Wednesday, January 19, 2011

Iron ore and Australian house prices

In my previous post, we started to examine the million dollar question for Australia's economy today. How long will China's rapid growth and the commodity price boom last? We noted that while the arguments for continued growth in commodity demand from China appear fairly plausible, there are significant risks in the near term. And in actual fact, we've greatly understated the risks to Australia's terms of trade so far in this discussion, because we haven't even looked at what is happening on the supply side of commodities.  

Commodity Supply 101
The supply of commodities like iron ore or coal tends to be fairly "inelastic" -- or unresponsive -- to rising demand in the short run. This is because there are massive capital costs involved in expanding mining operations or exploiting new reserves. Unlike agricultural commodities like potatoes, the average punter can't just start digging up iron ore in the back yard and selling it on international markets.

What this means is that when you get a surge of demand in commodities, supply doesn't rise by much in the short term, so prices shoot through the roof and the miners make boatloads of money. But what history shows is that commodity prices repeat long cycles of boom and bust. When prices get high enough, miners eventually find it more economical to add new capacity and expand supply. There's generally a lag until this new supply hits the market, but when it does, prices inevitably cool down again. And that's exactly what we are likely to see over the next few years.

The chart below from Global Mining Investments illustrates the economics of this very well. This is the cost curve for various iron ore producers around the world. I'm focusing on iron ore because, along with coal, it's Australia's biggest export.

You can see that the big three of Rio Tinto, Vale and BHP Billiton can make money as long as prices stay above $30-40 a tonne, around $100 below the current market price. This is because the big three, who control around two thirds of the market, have access to some of the world's highest grade iron ore deposits -- places like the Pilbara in Western Australia and Carajas in Brazil. So it's no wonder they're making a killing. But as the price of iron ore keeps rising, it becomes economical for higher cost producers in places like India and China to start tapping their lower grade iron ore deposits.

Source: GMI

A Coming Iron-Ore Glut?
In fact, one recent report says there could be an enormous 685 million tonnes of new iron ore production capacity coming on stream between 2010 and 2012, which is roughly equal to what Australia and Brazil (the worlds two biggest producers) produced together in 2009. For a list of some of these projects, see here. Furthermore, China has been speeding up the exploitation of domestic deposits and buying up mines all over the world to help ease their dependence on the big three. From a recent article by Stephen Bartholomeusz in Business Spectator:
The notion of a prolonged ‘mother of all booms’ is ... not one that the big miners necessarily subscribe to. They are aware that the mid-sized and smaller iron ore and coal producers, after something of a hiatus during the crisis, are now scrambling to bring their production into the market. There will be big and continuing increases in supply to discipline the prices... Goldman Sachs’ resource analysts suggested earlier this week that the iron ore market could move into balance in 2013 and over-supply as early as 2014. Even if steel production in China continues to grow at current rates the market would still be in an over-supplied position by 2015, they said.
Meanwhile, iron ore spot prices continue to grind higher, and are currently approaching $180 a tonne. But a growing number of analysts are warning that this rise is unsustainable, and that a fall back well below $100 is inevitable in coming years. From another recent report in Barrons:
The fading outlook for iron ore is being driven by miners' investments in new projects and mine expansions around the world. But it is also being driven by China itself, whose flourishing steel industry, currently the world's largest iron-ore consumer, may soon be producing more steel scrap, thus reducing the need to import the ore.

"From 2015, we believe an additional industry dynamic will enter the fray: the increase in Chinese domestic scrap supplies," Credit Suisse analysts say. China's new construction and its growing consumption of metal-intensive products will provide additional fodder for domestic scrap. Worn-out cars, household appliances, construction beams and old railroad tracks—all can be melted down and put it into a furnace to produce new steel products.

"We expect prices to begin falling well below $100 a ton..." Credit Suisse says, referring to the period beyond 2015.
Let's quickly summarize. We can probably expect at least another decade or so of strong growth in commodity demand from China. China isn't going away in a hurry. But the miners all know this, and have been investing accordingly. Which means there is a huge amount of new commodity supply set to come on line in the next few years. Even if everything goes right and the very strong growth in Chinese metals demand continues, this additional supply is likely to send prices lower.

And this new supply will also be hitting the market at a time when some economists (read Michael Pettis, for example) believe China is running into some serious constraints in its growth model. If China was to hit a speedbump some time in the coming few years and fall into recession, there is a chance that commodity prices could collapse, with disastrous consequences for Australia. This is not necessarily a likely scenario, but it is a risk that we need to be mindful of, because Australia's economy is extremely vulnerable to such a potential shock, as we will examine a bit further below.

Australia: Living on Borrowed Time
Let's go full circle back to the terms of trade. Some of you might have read reports of a recent study by the IMF, which surprisingly concluded that Australian house prices were only mildly overvalued. The IMF argued that there were solid fundamental reasons for Australia having the most expensive property prices in the world. And one of the key reasons they cited is the massive rise in Australia's terms of trade.

You can see from the chart below that, indeed, inflation-adjusted house prices have basically increased in line with Australia's terms of trade over the past two decades.


This raises an obvious question. If you agree with the IMF's logic, doesn't this imply that house prices have to fall when the once in a generation boost to the terms of trade reverses?

Now, Australia's terms of trade has gone through long rises and falls over history without huge problems. And a decline in the terms of trade wouldn't necessarily have to be a big problem if Australia had invested the proceeds of the current boom productively. But instead, Australians have turbocharged the boom by taking on record levels of personal debt (see below), mainly to purchase houses. And the Australian banks are financing a good part of this mortgage debt not through deposits, but through a potentially unstable source of funding: the international bond markets.

So we are now left very highly leveraged, and the valuation of the biggest asset that most Australians own (their houses and investment properties) as well as their ability to service this debt (and the banks' willingness to keep extending credit) is dependent on the continuation of the commodity boom. The enormous level of personal debt means that many Australians today are highly vulnerable to potential shocks in the economy, whether from a slowdown in China, or from higher interest rates.

Source: Steve Keen

The chart below, from an excellent post at deflationite.com, shows just how unbalanced the Australian economy has become over the past two decades. You can see that in 1990, the majority of Australian bank lending was being channeled into business investment, or investment in Australia's future productive capacity. But over the past two decades, the portion of bank credit allocated to business investment has steadily shrunk.  In place of this, we have seen massive growth in property-related lending, to the point where one in seven Australians today owns one or more investment properties.


In essence, Australians have been behaving as if the commodity boom and the days of easy credit will last forever. Nobody can predict the timing, but they won't. Now, that doesn't have to mean disaster, but we're kidding ourselves if we think the adjustment is going to be easy.

As Warren Buffet once said, "It's only when the tide goes out that you learn who's been swimming naked."

18 comments:

  1. I quite enjoyed this analysis, except it doesn't seem to include the high probability of another energy crunch, as we saw in the run-up to the GFC in 2008, or even peak oil occurring in the next few years, as an increasing number of institutions are forecasting.

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  2. ff, this is indeed developing into a fine blog, congratulations, and thanks.

    @mercury4 - you may find this of interest:
    http://www.thenation.com/video/157441/peak-oil-and-changing-climate
    experts generally agree that we are post peak oil and if there were a spike in oil prices all bets are off!

    ReplyDelete
  3. Nice work. This is becoming one of my favourite blogs.

    ReplyDelete
  4. Australian house prices have grown in line with Australian debt for a long time. If you look at the chart of debt vs GDP alongside the house price chart here...

    Debt/GDP & House Prices

    ... it's very clear where the ramp-up in credit has been going. There's no doubt Australia is hurtling towards peak debt, and when the limit is hit then massive deleveraging is the only option. Remember, debt needs to increase for house prices to rise. Standing still isn't an option. It's like throwing a ball into the air, it goes up and up and up and for a brief second it stops (and that's when the spruikers will scream the loudest about new paradigms and permanently high plateaus) but then gravity wins in the end and it all comes crashing down. Australian house prices can't defy gravity forever. Debt and houses prices will fall, it's a matter of when, not if!

    ReplyDelete
  5. Excellent post, I agree entirely on the iron ore pricing and the housing analysis. Combined the China and housing stories are the two big vulnerabilities for Australia. If you don't mind I'll borrow that graphic on total credit.

    ReplyDelete
  6. @ anonymous

    Thanks for that link. I'm not entirely convinced that we are post-peak, would need to see at least 5 years of YOY declines to be sure - but that day is coming. Meanwhile, the bumpy plateau continues for conventional oil (crude+condensates) since 2004, which has been in a range 73.5 to 74.5 m bs p/d production since then.

    However, moving forward, stagnant oil supply growth, when it meets increasing demand can only result in vicious price spikes and a termination of any incipient economic recovery. This will be our short to medium term economic fate - rolling recessions, until such time as we finally fall off the bumpy plateau. Hang onto your hat after that.

    ReplyDelete
  7. Good analysis. The future of iron ore prices seems to depend on the cost profile of the new production. It's unlikely to be as low as the current low cost producers, since if that were the case the new production would have been exploited first. The other question is the extent to which growing Indian demand can offset slowing Chinese demand. The former Rio Tinto analyst quoted in the article you linked probably had as good a guess as any - down to $US100 by the end of this year, $US80-90 for most of the next decade.

    ReplyDelete
  8. Nice post.. you summed it up well.

    ReplyDelete
  9. Well we are 7 months down the track and house prices are going down. Personal debt in Australia is extremely high and most of it is in housing.
    So have we become wealthy through this increase? I think not. If we assume that in time we will see a major correction then surely government should act now by phasing out negative gearing and first home buyers grants so that the market can start the correction sooner. In addition, governments at all levels should reduce the tax associated with housing construction and purchases. If this is done it will allow normal market forces to act and soften the landing, by the way low interest rates just fuel the fire and sustainable wealth is created by increasing productivity not borrowing from the future.

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  10. I really liked ur Iron ore and Australian house prices from graph sheet itself
    House Australia

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