GLOBAL commodity prices have fallen more than 30% over the past year. The extent of the decline has taken most producers, governments and investors by surprise. Profits have fallen sharply.
In South Africa, many gold and platinum producers are now operating at a loss.
Across the globe, miners have scaled back planned expansions dramatically. The Financial Times reports that the last time investors were as negative about mining shares as they are now was in December 2008, at the start of the global financial crisis.
Commodity markets for the past century have been characterised by cycles of rising and falling prices. Yet the current fall in prices seems to have caught so many actors unawares because there was a near-universal belief that the rise in commodity prices since 2003 was part of a new "supercycle" where prices would rise steadily for decades. Sharply lower prices have challenged this belief.
The notion of a "supercycle" was based mainly on expectations that sustained rapid economic growth in China and India would drive dramatic growth in the demand for commodities. Analysts therefore rejected the traditional "boom and bust" view and predicted continuing commodity price increases for several decades. And they also forecast escalating profits for producers, especially those who could increase their production.
But rapid growth in demand is an insufficient reason for prices to rise. Higher prices are sustained only if supply grows more slowly than demand. Initially this was true for commodities. Nervous miners held back on investment, expecting price increases to be as short-lived as in previous cycles.
Moreover, capacity to expand production was limited as commodity producers had not generated sufficient capital for several decades prior to 2003 because of the continuing decline in commodity prices in real terms. Shortages of skilled engineers and needed mining machinery also put the brake on the development of viable prospects.
As a result, demand-driven commodity prices rose far higher than initially imagined. Unusually, prices rose across the board — from agricultural to precious metals prices. It seemed to some that the boom was unstoppable as almost all commodity prices reached previously unimaginable heights.
But booming price cycles contain the seeds of their own eventual destruction. High prices constrain demand growth because consumers seek alternative products and use essential commodities more economically, including recycling. At the same time, high prices encourage the development of more expensive new sources of production, resulting in increased output. Thus the high price of oil, for example, encouraged the use of more fuel-efficient motor vehicles and the development of alternative production sources, such as shale gas in the US, whose costs were uneconomic at lower oil prices.
From an initially sluggish rise in commodity production, eventually producers were investing hundreds of billions of dollars annually in new capacity. However, in time this rising supply produced surpluses in a number of markets, including platinum, copper and iron ore. Further investments will shortly come into production, increasing supply further. A forecast slowdown in the Chinese economy has now added to concerns about oversupply and prices are falling sharply as a result. While arguing that investors have overreacted and are now too pessimistic about mining shares, the Financial Times warns that "the era of rapidly rising prices is over".
Yet, while its growth is slowing, the Chinese economy is more than twice the size it was a decade ago. So growth in demand for commodities is still substantial. Moreover, even after their recent declines, commodity prices are much higher than they were a decade ago. The problem for producers is that their costs have soared over the past decade. High prices encouraged development of more costly and marginal ore bodies, often with high accompanying infrastructure costs. High profits encouraged workers to demand higher wages and governments sought a greater share of profits.
Because costs have risen dramatically, many producers are now making losses at current prices. Unless prices rise, cost cuts are inevitable for producers to remain viable. In many cases, cost reduction will require the closure of more costly production, including new facilities whose higher costs were thought to be viable at higher prices. This will mean lost jobs, lost exports and the writing off of billions of dollars of shareholder capital.
These new realities present particular challenges for South Africa. After the Marikana tragedy, there are expectations for mining to provide more generous offers in terms of wages, worker benefits and other social obligations. Public pronouncements and wage demands reflect perceptions that the industry is making super-profits, not that many mines are already making losses.
Narrowing the gap between harsh financial realities and inflated expectations requires imaginative leadership from all. Above all, unnecessary job and export losses must be avoided as the long-term costs of these for all of us will be very high indeed.
Written by: Gavin Keeton
• Keeton is with the economics department at Rhodes University. This article was published on Business Day.