Commodities react like a canary in a coal mine

Commodities are suffering from a negative sector sentiment, independent of supply and demand dynamics. This is largely because concerns about Europe and the US getting trapped into recession and Chinese President Xi Jinping's ability to steer the country's economy into soft landing refuse to go away. No doubt commodities will be the first in the line of price collapse if recession hits the world. That is why Vedanta Resources chief executive officer Tom Albanese loves to describe the "commodities sector as a canary in a coal mine".

Albanese doesn't think global recession will happen. But, the thought of demand could take a hit is leading people to cut their commodities exposure. "Look at the statistics on institutional investors or long-only institutional ownership of commodities --they are the lowest in 30 years."

The US dollar, the currency of choice for foreign exchange transactions and trade, gained in strength in the past two years as economies of other countries, including China, faced headwinds. That has worked to the disadvantage of commodities.

As far as supply and demand goes, the galvanising material zinc, used to rustproof a host of things from cars to building materials, perhaps offers the most ideal balance among all commodities. Even then, driven more by negative sentiments than any rise in stocks and Chinese demand fall, zinc prices were down to their lowest since June 2010 in the third week of September 2015. Albanese describes the phenomenon as "fear of the unknown" with no linkages to fundamentals. Now as the fundamentals are coming into play, there is recovery in zinc prices.

Why zinc alone? "All commodities are doing better than they were three months ago. But, they are all worse than they were 12 months before," he says. Rerating of commodities has begun. Each commodity has its unique fundamentals, more on the supply side than on demand account, according to Albanese.

As for iron ore, a combination of new supply torrents, mainly from Australia's Pilbara region and Brazil and a slowdown in steel production along with capacity shaving in China brought the benchmark grade 62 per cent iron (fe) content material to shouting distance of all-time lows in the final week of November. A fall of that kind from a record high of $190 a tonne in February 2011, according to Albanese, hit the "fringe" iron ore businesses in China and West Africa "particularly hard." This also shrank profits of the mining giants in a big way from iron ore business.

But, they did not respond by cutting production, for that would have allowed smaller producers to benefit from likely improvement in prices and thereby avoid bankruptcies. But, new capital commitments by the giants have slowed down. Even then, earlier sanctioned mines development programmes will equip the likes of Vale, Rio Tinto and BHP Billiton with considerable new capacity.

The recent improvement in ore prices, which has come as a pleasant surprise to producers, was largely due to the seasonal factor of mills in China building up stocks ahead of the construction season and weather issues in Australia and Brazil and partly because of industry leaders applying brakes on new capital commitments.

"Iron ore producers should, however, be ready for lower prices in the near term, which may be caused by capacity expansions by big producers. Once expansions are complete, the flywheel starts spinning. It goes on and on. It will be value-destructive to stop that flywheel," says Albanese. Chinese supply-side reaction to price falls has been by way of mines closure and significant ore production curtailment. Restructuring of China's steel sector, a euphemism for large uneconomic capacity elimination, will lead to further fall in domestic ore production. Like last year, China's steel production and consumption will once again shrink in 2016.

"Seaborne iron ore will, therefore, have a higher share of China's use of the material this year," says Albanese. This will not, however, help India which had already lost the plot because of the high export duty New Delhi had earlier put on both lump ore and fines to placate the complaining steelmakers. India's ore exports slid from 117 million tonnes (mt) in 2009-10 to about 5 mt in 2015-16. In this year's Budget, the government wisely did away with export duty on fines and lumps with fe content below 58 per cent. Market abhors vacuum. "Australian producers were quick to pick up the slot India had vacated. India appears to have permanently lost the share of global iron ore market it had a few years ago," says Albanese.