A capital equipment supplier to a cyclical industry is almost always more cyclical than the cyclical industry itself. Bearish on commodities? Short CAT.
At the Ira Sohn conference yesterday, Stanley Druckenmiller put forth an extremely bearish view on commodities. As we understand it, his thesis is driven by increasing commodity supply and reduced Chinese fixed asset investment. We in no way claim to be as smart, savvy or good-looking as Mr. Druckenmiller, but we do agree with much of his commodity thesis.
In our March 2013 Mining & Construction Equipment black book, we highlighted an environment that appeared weak for commodity prices and downright terrible for resource-related capital investment. The data do point to a very negative commodity price environment, but even flat commodity pricing would likely result in large declines in commodity-related capital investment. Importantly, these are not short-term headwinds, but are rather multi-year, largely unavoidable negatives.
A key conclusion is that resource-related capital investment – the key end-market for CAT, KMTUY, Sandvik, JOY and others – is likely to drop by approximately 50%-80% in the next few years (and stay there), not the 10%-20% expected by most bearish forecasts. Mining and other resource-related capital spending, in aggregate, will not rebound back above 2012 levels this decade, let alone in 2014 or 2015, in our analysis.
We highlighted four drivers for the enormous price gains through 2011 that now appear to be reversing:
- Under investment in the decade prior now met with over investment
- Slowing Chinese fixed asset investment growth
- Financial demand from investors, which can be subject to performance chasing
- Easy monetary policy, which is at the whim of unelected central planners
Outlier Price Gains Attract Outlier Supply Growth
Looking at real copper prices, the five year gains by 2010 and 2011 were the highest in over a century. The gains even exceeded the transition from the Great Depression to World War II.
Not surprisingly, these gains have attracted what we estimate to be the most copper supply growth of the post-war period. Most of it will come on line in the next few years because it takes 5-10 years to get a mine up and running.
And the cash cost of the expected new production is far below current spot prices.
While the charts above may not say much about copper prices over the next few weeks or months, the outlook for the next few years appears poor.
The over-investment in commodity production goes well beyond copper. By mass, iron ore has no doubt seen, and will continue to see, the most supply growth. In the last ~12 years, iron ore prices increased by ~1,000%. Really, that isn’t a typo. Iron ore went from being a “rock” to a “commodity” and a Brazilian iron ore company went from being “CVRD” to “Vale.” If it were not for the Indian production removed from the seaborne market by a series of Indian Supreme Court decisions, among other factors, iron ore would likely be in vast oversupply.
Rapid capital investment growth can also be seen in the energy sector, as high oil prices, among other factors, attracted investment in new supply. (h/t Kevin Kaiser, Hedgeye Energy)
Already In Oversupply
The judging by the growth total exchange inventories, many of these metal markets are already in over supply before much of the new production comes on stream. If this continues, it is not good for CAT mining truck orders and it is not a factor that can reverse quickly.
Chinese Fixed Asset Investment Slowing
Chinese fixed asset investment (FAI) is slowing. The binge in FAI – a key factor that drove commodity prices higher – appears unable to continue at previous rates for a number of reasons. We have already witnessed slowing growth and have hosts two excellent expert calls on Chinese financial and environmental regulation. There is also excellent work here by Darius Dale on the Hedgeye Macro team.
Critically, mining and resource expansion plans have come to rely on high levels of FAI demand growth from China, just as it appears to be drying up. Rapid Chinese FAI growth was initially met with skepticism, but is now a standard assumption in metal demand forecasts.
“Then again, there is scope for China’s economy to slow down from 2003’s frenetic pace and still achieve relatively high growth rates. The consensus is for an 8% growth in GDP, with a shift in the composition of growth away from investment towards consumption.” - David Humphreys, Chief Economist, Rio Tinto, 2/4/2004
Investors have had a very significant demand impact on a number of commodities. In around 2001, it generally believed that the negative carry of gold in a portfolio was not worth its diversification benefits. Five years later, following a period of very strong returns, commodities had become an “asset class.” The problem is that commodities do tend to decline in real terms over time because the technology to produce commodities generally improves.
“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” - Warren Buffett
Gold might be an okay short-term inflation hedge, but it is likely a terrible long-term one, at least from current levels. In the long-term, gold will price at its marginal cost of production. Said differently, if a buyer can dig it out of the ground for $800, he is not going to pay you $1400 for it. For new Canadian gold mines, for example, that is actually the cost.
The other huge problem for gold is that demand is currently dominated by investors and central banks. Around one-half of the gold is bought for financial reasons, a far higher ratio than 10 years ago. If investors and central banks just stopped buying gold (let alone sold) one-half of gold demand would disappear. That scenario would push marginal demand way down the marginal supply cost curve and probably yield a gold price in the $600-$800 dollar range. The success of a current long gold position looks dependent on the continued purchases of performance chasing capital allocators. If prices start to decline, as they have been, the risk of a reflexive tumble appears significant.
The gold supply and consumption table is useful, too.
If 10Y Treasuries were yielding 12% in the current inflation environment, we would bet that gold and other commodity holdings would look much less tolerable to investors. Negative real rates on shorter-term low risk government debt definitely lower the opportunity cost bar for commodity holdings. Experimental monetary policy has no doubt stoked investor fears of inflation, also driving further allocations. In China and other countries, monetary policy has been used as a tool to stimulate investment in commodity intensive areas of the economy. A weak dollar, the product of US monetary policy, also has a straight-forward impact on commodity prices.
Many excellent analyses of the impact on monetary policy on commodity prices have been put out by the Hedgeye Macro team (a top Q4 2012 Macro Theme, and they would probably note that timing matters). They have also raised an important point: with the job market improving at a fast clip, what happens when unemployment hits the fed’s 6.5% trigger level? It seems likely that, at the margin, some of the easy monetary policy supporting commodity prices would be removed. It is also likely to be dollar positive.
Rapidly growing supply, slackening investor demand, slowing Chinese FAI and marginally less accommodative monetary policy all seem poised to pressure commodity prices in coming years. Even flat commodity prices can be a significant negative for resource-related capital investment. The prospect of large, multi-year declines in resources-related capital spending leave us convinced that, long term, CAT is both a value trap and short opportunity.