A conversation with a fund manager started me thinking the other day. Talking about the distressed nature of the commodity markets at the moment, he bemoaned the way that producers – mining companies, in other words – seemed to be more interested in reducing production cost than cutting back production. He wanted them to close production facilities in order to give the price a chance to move upwards. (Thus – I suspect – helping out his long positions.) Well, you can’t fault his logic, up to a point. Of course the easiest – and probably quickest – way of getting a price to rally is to cut the supply of the product in question. That’s a simple fact and no doubt if enough cuts were announced, the price of copper, aluminium, nickel et al would bounce nicely and – perhaps – help the manager in question out of his position.
So why are the production cuts that have been announced as limited as they are? Don’t the mining companies understand what they should be doing? Well, to answer the second of those questions first, I think they do understand and they full well know that there is something else in the equation as well. Cutting production would support prices, and if what we were faced with was a straightforward, regular periodic slump in demand, then it’s probably a fair bet that things could be got back on track in the relatively short term. But that straightforward reaction is unlikely to be sufficient this time around. ‘New Paradigm’ is a meaningless phrase in this context, but super cycle is not. The level of demand out of China during the first decade or so of this century is unlikely to be repeated for a long time. The industrialisation of China, the development of the centre and west of the country, is clearly not over, but the pace of change has demonstrably slowed. That shouldn’t be a surprise; it was never going to be sustainable ad infinitum. But over the course of that time, the mining industry expanded to accommodate the ‘excess’ level of demand, which obviously has negative implications when things change.
Right or Wrong?
Were they wrong to chase production growth as they did? Of course not; look at the profits they generated and the dividends they paid shareholders. It was a golden opportunity and the major mining companies seized it with relish. Sadly, though, all good things come to an end; look at the share prices now, weep for all those departed dividends. And then remember it’s all cyclical……….
The miners don’t seem to think the simple exercise of market discipline – by cutting production – is the solution right now. Their central focus of where they sit on the price curve is telling us something, I believe. And that something is that low prices are here to stay for some time. Looked at in that light, then a fixation on cost is perfectly rational. If the game is about survival, then cutbacks don’t do the trick. You can cut your production, but that broadly helps everybody indiscriminately. If you believe demand is not picking up any time soon, then you are better off to get your own cost down as much as you can; then, when the inevitable cuts do come, you are more likely to be one of the survivors. A classic example is in iron ore, where the lowest cost producers are perfectly happy to keep on churning out product, in the full knowledge that they are not the ones who bear the deepest pain. Another is crude oil, where the producers down at the bottom end of the cost curve are keeping the pressure on their more expensive competitors in a deliberate attempt to force them out of business. It’s not about straightforward market discipline; it’s about survival and that means being in the right place, relatively.
So it seems to me that where we see miners choosing to put their energies into aggressive cost-cutting, rather than take the alternative production cutting route, we should understand that that is actually telling us that they expect the low price environment to last some time, and the game they have in focus right now is survival, not profit maximisation.
I wouldn’t hold my breath for that fund manager’s long positions to come good any time soon. It looks to me like the signal from the market is just as strong as it was around the turn of the century – but in the other direction.