Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

5 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the finest property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"The level of detail in Pete's work is superlative across all of Australia's housing markets" - Grant Williams, co-founder RealVision - where world class experts share their thoughts on economics & finance - & author of Things That Make You Go of the world's most popular & widely-read financial publications.

"Wargent is a bald-faced realty foghorn" - David Llewellyn-Smith, MacroBusiness.

Monday, 22 September 2014

Nervous shakedown

Oreful commodity price action

A most unusual situation in Australia we have, with commentators aplenty hoping that a crash in iron ore prices might lead to a crash in house prices, leading us to daily appraisals of spot prices and dalian futures contracts.

So, what do we think? Let's take a quick run-down in four parts, starting with...

Part 1 - Booming supply

Australia's mining boom is now well and truly transitioning into the export phase of the boom, following on from an epic bubble in bulk commodity prices and then the subsequent mining construction boom response. Resources exports are now on the up and up...and up...

Export Volumes graph

In particular Australia's bulk commodities export volumes are ramping up at a furious pace in response to what were unprecedented highs in prices. 

Bulk Commodity Exports graph

With the supply response turning into a full-blown glut, iron ore and coal prices in particular have now come back to earth with a painful bump, and it seems reasonable to expect that there will be an unsentimental shake-out of the highest cost producers until supply and demand fall back towards equilibrium. Prices have declined so we can expect some of the smaller and highest cost producers to face the axe.

No prizes for guessing where the largest share of exports by total value are bound for. 

Exports by Destination graph

In that context, it was an interesting exercise for me to chart here earlier this month the data from the Port Hedland Port Authority (PHPA) which recorded a massive 37,380,587 d/mt of iron ore cargo as being shipped out of the Pilbara in August, an increase of 3.6 percent over the prior month and easily the highest monthly Port Hedland ore export volume on record.

That represents a massive increase of 36 percent on Port Hedland iron ore volumes in just 12 months, with some 86 percent of that iron ore cargo by volume bound for China or Taiwan. Japan and Korea snaffled up most of the rest of the Port Hedland iron ore exports. That is representative of a lot of supply...

Part 2 - Declining demand?

I should disclose here that I am in no sense of the word an iron ore expert. Although my background is in the resources industry I only have practical experience of copper/gold/silver mining.

And nor for that matter do I pretend to have any specific insights into China, especially since I spent ~95 percent of my time on Chinese shores in casinos and ~0 percent of my time considering the sustainability of mainland Chinese demand for Australian ore.

Instead here I will simply consider how the Reserve  Bank of Australia views likely demand from China, the burgeoning supply response and the respective bulk commodity cost curves.

Firstly, the RBA expects China to achieve its target 7.5 percent GDP growth in 2014 (I will just insert for them here all the usual caveats regarding the woeful reliability of Chinese data - by the way, I conducted my own China GDP audit here) with recently reported PMIs having shown some signs of marked improvement. 

Of course, China's GDP growth clearly must inevitably slow well below 7.5 percent eventually. Due to the nature of compound growth an economy which keeps growing at such a romping pace will eventually dwarf every other economy in the world which is neither feasible nor sustainable.

The key questions, of course, are when will China's economic growth slow and how dramatically?

The viewpoints range from the debonair Michael Pascoe who sees an ongoing China boom as the cadres build "another Europe" over the next 15 years through urbanising another 300 million people. At the other end of the scale others see an inevitable residential property and credit bubble and bust.

Viewpoints often perhaps tend to be formed by preconceptions and biases rather than experience (I know mine are). Being bearish on China for the past 15 years hasn't been a good call or position to take, but then the China bears will probably be right one day too.

Part 3 - Bulk commodity cost curves

So what is the RBA's view on thisWell the central bank has gone to great lengths in its latest SOMP to point out that Chinese iron ore producers sit at the sharp end of the cost curve and therefore it is expected that it will be mostly mines from overseas which are shaken out first by this cyclical downturn.

Whether of not you believe in the integrity of the data is another matter entirely, but the RBA holds that the lower cost Australian and Brazilian miners should fare much better. although the below chart does show that Australia does have a number of smaller high-cost producers which are already sailing perilously close to the wind as the iron ore spot price flirts with US$80/t.

It looks likely that we will be saying goodbye to a few of them soon.

The RBA sees a slowing in the expansion of production with fewer new projects now committed. The lower spot price could even elicit a reduction in supply from the larger and lower cost producers, who are effectively safe from a shake-out due to their considerably more efficient production costs.

So what happens if the iron ore price really tanks? Will this crash Australian real estate prices as the bears hope? Certainly one could have expected house prices and rents in the Pilbara crash...that is, had they not already done so

The RBA's research concludes that Australia's larger operators will be much less heavily impacted than many commentators expect, while acknowledging the opaque nature of data related to China's producers.

Outcomes from a genuinely big decline in the iron ore price would in all likelihood include Australian interest rates closing in on the zero bound and at least a 10 percent depreciation in the Aussie dollar, neither of which in themselves are dynamics typically to be associated with crashing real estate prices.

Indeed the result of that could actually be more housing demand from speculators and mouth-watering cheaper prices for overseas buyers in Sydney and Melbourne. What the housing market bears and shorters are really hoping for is an all-out mining and commodities bust resulting in a cascade of unemployment followed by a biting recession. 

Will this eventuate? Well, recessions do eventually recur in a cyclical economy, although we haven't had a real Australian recession for well over two decades now. Forecasts suggest a slowing of growth from 3.5 percent to around 2 percent, but let's face it, nobody can say with any degree of certainty what will play out.

Certainly some commentators will continue forecasting a housing market bust, but then there is nothing new in that - we have seen 15 years of such predictions and counting.

Part 4 - Nervous shakedown?

While the above analysis suggests that the great bulk of Australia's iron ore production remains and will remain profitable, the coal industry is another matter entirely.

With global supply expected to increase over the next few years and with the spot prices of coking coal and thermal coal having already hit $110 and $69 as early as August, the below analysis suggests that a good deal of Australian coal production is not profitable in the current market environment.

This is true, both for coking coal...

...and for thermal coal:

For the thermal coal sector in particular, Australia miners generally appear to sit at the high end of the cost curve and thus may be the first to be shaken out should prices remain depleted. 

While some producers can and will continue to operate at a loss for a period of time, even with forward contracts being exercised this is unsustainable over the long run and some producers (including Australian producers) have already announced plans to shut down operations.

I have discussed here previously some of the critical challenges that have reportedly faced property markets such Bowen, Emerald and Airlie Beach.

And while the property experts have been out in force to declare that Adani's Abbot Point project will attract a green tick, it is difficult to envision how the project is viable while thermal coal prices have crashed to a four year low, as discussed here previously.

When property experts begin affirming resources projects it is probably time to get worried, just as we saw previously with the Olympic Dam expansion erroneously being called out by real estate pundits as definitely going ahead despite the copper price having tanked from US$4.50/lb to $3.50/lb.

Meanwhile unemployment in the Hunter Valley jumped alarmingly by 3 percent over the 2014 financial year to an eye-watering 9.2 percent (as compared to a state-wide unemployment rate of just 5.7 percent) with more than 4000 jobs lost in the region, which is frankly terrifying.

No doubt the vested interests will be out in force to assure everyone that all will be OK, and perhaps it will be, but that is not what seems to be playing out according to Mining Australia:

"The Singleton Chamber of Commerce said mass layoffs in Hunter Valley’s mining sector have left the region reeling, with business conditions at an all-time low. 

"I've never seen it this bad and I talk to people that are actually retired and they've never seen it this bad either,"  Singleton Chamber of Commerce Ryan Fitzpatrick said.

With coal prices expected to dip further, the news is not looking to get  much better in region over the short-term. Bank of America Merrill Lynch analysts said to expect more thermal coal price cuts this year.
Prices have halved since 2011 and are down almost 70 per cent on peaks reached in 2008. Prices for premium hard-coking coal fell to $US120 a tonne in the June quarter from $US330 a tonne in 2011. Thermal coal is sitting at $US72 a tonne on the spot market, a fall from $US125 in 2011.
Coal mines in NSW employed 21,953 workers last September, down from a peak of nearly 25,000 in June 2012 as miners move to readjust their workforces to pre-boom numbers."
Strewth. I guess there are two ways to look at this. 

One is that things might turn around, the high cost producers can look to slash production costs somehow, or potentially even mothball operations until prices recover (if indeed, they ever recover). In all likelihood, since ceasing and restarting production is a cripplingly expensive exercise, high cost producers will prefer to continue operating at a loss for as long as they can in hope of a commodity price rebound.

The way I tend to look at these things is that since we all have the choice of investing in any asset class, in any country in the world, at any time we want, I would not be plumping for property in a mining region right now with unemployment lurching towards double digit levels on the hope that coal prices rebound quickly. Caveat emptor.

Unfortunately, the RBA's analysis which has been reproduced in an abbreviated format above shows that the Australian coal industry could be set for quite some shake-out.