Stuart Burns

A giant robot fight will happen sometime next year. MegaBot MKII from the US will square off against Japan’s Kuratas.

I won’t try and justify this by the metal content — which is interesting in its own right — or by the turn of fortunes that has been created by taking an old repair shop for cargo ships and turning into a new industrial enterprise, admirable as that is, no this posts stands on its own two mechanical feet as pure fun.

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The robot constructors of the American entry are three engineers who basically wanted to live out their childhood fantasies and build a fighting robot. Weighing in at 12,000 lbs. and measuring some 15-ft. tall the MegaBot MKII is everything a child could imagine and more.

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One may think that China’s steel industry could hardly be in a worse place.

Half the industry is losing money in spite of falling iron ore and coking coal costs and a reduction in domestic power costs all aiding steel producers on the supply side. Even among those that did not lose money in the first half, margins are said to be razor thin and banks are reported to be cutting credit lines and presenting difficulties in rolling over loans according to China Iron and Steel Association (CISA) comments posted by Reuters.

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Concern in China is rising that June’s 3.4% fall in auto sales, compared to the year before, could be the start of a trend. After two years of consistent growth and high capacity utilization the world’s largest car market is showing signs of fragility.

Data from the China Association of Automobile Manufacturers quoted in the FT suggests China’s automotive market may be maturing after years of breakneck growth.

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Under Vladimir Putin, Russia bet its future on its abundant natural resources, believing it was irreplaceable as an energy source to the economies of Western Europe.

Three Best Practices for Buying Commodities

Russia pumped oil and gas, nickel, aluminum and other commodities at the expense of building its manufacturing base. With few exceptions, manufacturing suffered at the alter of a strong ruble and, for a time, was flattered by a strong domestic economy playing catch up after years of Soviet waste. The following graph of real effective exchange rate against exports of non-oil goods shows how the strength of currency correlates with falling exports of manufactured goods.

Source Telegraph

Source: London Telegraph

But now, a combination of falling commodity prices, particularly oil and gas, and western sanctions following Russia’s misadventure in Ukraine in 2014, have left the economy in a state of decline. According to the London Telegraph Russia is running a budget deficit of 3.7% which may not sound like much, but for an economy without developed capital markets it shouldn’t be running a deficit at all according to sources quoted by the paper.

Effective Default

Nor is it just central government, a report by the Higher School of Economics in Moscow warned that a quarter of Russia’s 83 regions are effectively in default as they struggle to cope with salary increases and welfare costs dumped on them by President Vladimir Putin before his election in 2012.

“The regions in the far east are basically bankrupt,” the bank Unicredit is quoted as saying. The central bank is burning through foreign exchange reserves initially in a wasted attempt to support the ruble, which has now been allowed to free fall, but the authorities are continuing to support companies having to roll over foreign currency debt as it comes due.

Source Telegraph

Source: London Telegraph

Some $86 billion in outstanding debt is coming due this year and supporting that has contributed to a reduction in official reserves from $524 billion in 2014 to an estimated $340 billion today when various commitments are stripped out.

Economic Contraction

The economy has contracted by 4.9% over the past year and, as oil prices resuming their bear market trend, this is likely to worsen. Half of Russia’s tax income comes from oil and gas, yet output from Gazprom has fallen by 19% this year while revenue is likely to fall by almost a third to $106 billion in the face of falling demand and lower prices. Core inflation is running at 16.7% and real incomes have fallen by 8.4% over the past year, by comparison a far deeper cut to living standards than occurred following the Lehman Brothers crisis.

Source Telegraph

Source: London Telegraph

Gazprom alone generates a tenth of Russian GDP and a fifth of all budget revenues, the paper reports. Oil is an even bigger worry. In volume terms, the spigots are wide open and Russia is pumping nearly 10.7 million barrels per day with the help of a new tax regime but even Lukoil’s vice-president, Leonid Fedun, said in March that Russia’s oil output could fall 8% by the end of next year, taking 800,000 barrels per day out of global markets as a lack of investment fails to reverse the depletion of old soviet era wells.

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Normally that would be enough to rally oil prices, but with Iran about to add twice that to an already over-supplied market the result will likely be lower prices and lower revenue for the Russian economy for years to come.

No Way Out

It is hard to see what the answer is for Russia, with so many of the country’s assets in the hands of so few individuals close to the president, the model is unlikely to change anytime soon. A desperate Russia is potentially a more dangerous Russia and with power in the hands of a small clique it is hard to predict how it will react as the screws of the global commodity market tighten. But, having worshiped at the alter of commodities for virtually all his presidency, Mr. Putin in unlikely to change or be able to change religion in time to avert a more serious deterioration of the Russian economy in the months and years ahead.

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An interesting if short article in the Financial Times reviewing research carried out by a team at Bank of America Merrill Lynch illustrates something those in the metals markets will have been subliminally aware of but may be not have focused on unless they were truly cross-metals active.

Three Best Practices for Buying Commodities

In recent weeks there has been wholesale weakness across all the metals in the face of fear over global demand, particularly Chinese demand, and concerns about when, not if, the Federal Reserve will raise rates and the impact that will have on the US dollar. A stronger dollar is invariably a harbinger of weaker metals prices as it raises the cost of metals in foreign currencies by virtue of exchange rate, not demand.

Source Bloomberg, re-printed in the FT

Source: Bloomberg, re-printed in the FT

Comparing how metal prices have moved relative to each other over the last ten years to how they have moved over the last twelve months, the bank contends that metals have been, with the exception of the most recent weeks, influenced more by their fundamentals these last twelve months.

Breaking From Metal Price Correlation

In the period prior to the financial crash, links between metals were tighter. The analysis said, “Correlations between metals’ prices were high ahead of the Great Financial Crisis (GFC) and in the immediate aftermath of it. Prior to the GFC, this was heavily influenced by exceptionally strong global economic growth and Chinese demand. Immediately after the GFC, cross-asset correlations remained high, partially because several governments implemented large fiscal stimulus packages and many central banks flooded the markets with liquidity.”

But since the post-crash period, say from 2013 onwards, metal prices have been relatively driven more by their fundamentals. In the last twelve months copper’s correlation with gold is down 11.9%, the bank estimates, and the copper’s relationship with aluminum is 17.8% weaker. Only precious metals have increased, with gold and silver rising from 78.8% over the past 10 years to 81.4% in the last year.

Back to Fundamentals

The trend among base metals is a reflection of the lack of demand and rising surpluses. As investor demand has weakened, supply and demand fundamentals have been allowed to take on more of a role in price determination. A trend that is likely continue for the next two years, as surpluses remain and global demand is muted by lower Chinese demand.

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The Big Mac index of currencies was created, somewhat tongue in cheek, back in 1986 in an effort to illustrate the extent to which a currency was at or diverged from its correct value.

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The Economist modestly puts parentheses around the word correct in an article this week introducing a beefed up version (unlike the article we will leave the Burger puns there) of the old index which seeks to create more finely nuanced price comparisons, taking into account the relationship between GDP of the country as a totem for local wages and the price of a Big Mac.

PPP vs. Wage Disparity

As the Economist says, the old model is based on the theory of purchasing-power parity (PPP), the notion that, in the long run, exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. So the index should highlight which currencies are over or undervalued, and hence which direction we can expect them to go over time.

The new index tries to account for the entirely reasonable argument that we would expect a product, in this case a Big Mac, to be cheaper in poorer countries because wages will be lower. The Economist uses the relationship between prices and GDP per person to create a set of adjusted results and, of course, the data is displayed in a series of graphs based on any one of five currencies – the US dollar, Euro, Japanese yen, GBP sterling and Chinese yuan, allowing the user to see to what extent the index believes the local currency is over or undervalued to these five.

What’s Going on in Venezuela?

Pity those at the bottom of the scale; Venezuela, Ukraine, India, Russia, Malaysia, South Africa and Egypt. If the index is right, their currencies have a huge potential on the upside. Of course, it isn’t quite that simple or every currency speculator in the world would be using the index to trade on sure fire medium-term bets.

Many of those at the bottom of the chart have profound economic problems impacting their exchange rates, countries like mismanaged Venezuela, Ukraine and South Africa or sanctioned Russia, but, all the same, the charts make interesting reading, and in an area of study – economics – that some would argue is at best a pseudo science, who’s to say the Big Mac index is any worse than any other measure?

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Usually, articles about the share price of specific companies bear some kind of footnote concerning the authors own exposure to the shares, whether they are a direct investor or via a fund, in the company in question.

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I can say, with some relief, that I am not, to my knowledge and fervent hope, an investor in BHP Billiton nor, at least in the short term, am I likely to be in the mining sector as a whole. I would accept there is an argument that some commodities could have hit bottom. If I was a betting man I might permit a small punt, but I am not and I won’t.

Caution: Watch for Falling Assets

Mick Davis looks like he may make a contrarian bet and buy Rio Tinto Group’s Australian coal business but that may have as much to do with the fact he has been sitting on a cash pile of investors’ money burning a hole in his pocket than coal is suddenly a great bet, even at these depressed asset prices.

Having spun off a chunk of mining assets under the trendy sounding name of South32 earlier this year, BHP probably hoped the worst of its write downs was behind it. South32 is a collection of alumina, aluminum, coal, manganese, nickel, silver, lead and zinc assets formerly known as Billiton. No one wanted the post-merger assets and BHP — formerly known as the Broken Hill Proprietary Company Ltd. — couldn’t sell them, so the firm wrapped them up into a bundle and gave them to their shareholders. Since May, the share price of South32 has, well… gone south. There’s no doubt BHP knew it would, but at least it got them off the company’s books.

Screen Shot 2015-07-20 at 17.59.10

Source: Financial Times

Not that BHP is alone, even the strategically savvy and fleet of foot Glencore PLC had trouble finding a buyer for its shares in platinum miner Lonmin and ended up doing the same thing, giving those shares to shareholders. Glencore is well shot of it, according to an FT report, the share price has collapsed from £40 each in 2007 to £1.08 today.

Back to BHP, though. Like its competitor, Rio, BHP has a history of buying assets at the wrong time or for the wrong reasons. Bigger isn’t always better and timing is everything. BHP moved into US shale gas too late only to see the price collapse. In 2011 the firm bought US gas operator Petrohawk for $12 billion only to take a $2.84 billion hit writing down goodwill as the value fell. The Telegraph reports the firm has taken a further $2 billion on its Hawkville gas project in Texas as geology complexity slows and complicates the development of the field.

What Does This Mean for Gas, Oil and Metal Buyers?

BHP, Rio and the rest of the major miners are big enough to weather the storm of low commodity prices, but with little on the horizon to suggest commodity prices are likely to rise significantly in the medium term and evidence that some may have further to fall, the companies dividend policies are going to come under pressure. A PriceWaterhouseCoopers report on the industry, covered by the FT, says their policy of borrowing money to pay consistent levels of dividends on their shares is unsustainable.

Dividends paid by the top 40 miners in 2014 consumed all their available cash, reducing their balance sheet flexibility in continuing tough times. Capex has been cut, for the top 40 by 20% in 2014, and exploration budgets fell to $4.9 billion last year, half the level of just two years ago. The maxim that today’s shortage is tomorrow’s glut is writ large in the minds of mining executives, but with investment falling so markedly we can be sure as the decade unfolds the reverse will become true. Whether the current crop of executives will be around to see it is another matter.

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As always, ThomsonReuters’ Andy Home turns out some excellent commentary backed by solid statistics.

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In a recent article, he reviews comments made by Alcoa Inc.’s Klaus Kleinfeld about China’s primary aluminum production leaking out of the country under the cover of the burgeoning export trade in semi-finished products. As the article explains, China exported 2.5 million metric tons of unwrought aluminum and aluminum products in the first half of the year. That was 35% or a 650,000-mt increase over the same period last year.

Untaxed Semis, Taxed Ingots

The temptation for Chinese producers to ship primary metal for export is significant in a domestic market oversupplied with unwrought primary metal, but producers are dissuaded from exporting ingot by a 15% export tax and a negative treatment on the value-added tax which is set at 13%.

Rightly in a country with high power costs, China sees exports of low-value primary aluminum as a wasteful export of energy-intensive material. Producers, though, are desperate to shift metal and the article suggests (and to Klaus Kleinfeld’s point) that a large part of this tidal wave of “semis” exports is not really semi-finished product at all, but simply primary metal either misrepresented on export paperwork or marginally re-worked to qualify it as a semi-finished product.

Many point to the fall in aluminum physical delivery premiums as support for the argument that Chinese exports of this primary-masquerading-as-semi-finished metal are a significant contributory factor to greater primary metal availability outside China.

What Does This Mean for Metal Buyers?

We have our doubts that the export of Chinese semis is causing a massive disruption in the marketplace. Chinese semi-finished product is being offered aggressively all over Asia and Europe. Chinese producers – aided by changes in export taxes and a falling Shanghai Futures Exchange base price relative to the London Metal Exchange – are able to compete in the semis market now to an extent they were not able to 12-18 months ago.

We are seeing increased market penetration and volumes hitting the European distributor and end-user markets this year. We are seeing European and Asian manufacturers lead times come down, in some cases to days, for extruded products, suggesting order books are weak.

Under such circumstances converters outside of China will not be buying as much primary metal and billet. Couple that with new Middle East smelter start-ups and metal coming off long-term financing deals earlier this year and there is enough to justify the fall in physical delivery premiums without some vast confidence trick going on in misrepresented metal exports from China. We are not saying Alcoa is wrong in making their assertions regarding this trade, no doubt there are situations in which it has happened, we just doubt it is as significant or is having as much impact as they suggest.

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The statistics illustrate the dire state of the Chinese steel market only too clearly.

Coiledsteel_585

Excess Chinese steel capacity has nowhere to go but export markets.

Crude steel output dropped in June by 0.8% from a year earlier while apparent consumption of steel for the first five months declined by 5.1%, according to Reuters. Meanwhile, steel prices are at their lowest in more than 20 years. In spite of weaker iron ore prices, large steelmakers’ losses on their core business more than doubled for the January-May period from a year earlier.

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Steel prices have been sliding as construction activity has remained weak, rebar futures on the Shanghai Futures Exchange have lost about 25% so far this year, on top of losing 28% across the whole of 2014.

Market Share at Risk

Steel mills have talked about bringing forward maintenance and refurbishment work this summer in an effort to curb the over-production and stabilize prices, but, so far, there has been little sign anyone wants to be the first to risk losing market share.

Rather, exports of steel products surged 28% to 52.4 million metric tons in the first six months of the year as mills dump excess production overseas. According to Reuters, CISA members (who comprise the top 100 mills) posted a loss of 16.48 billion CNY ($2.65 billion) for their steelmaking businesses in the June-May period, up from a loss of “just” 6.12 billion CNY ($984 million) for the same period last year.

The Chinese economy, in broad GDP terms, has been slowing. Depending on which numbers you look at (nominal or inflation adjusted) it is 5.8% or 7%. The inflation adjustment is a Beijing black box fudge factor and you can take it or leave it, but the underlying trend has been down earlier this year and is, at best, steady today.

Manufacturing, Construction Worse Off

Within that, though, manufacturing is suffering more than the wider economy. According to CNBC, Chinese industrial output for June rose a nominal 6.8% year-on-year, while last month’s retail sales climbed 10.6%.

The booming stock market in the first six months of the year will have contributed to that service sector GDP number and doubts must be raised over the near-term prospects for a stock market that was being propped up only by government intervention. Chinese stocks are still suffering from last week’s market shock.

If prices return to falling, as they surely would without Beijing’s life support, then both financial sector activity and consumer sentiment could suffer in the second half. Under such circumstances, an increase in steel demand seems even more remote and steel mill closures more likely. In the meantime, expect export markets to continue to be the destination of choice for unwanted production. If mills don’t mothball production and demand doesn’t pick up, it’s the only game in town.

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A quiet revolution is going on in the US power generation market, and it may be giving a lesson for those countries dithering over whether to allow hydraulic fracturing (fracking) of oil and natural gas deposits identified but not yet proven.

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According to the FT, April was the first month in US history that gas-fired electricity generation surpassed coal-fired generation, (although it came close in 2012 when gas prices were also very weak). By comparison, in 2010 coal provided 45% of US power. In April of this year 31% of US electricity was generated by natural gas compared to 30% for coal, and the trend continues.

Watts Up

In gigawatt terms, wind power is growing even faster than natural gas, flattening the latter in the league tables. US coal capacity dropped by about 3.3 GW during 2014, and the US Energy Information Association predicts it will shrink by a further 12.9 GW this year, while wind power capacity rose by 9.8 GW and gas by 4.3 GW.

Source FT

Source: Financial Times

The reasons are more complex than simply low natural gas prices, although that, undoubtedly, is a major factor. The Environmental Protection Agency’s failed attempt to force environmental compliance by the back door this year encouraged some coal-fired utilities to see the writing on the wall and either mothball plants or invest in new technology to accommodate the mercury emission and other pollution targets, raising costs.

Brett Blankenship of Wood Mackenzie is quoted by the FT as saying, “low gas prices mean coal plants are running less, and when they run their margins are typically compressed. So companies find it difficult to make the investments needed to comply with regulations and keep those plants running.”

The Imitation/Substitution Game

It’s a vicious downward spiral in the face of lower-priced and less-polluting competitor fuels. Although natural gas makes a better swing fuel source to balance wind and solar renewables variability, not all utilities are blessed with an abundance of such spare generating capacity so they rely on their coal power plants to step in at times of peak demand. Unfortunately, running a coal plant at anything other than full or near-full load on a continuous basis brings per-gigawatt operating costs up AND per-gigawatt emissions of pollutants.

Not surprisingly, coal producers share prices have fared even worse than shale gas companies. Peabody Energy’s share price, the largest US coal producer, has fallen 98% since April 2011, while those of Arch Coal have dropped 99.2% and of Alpha Natural Resources by 99.6%, while their debt is so devalued it is yielding 17.9% for Peabody suggesting investors are expecting default.

With natural gas prices set to stay low for some years to come and renewable costs falling steadily the writing is on the wall for all but the latest and most efficient coal-powered electricity production. At least the environmental lobby will be pleased and the EPA may have achieved much of what it set out to do, Supreme Court slap down or not.

This September: SMU Steel Summit 2015

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