Commodity rally adds to manufacturers' worry

While the sharp rise in raw material prices since June has increased their input costs, they might not be able to pass on the burden to consumers

After a long slump, commodity prices have started to rally once again. While higher spending by the US on infrastructure and the stabilising Chinese economy have fuelled the rally in certain commodities such as zinc and coal, which have shown a sharp V-shaped recovery, prices of other commodities are also picking up.

So far this financial year, the Baltic freight index, a measure of shipping costs, has nearly tripled; coking coal prices have more than doubled; iron ore on the London Metal Exchange is up 13 per cent; and the Bloomberg World Basic Raw Material Index is up nearly 12 per cent.

Apart from the revival in demand, the correction in the supply-demand imbalance following the closure of several mines during the slump is also aiding the rally.

Is the rally here to stay?

Satish Pai, managing director, Hindalco Industries, says, “The worst is over for both copper and aluminium. In fact, mines have started to hedge future production at higher prices, especially in aluminium.”

Most base metals reached the bottom either in Q4 2015 or Q1 2016. Copper was the last metal to show a turnaround but it has now entered an up-cycle as well.

“One of the most important drivers is obviously China’s economy looking far more stable now. But also investors (fund houses) are coming back to commodities in a broad way as they look for portfolio diversification and recognise that the bear market is over,” says Andrew Cole, principal metals analyst, Metal Bulletin Research.

The only exceptions to this uptrend are gold and silver. “Base metal prices benefited from the election of Donald Trump as the US president, given his keenness on spending $1trillion on infrastructure spending over the next 10 years. In his victory speech, the president-elect stated, ‘We are going to fix our inner cities, and rebuild our highways, bridges, tunnels, airports, schools, hospitals’,” says Burnand Dahdah, metal analyst with London-based Natixis Corporate & Investment Banking. According to him, over the next two years, base metal prices will continue to rise.

However, the trend for some commodities may be short-lived. Coking coal prices have zoomed to over $300 per tonne from $110 per tonne a few months ago. As a result, a lot of latent capacity in the US has become active, leading to higher shipments of the commodity across the globe.

“Since more latent capacities in the US are turning active, the current spurt is expected to be short-lived and prices may soon move downwards,” says an industry analyst.

The sharp rise in coking coal prices may have a short-term impact on earnings of steel producers as well, which are among the key consumers of coking coal.

“As long as coking coal prices remain high, the upside will have to be passed on to steel prices,” says Ranjan Sinha, director (raw material procurement), Tata Steel. “This, however, may be only for a quarter; once coking coal prices start to fall, the same will be reflected in steel prices as the latter has 75 per cent co-relation with coking coal.”

Passing on the cost burden to consumers, however, won’t be easy for steelmakers. Globally, there is still an overcapacity and only a cut of about 200 million tonnes by China could bring in some respite to the industry, say experts.

While India continues to be a bright spot in terms of potential demand (given its low per capita consumption of 68 kg as against global the average of 218 kg, there is ample scope for the industry to grow), the actual demand for steel is still to pick up in a big way as growth is yet to return to the infrastructure sector.

“Our order books have doubled in the last one year but projects are not kicking off. It should take another six to nine months for demand to pick up,” says Ajit Shenoy, general manager (procurement), Hindustan Construction.

Auto, cement, paints and FMCG companies too may have to absorb the higher prices of raw materials themselves.

Dharmesh Mehta, MD & CEO, Axis Capital, says, “Many business-to-consumer companies in India benefited in the last one and a half years from lower commodity prices as they did not pass on lower costs to consumers fully. Most prominent ones are the auto, cement, paint, and FMCG sectors. These are likely to get hurt particularly if the demand is weak, limiting their ability to raise prices.”

However, he adds the demonetisation drive could prove beneficial for commodities in the long run if the government decides to spend the extra cash it has collected from people on infrastructure.

Reviving closed mines

Despite the turnaround in commodities, miners are not rushing into reopening mines that were shut during the slowdown.  Pai of Hindalco says the upside in aluminium prices will be capped once the Chinese start to close or open capacities to regulate supply.

Closed capacities could come in only if the rally lasts. Cole of Metal Bulletin says, “If these rallies stick, we are likely to see more mine restarts. But there is a sense right now that prices have run too high, too fast. So first let’s see where they find support when the pull-back comes.”

Investors too are moving cautiously as the market grapples with the after-effects of the demonetisation drive and foreign fund exits in the wake of rate hike fears in the US. Investors want to factor in these issues in the commodity price rally before they make up their mind.

Tom Albanese, CEO of Vedanta Resources, says, “Commodity prices have recovered from the lows of earlier this year, but they are, for the most part, well below the prices seen three to five years ago. Chinese economic growth has significantly slowed from what we saw a few years ago, and new supply resulted in oil, iron ore, copper and aluminium seeing lagging price performance.”