Commodities hoarding no sign of a turnaround
Sluggish prices drive unforeseen consequences
Canadian investors did pretty well during the rising tide of commodities prices a decade ago, but they are looking for signs of hope these days. With the S&P/ TSX energy index down 20 per cent on the year, and the metals and mining index down by nearly a quarter, they could certainly use one or two.
Maybe investors can simply put their faith in the adage that the cure for low prices is low prices.
What’s supposed to happen is that low prices will discourage production and encourage consumption. That will raise prices, eventually. Then demand will inevitably wane in response and producers will overdo production, as they always do. Prices will decline again. It’s the cycle. Rinse and repeat.
Unfortunately, we are not seeing many signs of the cyclical uptick. Prices remain in the toilet, and that’s driving some unforeseen consequences in commodities markets.
There might be many reasons for this, but a big one is China. To see how, look no further than the recent performance of the Baltic Dry Index. OK, maybe a little further. The London-based BDI reflects the price charged to move stuff — specifically, “dry” stuff such as iron ore and corn — along the 23 shipping routes the index tracks. Some have long viewed the BDI as a leading indicator for global trade and economic growth, since it can reflect demand for the raw materials that are used to produce the economic output measured later by trailing indicators like GDP.
The BDI was in the doldrums for much of this year, even hitting a historic low in February, but the tide has recently turned.
Since early June, the index has risen by an astonishing 85 per cent, approaching levels not seen since last December — before the Organization of the Petroleum Exporting Countries put the boots to oil prices by refusing to cut production.
Shipping costs are subject to the law of supply and demand. Shipping companies have scrapped a bunch of vessels, which has lowered capacity and supported prices. But that’s only part of the reason for the BDI’s rise. The other big part is more shipments to China.
A sign that the sputtering Chinese industrial engine has been given a jump-start? Well, don’t get too excited.
For instance, massive imports of corn in June — up from year-ago levels by a factor of 30 — are reportedly one factor in the increased shipping activity to China. That’s because the Chinese government, which tightly controls grain supply and production, is buying a whole bunch of kernel-y goodness from Ukraine, which was responsible for more than 85 per cent of corn imports to China in the first half of the year.
Why Ukraine? In part, analysts say, for political and security reasons — more specifically, to decrease reliance on the West. Stability of corn supply is a political issue in China, mostly because it is used to feed pigs, a major food source.
But what’s worrisome is that China is buying up corn not to use it, per se, but to stockpile it. According to the U.S. Department of Agriculture, China has by far the world’s biggest corn reserves at 77 million tons. The government also subsidizes Chinese farmers bigtime.
All that buying, storing and subsidizing gets expensive, and some analysts are predicting that China will want to off-load its reserves. If it does, that will put further down- ward pressure on prices.
A similar stockpiling is occurring in oil. In April, China overtook the U.S. as the world’s largest importer of crude, and June’s imports of more than seven million barrels were up 27 per cent from May.
Why is China buying so much oil when its economy is foundering? In large part, analysts say, to take advantage of low prices and fill up its strategic reserves — and new storage facilities are set to open next quarter.
The trouble with all this hoarding is that it tends to delay a price rebound when or if global (i.e., Chinese) demand recovers. That’s not good news for commodities investors.
A similar dynamic is in effect in iron, though with different results. Prices of iron ore shipped to Qingdao have risen by 25 per cent since July 8. In effect, Chinese steel producers have taken advantage of low prices and gone on a buying spree. Great news, eh? Not so much. With domestic demand falling as the economy slows, Chinese steel producers have been forced to ship it elsewhere: steel exports were up more than 25 per cent in the first half. That’s flooded the global market and lowered prices, putting huge pressure on international producers, who have accused the Chinese of dumping.
But it also puts pressure on the Chinese steel mills, whose profit margins, according to Goldman Sachs, have fallen into negative territory. That makes it unlikely that increased demand for iron ore can last very long, barring a surprise recovery in China’s economy.
This is not to pick on Chinese steel producers. It’s not their job to salvage the global economy. But investors should be cautious when looking for signs of a recovery, particularly when it comes to commodities.
These are unusual times, and not all signs point in the right direction.