Are current commodity prices all about structural weakness?

With commodity prices falling below levels much lower than most have forecast, many have been willing to not only cut near term prices, but have changed views on the long term outlook for prices as well. The view across many commodities that prices are either going nowhere, or are likely to fall.

It is abundantly clear that there has been a structural shift in demand and supply across many commodities which means prices seen a few years ago are now a distant memory. 

But it seems unlikely that 100pc of the weakness in demand in many markets is being driven by factors which are structural, with the economic cycle also playing an important role. This has significant implications as to whether current prices will be persistent in the longer term.

Steel example

There has undoubtedly been an inflection point in Chinese steel demand from a structural perspective, with the rapid acceleration of steel intensive industry in China during the surge in growth in development in the last 10 years reaching a saturation point.





This slowdown is compounded by the more limited rates of growth in other parts of the Chinese economy. In investment, housing construction and credit have become very large relative to the whole economy, which stifles the rate of development over the coming decade.

But it also needs to be recognized that at least part of the weakness was a deliberate attempt to cool very strong markets.

While it seems like an eternity ago now, Chinese steel production, housing construction and prices were growing extremely strongly, with "shadow credit" markets also posing financial risks.




Policymakers deliberately cooled this aspect of the economy by raising interest rates, tightening lending measures and creating blockages on certain types of lending.

Much of these policy measures are being reversed and are starting to have an impact. Housing prices have risen in tier one cities and are stabilizing in elsewhere. Property sales have picked up markedly, helping to reduce inventory. Money supply is rising and credit growth has improved. Credit outstanding in shadow financing sectors has been stable rather than contracting and creating a credit crunch.

These developments should ultimately support Chinese housing construction, which is currently falling at around 20pc. While a small bounce would leave construction levels below the previous peak, it would still remove a large drag on steel demand at present.

To be sure, many have rushed to call the peak in Chinese and global steel demand now that it is declining. But this is at least in part by deliberate policy which is now being reversed. And while a small increase in steel consumption in China from current levels would still leave it below the previous peak, it would nevertheless be an important inflection point for markets.

Coal and power example

There has also been a growing consensus that the decline in  Chinese coal demand is a permanent condition based on improvements in energy efficiency and a growing shift away from coal in the power mix. This is compounded by environmental considerations and the renewed global push to reduce carbon emissions, with China more progressive on this front than many previously would have anticipated.

We don't dispute that these are key factors impacting the market, but its unlikely that these structural factors 100pc responsible for the weakness in coal consumption. The reasoning is similar reasons to the steel example, with cyclical factors also having a large impact on power demand via heavy industry.

Its also likely that continued displacement of coal in the power mix will be more difficult in coming years than it was in 2015. Weaker hydro conditions have seen hydro generation fall in the past few months, with additional capacity in this sector starting to slow sharply after the boom in the past 5 years.

Wind generation capacity is growing incredibly quickly, but in aggregate is thus far proving to be very inefficient. The ramp up in nuclear generation maybe tougher given the slowdown in project development in 2011/12.

Even a small improvement in power demand could have a sizable impact on coal burn given coal is still about 70pc of the generation mix. This level of coal burn maybe lower than peak levels, but this can still push prices higher if supply is contracting and inventories are low enough. We think both of these conditions are currently true.

Small changes in demand can make a big impact on prices when supply is shrinking

For some markets it may not matter if demand improves a little if supply growth is still strong. Iron ore seems to be an example in the space given projects that are still to come even though prices have fallen so far.

But even a small change in demand can be important for those commodities for which low prices have crimped supply.  A clearer example, however, appears to metallurgical coal, where supply within China and in seaborne market is shrinking. 

Seaborne coal markets have the extra complexity of increased regulatory measures to support local producers and reducing imports, which have fallen much faster than Chinese demand. But even if Chinese imports are smaller, we think arbitrage pricing will play a central role in determining global prices. So far, there hasn't been a lot of evidence that policymaker measures have created a widening divide between domestic and international prices.

Don't forget about inventory!

Stronger demand can always be met by consuming inventory, with little implication for prices if they are much higher than usual levels that are kept through the supply chain. In the case of both thermal and metallurgical coal, it doesn't look like high inventories will be a problem if demand shows strong signs of growth.

Chinese thermal coal markets in particular have seen a large degree of destocking that doesn't get much airtime as the structural market concerns. Inventory at key mines, power plants and ports, is considerably lower than this time last year. This has historically helped push prices higher, although so far this has only kept prices steady.


Not forecasting a price boom, but upside can still be considerable

Prices for many commodities could easily rise 10pc to 20pc in the next 12 months. Given how far they have fallen just in the last few months, this would still be below levels seen 12 months ago.

This kind of price bounce may challenge the increasingly negative views about long term prices that have developed over the past few months. While these projections could ultimately prove to be correct, we question whether there has been enough of a structural shift in markets in the last 3 months to justify such a large change in longer term views.