When analysts talk about commodities they can as often be referring to agricultural products as energy or metals. Indeed, while the China-fueled supercycle lifted all commodities, there is no reason why all commodity classes should perform the same way at the same time. Often, taking a spread across classes is seen as a sensible distribution of risk for those without the deep expertise to read the nuances of different products and markets. But a recent Reuters article is interesting as it explores the correlation between one class – energy, with another – metals.
Specifically Reuters examines the collapse in oil prices and its effect on the prospects for copper prices, but the issues aired and the conclusions drawn could equally apply to aluminum and zinc and, by extension, other metals too. The article suggests energy needs make up as much as 50% of the production costs of metals, which sounds like it’s at the high end as even aluminum, with massive energy input requirements in the form of electricity, generally accounts for about one third of the cost of production. Norsk Hydro put the industry range as 20-40% electricity costs in smelting alumina to aluminum depending on the efficiency of the process.
Now, clearly oil is rarely used for electricity production except in markets like Saudi Arabia where it is in relative abundance, but oil prices directly impact the price of natural gas and, indirectly, the price of thermal coal, so falling oil prices create a momentum for falling energy costs given time. The costs of metal production are often taken as being relatively static and the sale or market price variable, so as market prices fall producers margins are squeezed and a point arrives where high-cost producers can no longer operate except at a loss and production is taken out the market.
The reduction in supply, then, allows the remaining producers to raise prices, but if production costs fall at the same time as market prices fall, producers tend to fight for market share and continue to produce. No supply balance is achieved, so the market drifts lower and lower. That, the article suggests, is what is happening for metals.
Power or energy costs are falling, moving producers or refiners down the cost curve and preventing the closure of the highest cost producers. If they are right, a fundamental support for the market is not there and prices for metals are going to be even more dependent on rising demand creating a shortage than the possibility of production closures. For consumers, falling oil prices could, therefore, have the double benefit of lowering their own energy costs and their metal costs. To the extent that oil prices continue to fall, 2015 could be a good year for metals consumers.