Easing cost pressures on commodity producers
(John Kemp is a Reuters columnist. The opinions expressed are his own)
LONDON (Reuters) – As the economic outlook darkens, and speculative interest in commodities and other risk assets wanes, prices have fallen back from the upper part of the trading range set by fundamentals, and the market is now hunting for the floor set by supply-side cost structures and producer strategies.
Two points are especially important to note. The first is that on the way up, prices for oil and other commodities were pushed far above levels that could have been sustained in the longer-term. Substantial demand destruction was already evident at prices above $100 a barrel, let alone above $130.
In the short term, demand destruction was limited by the delays and costs of changing products and processes to promote conservation and the use of substitutes. If prices had settled at this level for any length of time, however, far more demand would have been lost. Consumers would have had much more opportunity to adapt behaviour and consumption patterns to maximise substitution and conservation opportunities.
In the short-term, the influx of investment money drove prices far above their medium-term sustainable level. But as some of that investment money leaves the market, there is a risk prices will fall below their medium-term sustainable level on the way down.
There is no reason why prices for crude oil and other raw materials could not fall to the level required to force shut-ins of production dictated by operating costs — significantly below the level needed to attract new investment into the industry in the medium term.
Just because development of high-cost Canadian syncrudes might require prices above $80 a barrel in the medium term to bring capacity onstream, it does not mean that prices could not fall to $45-$50 first in the short-term.
The second point is that commodity production costs are strongly cyclical. Commodity producers are among the most intensive consumers of other commodities. Mines, oil refineries, petrochemical plants and smelters are all massive large users of steel, alloys, diesel, electricity and gas.
According to the U.S. Bureau of Economic Analysis, commodity producers accounted for 8 of the 12 most intensive users of natural gas in the United States in 2002, and 8 of the 12 most intensive users of electricity.
In a bitter twist, commodity producers have therefore been among the biggest victims of the upsurge in commodity-driven inflation worldwide over the last five years.
To take just a few examples: rising iron ore prices have pushed up costs for steelmakers and shipbuilders, in turn raising freight charges, which themselves account for more than half the landed price of coal and iron ore.
Increasing energy prices (and subsidies) fuelled the surge in biofuels, raising prices for grains, and ultimately boosting demand for natural gas to make fertilisers. Rising gas and energy prices have filtered back into higher costs for aluminium smelters, steelmakers and shipping companies.
Like businesses and workers futilely pushing for relative price and wage increases during a wage-inflation spiral, the commodity sector has been locked in a cycle of escalating prices and costs that has been partially self-defeating.
Making matters worse, the commodity boom was accompanied by a sharp rise in producer currencies, such as the Australian and New Zealand dollar and the South African rand, as booming economies attracted capital and rising inflation and real interest rates attracted even more hot-money inflows. Surging exchange rates for commodity prices added even more to cost pressures.
BHP Billiton reports that cost-inflation (+$2.1 billion) together with adverse exchange rate changes as producer currencies rose (+$2.8 billion) added more to its cost base between 2003 and 2008 than increased higher usage linked to increased output alone (+$3.7 billion).
Saudi Arabia has blamed the massive cost-overrun on developing its new Khursaniyah field in part on surging costs for steel. Commodity-driven inflation has had an even more severe impact on other firms and producers.
On the way up, escalating commodity prices and costs steadily increased the floor of the feasible price band. But as commodity prices ease, producers will be among the largest beneficiaries. Industry costs for everything from diesel and power to construction steel and skilled workers should decline.
Long-term price analysis needs to account for these strong cyclical effects on industry costs.
Modern forecasters do not have a monopoly on mistakes. Economists spent much of the 1920s fretting future gold supply would not be sufficient to support monetary growth and the expansion of the world economy during the next decade.
In the event, the Great Depression cut money demand. But it also sharply reduced production costs and resulted in a much faster expansion of gold output than had seemed possible 10 years earlier under higher cost assumptions.
It is counter-intuitive, but escalating commodity inflation ultimately had a negative impact on commodity supply-growth over the last five years. On the way down, falling prices could now have much less of a negative impact than many analysts expect if they help reduce operating and construction costs.
Just as commodity-driven inflation raised the range of feasible prices for a whole range of industries, it should lower production costs, increase supply and lead to a lower feasible range as prices ebb.
Cost curves for a range of mining and oilfield developments need to be re-examined in the light of lower prices for energy and construction materials.
There is a tendency to examine supply and demand fundamentals one commodity at a time. But given the extensive linkages between them — on the supply side as a result of costs as much as on the demand side as a result of substitution — a more integrated approach is necessary to avoid repeating previous forecasting errors.