Interesting exchange of posts at the GaveKal forum...
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As you probably know, seaborne coal prices have exploded upwards. Oil prices are still high. Grain prices appear poised to move higher. The inflationary implications for china are quite bleak.
China can’t do what India did (i.e. let rupee spike 30% vs USD in 1 year) b/c that would kill the manufacturing sector. They can’t really tighten by trying to cool aggregate demand because of the growth implications. I find it extremely scary that they are backed into a corner with few plausible policy alternatives. Assuming coal and oil prices stay strong (see below comment re: copper, a lot of which applies to coal and oil), what will they do? How do you see this playing out? Which equity sectors (both in the US and in china) will benefit or suffer?
Also, I just have few comments regarding metals—this is actually a rehash of a similar theme that I wrote to you a couple of months ago: with commodities, we're largely in a new paradigm, where the factors focus primarily on inelastic supply which responds to noneconomic factors (some of which are so twisted to act in the diametric opposite direction of supply/demand). This is utterly different than what we have experienced in the last 2 decades in metals markets. While copper may have had a 'PhD" in the 80s and 90s in a world of (very) elastic supply, it will flunk grade 1 in the coming years.
For example, it is clear that OECD growth is slowing. The OECD directly or indirectly (via purchases of Chinese manufacturing goods) consume a boatload of copper. For all the China hoopla out there, a lot of China’s copper "consumption" gets re-exported (trying to estimate how much is a hair-pulling exercise given breadth and diversity of country’s manufacturing export sector). My point is that if copper had a Phd, it would be a lot more sensitive to OECD economic results, and its price would be approaching marginal production cost right now (at $2/lb). But it is not.
And yet copper may be about to spike, even as a) Chinese demand slows and b) world production "grows"(or is projected to, anyways). The reasons are simple:
1) Cost inflation (both on capital and operating)—you can say, yes but the copper boom is in its 4th year; can’t companies increase production of capital goods? While, yes, Caterpillar can increase its capacity for manufacturing new 797 trucks for use in Chile, neither Caterpillar nor anyone else for that matter can increase "production" of experienced engineers. For the last 2 decades, mining has been a dead-end career. SO this is not surprising. Lack of human capital, unfortunately, is not a problem that can be resolved with $$ alone—it takes time.
2) It is no longer a free market: capital equipment costs have exploded in mining. In a free market, competition will theoretically enter the lucrative mining equipment space and help lower capital costs (other than that due to human component). But again, 2 decades of neglect has meant that bankruptcy/consolidation has molded the tattered remnants of this industry into a monopolistic/oligopolistic structure, which is incapable and unwilling to respond rapidly to demand. Take sagmills (key to grinding rock, etc.). There are only 2 companies with the expertise to take on construction of such projects. Both are in Finland. Both have multi-year backlogs. Or giant shovels (indispensable to open pit operations in coal, copper, iron ore, the oil sands, etc.). There are 2 as well-they’re both in Milwaukee. And they’re both sold out for the next 3-4 years. Yes they’re increasing capacity, but since both were in chap 11 as late as in the early 2000s, they’re doing so cautiously. While you can deal with extra costs eventually, it’s the delays that are really supportive of the metal price. Your project can’t come on-stream unless the Finnish finish your grind circuit, and P&H delivers your mining fleet. And if either is late, there’s no other physical recourse but to wait (politely) and delay commissioning.
3) Rising operational costs—5 years ago, no one had operational costs above 75 cents/lb. Now the highest cost producers are easily approaching $2/lb (excluding operational costs of capital to finance a new project), there are multiple parties in the mid $1 range. This is due to the combo of: 1) headgrades are declining at major mines, there are seeing all kinds of construction pressures: steel costs more, diesel costs more, experienced labor, productivity, parts shortages...you get my point. Plus, much of this has to do with the foll fact:
4) The failure of exploration—You may ask, wouldn’t higher prices incentivize more exploration? The answer is yes, absolutely. World mining exploration budgets have been growing at 50%/year. But as one major mining CEO said in a recent conference call: "We have spent $20 billion as an industry over last 2 years, and failed to find a single new significant deposit".
However, the good news is that there are significant existing, undeveloped deposits. In fact there are currently 2 deposits, each with enough metal to potentially supply the entire world for 2 years, which are under "development"—sort of. One is facing title disputes and another is facing outright confiscation. This brings us to the next problem:
5) Labor disruptions and resource nationalism—enough said. For example, the 2 aforementioned deposits are in Mongolia and the Congo. And when one country imposes windfall profits taxes, its neighbors are under extreme political pressure to "follow suit", less "foreigners steal their natural resources". Windfall taxes take much of the high price incentive away from encouraging new production. Just like governments, the labor unions also want their cut. Knowing perfectly what the supply/demand for experienced work is, they’ll walk off the job for extended periods of time to get what they want (Note the strikes at codelco, bhp, teck, southern peru, etc.).
5b) The law of increasing political risk: this is something I have formulated myself. Historically, let us assume the world’s mineral deposits are distributed randomly, independent of political and economic stability. The politically/economically stable places get explored first; deposits there get developed and exploited first for obvious reasons. Only then do you face the conundrum of whether to a) go to the jurisdictionally risky but higher-quality deposits, or develop the higher cost, marginal riffraff sights that remain, without jurisdictional risk, but that, in "normal" mkt conditions, would be uneconomical. This has happened in just about every commodity sector in the last 50-100 years. And ties in with 4), since new deposit finds tend to worsen in quality over time.
6) NIMBY. Ok, you decided to deal with 5b by going to a safe place to develop a large marginal deposit, like Alaska. All of a sudden, you realize that your project requires 2 tailings dams that each are bigger than 3 gorges and filled with reservoirs full of sludge, located in a scenic area. And it is no wonder that your neighbors, whom are fishermen or work in tourism related industries, don’t particularly welcome the prospect of having you as a neighbor. So, while the US will likely never tax your copper like Zambia will, unlike Zambia, you may find it impossible to get an environmental permit.
So if you’re a mining company, you’ve got to wonder what to do next. Yes, your mines are spewing out cash flow, because they were built 10 years ago, but operational costs are rising rapidly. And the mines have a finite reserve life. Developing new projects doesn’t make sense because you face points 1-6 mentioned above, which even at today’s copper price will render your mine potentially uneconomical on a risk-adjusted basis. So you either buyback stock or engage in M&A, because one flawed development project can make you look silly and put you "in play".
Yes, there were are a slew of juniors coming in to take your place, but they all face these issues and a lot of them won’t make it to the finish line in time to respond to mounting demand.
Seeing all of the above, I can easily understand why global production is struggling to catch up with demand. In fact, in the midst of a US-led slowdown and seasonally low demand from China (being winter there, construction activity is slower than usual) copper inventories are once again plummeting (!), not increasing.
Posted By : Louis Gave - 2/6/2008 5:19 PM
Thanks for taking the time to pen the below. All your points make a lot of sense and correspond to a large degree to what I am hearing from all of my family members who work in energy in Oklahoma. Undeniably, the biggest constraints today to further production of raw materials are: a) people, b) environmental rules which prevent digging/drilling, c) equipment, etc… I take all that and I think this explains to a large degree why prices today are so far above the cost of production and not coming down. There are bottle-necks all over the place.
On a side note, I am not sure that the same bottlenecks apply to agriculture. While it takes many years to get an oilfield, nuclear plant or copper mine on stream, one can boost the productivity of existing fields decently quickly, especially if one is willing to go down the genetically modified route. Now I realize that we in the Western World don’t want anything to do with “Frankenstein foods” but I am not convinced that China/India/Indonesia etc… will not make that jump when facing higher prices/food shortages. Don’t get me wrong, I am not saying that softs are about to plummet. They look technically strong and have no short-term reasons to crater. But it is harder to believe in the “super cycle” for softs, given that bringing more softs online is not that hard….
Now unto your main point: What will be the Chinese policy response to the growing threat of higher commodity prices?
I think the first remark here should be that there are only two (types of commodities that really matter for China: 1) Energy (whether oil, gas, coal…) and 2) softs. Although, another one that sort of matters is iron-ore.
Of course, china would rather that the copper, nickel and tin prices were low but if they are not, that’s not the end of the world for them. After all, how much copper, tin or nickel does the average Chinese consume a day? Meanwhile, China’s thirst for energy remains strong, as does its need for iron-ore to build out the infrastructure it needs to be the power it wants to be.
So the question at hand is: How is China going to deal with higher food prices, higher energy prices and higher iron-ore prices?
I think the answers here are multiple, but before I go into them, I will lay my cards on the table: I do not share your view that things are very scary for China and that the policymakers are backed into a corner with few plausible policy measures. In fact, China has lots of options:
Option #1: China can use some of its geo-political weight.
Continue to use its vast reserves to purchase commodity producers (note today’s news on Rio Tinto) or improve the infrastructure in commodity producing countries so as to provide itself with better access to raw materials (note all the money that China is plowing into Africa, but also the investments it is making on the agricultural side in the Philippines, etc…). On that idea, it has to be noted that China is plowing money into Myanmar and that Burma was once Asia’s “rice basket” before the socialist policies of the military regime reduced the country to a walking dead. So one easy way for China to partially solve some of its food issues is to modernize the farming industry of Myanmar and tell the generals there to shape up. I believe that this is starting to happen now that food prices are high (there was no real incentive for China to do so before).
Option #2: Massive infrastructure spending.
As you know, this has been one of our themes for a long time. Basically, China’s distribution costs are still massive. As is the waste (on softs) inherent in an inefficient transportation system. Consequently, one easy way for China to deal with the growing inflation” is to target the “friction costs”. Needless to say, this is what China is doing by building roads, ports, airports etc… Of course, this takes time, but by 2010, China’s road construction exercise will be getting close to done. And the dividends across the overall economy should start to accumulate.
Incidentally, the recent storms mean that the leadership will only accelerate this trend of massive infrastructure spending, if only to make sure that, should next winter be bad, they are not accused of having done nothing to prevent a repeat of the panic and suffering we have been witnessing for the past fortnight.
Option #3: Allow for a currency appreciation.
Here, I disagree with you that China cannot afford to revalue. In fact, I tend to believe that the low level of the RMB is one of the major market distorting factors out there… and the markets don’t like to be distorted. But how can the markets force China’s hand? The only answer is by pushing up energy and food prices. Nothing else will force China to revalue. So sure enough, this is what is happening.
Undeniably, China can only revalue so much without crushing its manufacturers. But having said that, China’s producers adapt very fast. I’ll be honest: If five years ago you would have told me that commodities were going to rise 5x and that china’s manufacturers would not only survive but do very well, I would have thought that you were nuts. Yet here we are. These guys adapt to the new conditions very quickly.
The other reality of course is that China is in a unique space in the developing world in terms of manufacturing. If China revalues 15%, will this stop Wal-mart from producing in China? Where else will they go? Vietnam? Sri Lanka? None of these places have the infrastructure necessary to take the kind of orders that China churns out.
So anyway, unto the meat of your question which is: which equity sectors will benefit? As I see it, these are the trends that we can bank on:
a) China infrastructure spending will continue to accelerate in the coming quarters
b) The revaluation of the Asian currencies has just started. This means that real rates around Asia should continue to fall to even lower levels. Higher currencies + lower real rates is usually a potent combo for real estate.
c) China will likely continue to use its cash hoard to win access to commodities. This may not mean stock-piling of “stuff” but instead buying producers and investing in the infrastructure it needs to get the “stuff” to its factories (from ports, rail etc… to spending in Africa and across Asia)
I think you want to remain very overweight Asian local consumption plays, Chinese real estate and OECD exporters that sell to Asia.
Posted By : Anonymous client - 2/6/2008 5:20 PM
In response to your claim that softs are not facing the same constraints as metals:
If anything, the softs face worse constraints than mining. (Note that I used copper in my email as an illustration, it’s obvious that when it comes to inflation, base metals are a rounding error in terms of overall influence). And the resource scarcity issue is real, in terms of arable farm land, which has been dramatically shrinking (in both the US and in China). Furthermore, a huge chunk of US output is dependent on the ever-depleting aquifers which cannot be replaced. While there is land in the Mato Grosso in brazil for example, expanding involves the same logistical nightmares confronting the miners (and possibly worse, since you'd be burning down rainforest for the sake of soybeans). You face the same situation when going into say Zambia.
The fact that people in mining worldwide and that oil and gas folk in Oklahoma (and some in Calgary) all face the same shortages leads to one unifying conclusion: The non-OECD block's sudden growth has pushed the world resource sector past the breaking point. The latter cannot cope with 7-10% non-OECD growth going forward, it simply cannot generate the amount of raw material supply that such growth requires, and at no time in the next 5-10 years will it be able to do so, given the dynamics that we discussed.
And as in all functional markets, supply rationing leads to skyrocketing prices until an equilibrium point is reached. Such an equilibrium point involves significant demand destruction in the form of slower growth. So, to come back to an earlier point that I made to you and Ahmad back in December: Going forward, commodity supply will dictate the pace of growth in non-OECD countries, not vice versa.
Your options for China to solve short-term inflation may be plausible in 5-10 years time (and possibly longer), but for now they do not solve the problem at all. Throwing money at the problem doesn’t accelerate things—physical constraints are physical constraints. The common theme in all of them is that they take too much time—time that China does not have, since inflation is already running near 10% even as coal/food/oil prices are "frozen".
RMB appreciation is already accelerating (it’s going at 16% annualized recently) but one has to wonder whether it really makes a dent. Take coal for example: Currently domestic prices in China ($75/t) are about half what they are globally (i.e., on a cif basis in Japan/Korea).
So the RMB will have to go up by a factor of two to mitigate the impact of coal price inflation if they decide to "suck it up" and pay global prices. The alternative is supply shortages which forcibly lead to an economic output cut if they insist on artificially fixing prices.
And in regards to your infrastructure investments remarks: They take too much time. Building a railroad/port takes years; they need solutions that they can apply in weeks.
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