Two major developments will provide important new insights into the outlook for resources in Australia. Overall, these developments are likely to make for sober reading: Australia is facing massive short and longer-term challenges on the resources front.
For starters, the international climate agreement achieved in Paris on the 12 December 2015 means countries have signed up to pursue persistent efforts to limit the increase in global temperatures to less than 2 degrees.
[1]More generally, the IEA forecasts note that under a “current policies” scenario fossil fuels still provide a significant part of energy supply in coming decades, while under a “450 scenario” overall fossil fuel use will decline, led by coal and oil, while gas demand levels out.
In short, the once optimistic long-term outlook for carbon based energy sources is no longer simply dependant on continued strong growth in China and India. More vigorous efforts to limit global warming must now also figure into the calculations.
Indeed, as recent news footage of Chinese choking on their own air pollution should make clear, it increasingly appears in China’s own interest to move away from fossil fuel based energy use as quickly as possible.
[2]Of more immediate concern for the resource sector is the current shift in supply and demand dynamics that has pushed both prices and profits southward. The belated lift in supply in recent years – just as demand from China has slowed – has led to a progressive slump in prices over the past four years that as yet shows little sign of abating.
As noted by Reserve Bank Governor Glenn Stevens recently, despite the major drop in commodity prices of late, they are still relatively high by historic levels. An iron ore spot price of $US40 tonne is still 60% higher than the level in 2000, for example, while natural gas prices are still 50% above their level in that year. More broadly, Australia’s terms of trade is still 30% above the average over the past century.
As with regards to Australia’s near-term economic outlook, the key commodity remains iron ore. In the May budget, the Government forecast that iron ore prices would average $US48 tonne this financial year. Media leaks, however, suggest the Government could slash to this forecast to only $US35.
While it is common to blame slowing Chinese demand for the price slump, the reality is that supply is probably an even bigger factor. Indeed, Chinese demand for Australian iron ore is up 13% this year on average levels in 2014 thanks to resilient steel production (as Chinese producers boosted exports to make up for weak local demand) and the substitution of cheaper imported iron ore input (especially Australia) in place of higher cost local supply.
Indeed, Australian iron ore exports are estimated to have increased by 100 million tonnes in 2014-15, and will rise by a further 50 million tonnes this financial year. Supporting the expansion in Australian supply is the fact we remain among the lowest cost producers in the world, with a marginal cost of production likely around $US30 tonne.
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The big challenge for next year is the fact that Chinese demand should fall further, while global supply will continue to increase. On the demand front, more rationalisation in the Chinese steel sector is still required, as unprofitable producers exit the market. Meanwhile, the Federal Department of Industry predicts global supply will rise by a further 42 million tonnes.
I suspect prices will need to fall further in coming months to force a faster pace of supply adjustment – not just in high-cost countries but even lower-cost countries such as Australia.
Don’t just focus on China: it is only once more evidence of supply adjustment takes place can we become more confident that commodity prices have found a bottom.
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