In December last year the iron ore price sank to below US$40 per metric tonne, a price not seen since 2005. Two years earlier, in December 2013, the price was approaching $140 per tonne. The boom in the price of this commodity was mostly driven by Chinese steel demand and as that demand slowed, the price collapsed.
At the close of 2015 a few analysts forecasted the iron ore price hitting US$50 in 2016; the Australian government reportedly based budget projections on a 2016 price averaging US$39 per tonne. This is what happened to the price.
The 18.6 per cent one day spike in the price of iron ore represents the highest upward move ever recorded. So what happened?
On 12 January 2016 the price of U.S. West Texas Intermediate crude oil fell below $30 per barrel; a price not seen since 2003. A few days later on 20 January the world standard Brent Crude joined the rout, also dipping below $30 per barrel with a low of $27.29. Predictably this fall unleased a horde of analysts baying at the moon like a pack of wild dogs warning of $20 dollar oil and even $10 dollar oil. Bearish sentiment enveloped markets in a renewed frenzy of selling. It is now 11 March and here is what has happened since.
As of 10 March US time, the price of a barrel of oil had clawed its way above $40 per barrel.
In a totally rational world the answer would lie in the law of supply and demand. As you know, what happened to drive down the price of both these commodities was too much supply chasing too little demand. The rational response from commodity producers to diminishing demand would be to cut back on production, reducing supply and stabilising prices. Unfortunately, rationality has a way of taking a back seat to the prospect of bountiful profits from commodity prices at their peak. Production ramps up and who needs to worry about cost control in the face of all that money to be made. The current response appears startling and irrational. Producers have not only refused to cut back, most are digging and drilling at record levels.
So in the case of both oil and iron ore one could assume the recent increases in price are due to some shift in the supply/demand equation. Either the supply is dropping or the demand is increasing, right?
Oil tankers are still parked in ports around the world, loaded with crude. Storage facilities everywhere are brimming with oil. Fuel efficient cars are increasing, not decreasing, and there is no evidence oil demand will increase enough to begin sopping up the excess supply anytime soon.
So what happened to the price of oil? The rout began when OPEC, led by Saudi Arabia, balked at the idea of cutting production to stabilize the falling price back in November 2014, something they had done routinely in the past. Once the undisputed king of oil production, Saudi Arabia now faces increasing competition from US Shale Oil producers. In one of the most remarkable technological advancements in history, the ability to extract oil from shale rock formations has catapulted the US into the world’s leading oil producer, by some measures. The Saudis have a vested financial interest in reducing US oil output, an inevitable result, they felt, of lower prices.
US Shale producers have learnt to extract more oil from existing wells at much lower costs rather than bringing new wells on line. While total production is down, it is still higher than estimated. Iran is ready to get back in the game and the Saudis are still pumping. Demand has not risen nor has supply fallen.
What has happened is a shift in investor sentiment due to continual speculation producers will reach some kind of agreement to cut production. The latest speculation blossomed following a statement from a Kuwaiti official stating the government would cut if other oil producers, including Iran, followed suit.
The world’s largest iron ore producers have cut costs to the point they can remain marginally profitable in the face of low prices. Producing at record levels is driving smaller players out of the market. If rumours about a reduction in supply fueled the rise in the price of oil, the dramatic spike in the price of iron ore resulted from speculation about a shift in the other side of the equation – increasing demand. The Chinese Finance Minister released a statement that China is ready to use deficit spending to boost economic growth. Here is what he said:
A rational person would look at that statement as nothing more than a claim that the country can handle a rising debt load. There does not appear to be anything in that statement to suggest the boost will come from a return to massive infrastructure projects that would increase the demand for steel. In the lack of hard details, the market is assuming something that may not be there.
In a quick response, analysts at US Investment Bank Goldman Sachs poured cold water on the speculative fires, claiming they see no “evidence of higher-than-expected steel demand – whether in the order books of individual steel producers or in the official data for new orders.”
Assuming a belief in the validity of the economic law of supply and demand, it certainly seems that irrational speculation about future conditions can lead investors to sell shares when they shouldn’t and stay away from shares when they should at least consider buying.
First let’s look at the price action since the recent low point in the price of iron ore and some forward looking earnings estimates for the top three ASX iron ore producers.
In response to the calamitous 15 December drop, the irrational investor inevitably follows the herd and sells the stock, only to see it register a healthy gain in a short time. In fact, as the following price chart comparing BHP and RIO shows, the share price of both took another dip when the price of oil crashed below the $30 mark. Here is the chart.
In contrast, the rational investor might rely more on the validity of the law of supply and demand and take the risk on one of these miners, knowing the share price could see another drop, as happened. The share price could drop again and probably will as the fall-off in earnings per share between FY 2015 and FY 2016 is reported. Notice however, that with the exception of Fortescue the two biggest miners are forecasted to see EPS increase in 2017 and in all cases a majority of analyst have revised their EPS forecasts upward for both 2016 and 2017.
The belief that in the long run a balance between supply and demand will lead to better days applies to the oil stocks as well. In both cases producers spent like madmen expanding production capability and exploring for new prospective sites, but no more. Capital expenditures are nowhere to be seen and production may still be high, but it is dwindling. In the US the number of operating oil rigs hit a five year low last October with analysts forecasting more reductions to come. Some of the breathless commentary on the state of the commodities market seems to imply the world will very soon no longer need another drop of oil or another piece of steel. Only a fool believes that to be the case.
The stage is set for a rebound and the only question is how long it will take the existing over-supply condition to correct. At that point the world will discover what is now obvious to some – investment in future production has ground to a halt and will ultimately lead to less supply.
Now here is the same set of numbers for three of the top oil and gas producers on the ASX.
There are market experts who feel the price of oil may begin to rebound at the close of 2016 and on into 2017. Note the healthy EPS growth forecasts for these three stocks between FY 2016 and FY 2017 – a 34% increase for Woodside; and a 63% increase for both Oil Search and Santos.