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Caution: More Commodity Price Weakness Ahead

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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It's hard not to notice that commodity prices have been plummeting. It seems the price of everything that is grown or pulled out of the ground -- from oil and gas to sugar and copper -- has declined 46 percent since early 2011, causing bankruptcies and industry consolidation.

Prepare for further big declines. 

Directly or indirectly, developed countries consume most commodities. Yet economic growth and demand for commodity-based products remain weak as North America and Europe continue to unwind their financial excesses. The earlier rapid expansion of debt, which helped fuel robust growth, is being reversed. 

QuickTake The Resource Curse

U.S. real gross domestic product has risen at just a 2.2 percent annual rate since the business recovery began in mid-2009 -- about half the rate you’d expect after a recession. The euro area is limping along at a 1.2 percent annual growth rate, with recovery from the 2007-2009 recession interrupted by a mild downturn in 2011-2013.  Economic gains in Japan’s stop-go economy have averaged only 1 percent.

The world is now eight years into a deleveraging cycle. At this rate, it will probably take more than the historical average of 10 years to complete. 

Meanwhile, supplies of almost every commodity are huge and growing. China joined the World Trade Organization in late 2001 and, not by coincidence, commodity prices took off in early 2002. As manufacturing shifted from North America and Europe to China, it sucked up global commodity output. From 2000 to 2014, China’s share of global copper consumption leaped to 43 percent from 12 percent. China's portion of iron ore purchases similarly zoomed to 43 percent from 16 percent, while aluminum went to 47 percent from 13 percent. 

By the mid-2000s, industrial commodity producers were dazzled by China’s seemingly insatiable demand and made the same big mistake that always occurs in every economic cycle:  They assumed surging demand from China would last indefinitely. 

Producers embarked on massive projects that often take a decade to complete. These included digging copper mines in Latin America, removing iron ore in Brazil and producing coal in Australia. All that new capacity began to come onstream in 2011, just as it became clear that the hoped-for post-recession return to rapid global economic growth wasn’t occurring. 

The downward pressure on commodity prices has been magnified in recent months by the realization that economic growth in China is slowing. This is nothing new, really. China doesn’t grow independently, but has an export-driven economy. It imports raw materials and equipment that it uses to produce manufactured goods, largely for export. 

But muted demand in North America and Europe for Chinese exports has slowed economic growth in China.  Meanwhile, over-investment in ghost cities and building of excess infrastructure, in which China engaged to create jobs, has spawned huge debts. I estimate that the true rate of inflation-adjusted growth in China is about 3 percent to 4 percent, half the 7 percent official number. 

Few investors and most of the media were unaware of China’s dependence on the West and its slowing growth until stocks went off the cliff in June. The Shanghai index is now down 40 percent despite Beijing’s clumsy and heavy-handed efforts to support equities. Devaluation of the yuan soon followed.

With most other currencies also devaluing against the dollar, the trade-weighted yuan is down 30 percent from May 2011, and China wants it to go even lower to spur exports in a softening economy. To prevent the pegged yuan from collapsing -- and accommodate the rush of money out of China -- the government has sold about $400 billion of its nearly $4 trillion in foreign currency reserves to buy yuan. 

Additional forces are depressing commodity prices beyond the general surplus of supply relative to demand. A number of hard-rock miners are so deep into new projects that they are compelled to complete them. Closing down the ventures would be more expensive than the losses they'd incur from selling production at today's prices.

The world’s biggest iron ore producers -- Rio Tinto, BHP Billiton and Vale -- continue to produce huge quantities of ore even as prices drop 70 percent to $57 a ton, from $189 in February 2011. The companies believe they can squeeze out less-efficient producers, such as those in India, that may lack staying power. 

Some commodities, especially aluminum, are produced in developed countries like the U.S. and Canada. In textbook fashion, once demand falls and profits nosedive, owners shut down smelters. The drop in supply offsets some of the downward pressure on prices.

But copper, used in numerous manufactured products ranging from autos to plumbing fixtures to computers, is mostly mined in developing nations like Peru, Zambia and Chile.  They need the revenue from copper exports to service their hard-currency debts. So the lower the copper price, the more physical copper they must produce and export to earn the same dollars. And the more they export, the lower the price, in a self-feeding downward spiral. 

Similarly, Brazil subsidized the export of sugar, which is down 67 percent in price since February 2011, and no doubt will be forced to pour more money into the industry. Already, 80 of 300 sugar mills in the South Central region, where 90 percent of Brazilian sugar is produced, are closed. Stockpiles are at a 35-year high. Insolvent mills are trying to sell as much sugar as possible to generate cash, which has depressed world sugar prices. 

Meanwhile, sugar imports in China were down 25 percent in August from a year earlier. Adding to the pressure, the Brazilian real is down 33 percent so far this year. Standard & Poor’s cut the country’s debt rating to junk in September. The dollar-denominated debts of Brazilian sugar producers are becoming next to impossible to service, as a result. 

As with iron ore, the Saudis are trying to use low prices to squeeze out other major crude-oil producers. I previously explained why that could result in per-barrel oil prices of $10 to $20.

As long as market prices exceed marginal cost, more (not less) production is encouraged to make up for lost revenue. Some producers will raise output even when prices fall below marginal costs. 

Russia depends on energy exports to cover import costs and government spending. With the collapse in oil prices and Western sanctions, Russia is desperate to earn foreign exchange.  

Tomorrow, I will explain how all of this came crashing down on Glencore, the world's largest commodities player.   

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
A Gary Shilling at insight@agaryshilling.com

To contact the editor responsible for this story:
Paula Dwyer at pdwyer11@bloomberg.net