies.1 From the table below, the scale of increase in investment in productive capacity in recent years is clear, with collective capex in the eight years from 2007 to 2014 dwarfing that of the previous thirteen years. In particular the mining sector has seen a two and a half fold increase against a mere doubling in oil & gas and agricultural capex.
Table 1: Collective capex by major companies in each sector
Source: Argonaut, September 2014
The problem facing these companies now is how do they get the best return on their investment? Remember it has taken management many years to bring these projects on stream and today’s environment is arguably significantly different to when these investment decisions were first made. No doubt there was in-built conservatism in the financial models, but the problem is that the bedrock that had underpinned the commodity markets for the first decade of this century – the lack of investment in productive capacity – is no longer there.
The imminent rise in US interest rates could well be the catalyst which unleashes this productive capacity as producers push through greater volumes in order to lower their unit costs in the face of declining commodity prices. And commodity prices will decline as rising interest rates incentivise extraction today rather than tomorrow (due to a higher opportunity cost of leaving it in the ground) as well as increasing the cost of carry (cost of holding inventories). Undoubtedly rising US rates will also put upside pressure on the US Dollar, further pressuring commodity prices.
This fall in commodity prices, quite naturally will have a knock-on effect for commodity equipment and service companies who have also over the years increased their capacity (and thus fixed cost base) to service the growing demand from their clients – tractor and combine manufacturers have built new plants, oil rig operators have expanded their fleets and engineering companies have recruited more engineers. However in a climate of falling commodity prices, with producers focusing more on eking out a return on their investment rather than expanding capacity, demand for these products is waning and likely to fall further.
Like their clients, service companies face a similar dilemma - either close capacity (and benefit their competitors) or take lower prices in order to cover fixed costs. Either scenario though results in lower earnings. This negative environment is already unfolding, as earnings expectations for service companies are being revised down significantly. The table below illustrates this for a sample of commodity service companies.2
Table 2: Average change in full year earnings estimates for a sample of service companies
Source: Argonaut, September 2014
Many companies though across the commodity spectrum remain in denial and are reluctant to be proactive in managing their cost base for a prolonged downturn or tempering their earnings outlook. The mantra of emerging market urbanisation and demographic growth trends remains core to their sales pitch. The fundamentals though have changed – massive investment has led to a significant rise of global production capacity, meaning it is unlikely that demand will meaningfully exceed supply. As commodity production is an operationally geared business model with high fixed costs, producers will have to increase volumes to stay in business, further depressing prices and eventually leading to production closure and consequent evaporation in demand for service products – completing the cycle, in what has always been a cyclical business.
1 Companies included in the samples:
- Oil & Gas Producers: Exxon, BP, ENI, Total, Royal Dutch Shell, Chevron
- Mining: Rio Tinto, BHP, Vale, Freeport-McMoRan, Anglo America, Nemont, Barrick Gold
- Agriculture: Agrium, CF Industries, Potash Corp, K+S, Archer-Daniels-Midland, Tyson Foods
2 Companies included in the samples:
- Oil & Gas Rig Operators: Transocean, Diamond Offshore
- Oil & Gas Engineers: Technip, Saipem
- Mining Services: Outotec, Sandvik
- Agricultural Equipment: Deere, Agco
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