If one had to craft a narrative around the state of the global economic “recovery”, it might go something like this. Wildly optimistic assumptions about the sustainability of China’s torrid economic growth (and the voracious demand for raw materials which accompanied it), led to overbuilding and oversupply in the lead up to the crisis. In the aftermath of 2008, not only have multiple rounds of central bank money printing failed to provide a meaningful boost to aggregate demand, but global trade has also been hampered by China’s transition from an investment-led, smokestack economy to a model driven by consumption and services.
As Goldman put it in May [13], "there are no other markets large and/or dynamic enough to offset a slowdown in China in the foreseeable future, and we forecast trade volumes to stabilize in the period to 2018." This has been bad news for commodities as the following chart makes abundantly clear:
[14]
It’s also bad news for the global mining industry which, as WSJ reports, borrowed “heavily” in anticipation of neverending Chinese demand. Here’s more [15]:
As forecasts predicting endless growth in China’s appetite for raw materials became a matter of industry faith, mining companies borrowed extensively to build networks of pits, railway lines and port terminals. Megadeals abounded as a merger-and-acquisition frenzy took hold. Cheap borrowing costs, thanks to low global interest rates, fueled the splurge.
Now, as China’s hunger for resources ebbs and mining companies' profits suffer amid falling commodity prices, those debts have become an albatross around the industry’s neck.
Amid a slump in Chinese share prices last week, metals such as copper and aluminum fell to near six-year lows. Iron ore at one point hit its weakest level for a decade.
"There’s been a colossal misjudgment of future demand," said Dali Yang, professor of political science at the University of Chicago. “That long boom made it especially difficult for people to expect anything otherwise. Many bought the big story about urbanization, instead of thinking how things could go bad.”
The world’s largest mining companies by market value had accumulated nearly $200 billion in net debt by 2014, six times higher than a decade ago, according to consultancy EY, while their earnings only increased roughly two-and-a-half times. Large mining companies have written off roughly 90% of all the acquisitions they made since 2007, according to Citigroup Inc.
Even if top mining companies devoted all their earnings less investment spending to paying down debt, it would take up to a decade to clear the decks, according to a Wall Street Journal analysis of EY data.
Mining companies cut big project spending recently, but many still face the decision to reduce dividends to shareholders, or borrow more to keep funding high payouts, risking downgrades to their credit ratings that would drive up interest costs—even as they still need to spend to shore up aging mines. "Something has to give," said EY’s global mining leader, Mike Elliott.
An old-fashioned gold-rush mentality underpinned the mining sector’s debt binge. The logic was simple. As China’s economy grew, and more Chinese people moved from villages to cities, the country would need ever-increasing amounts of metals—particularly the steelmaking ingredient iron ore—to build homes, office buildings and other infrastructure.
"Analysts are popularly criticized for ?thesis creep, the incremental mutation of a call’s drivers over time, such that it’s not really clear that the original call was just plain wrong,” said Morgan Stanley mining analyst Tom Price. “I suspect the same thing’s happened here with the Big Mining’s view on China’s iron ore."
This serves as still more evidence of how central bank policy, ostensibly designed to stoke inflation and save the world from a brush with the deflationary boogeyman, has ironically served to perpetuate the global deflationary supply glut, a dynamic we've outlined on a number of occasions this year, but which found perhaps its most unequivocal expression in "When QE Leads To Deflation: A Look At The Confounding Global Supply Glut [16]." Here's what we said in April:
Those who have access to easy money overproduce but unfortunately, they do not witness a comparable increase in demand from those to whom the direct benefits of ultra accommodative policies do not immediately accrue. Meanwhile, governments are reluctant to spend in the face of heavy debt burdens and increased scrutiny on fiscal policy in the wake of the European debt crisis while China, that all important source of voracious demand, is in the midst of executing the dreaded “hard landing.
Rock-bottom borrowing costs and easy access to capital markets made possible by accommodative central bank policies tempt insolvent producers to keep producing, contributing to their own demise by driving prices even lower, a vicious circle which creates Matt King's dreaded "zombie companies":
[17]
And finally, in an effort to connect all the dots, we'll close with the following from Credit Suisse, who notes that another theme [18] we've been keen to emphasize lately is in fact serving to exacerbate sluggish demand for the world's commodities surplus:
Three years on from commodity price peaks and we are still searching for the floor in bulks pricing, let alone any recovery. This is not the usual bust after a mining boom, but the down-half of the supercycle. Rather than a couple of excess mines, the entire iron ore and coal sectors are geared towards growth that has gone missing. For the rest of the metals, with China's demand drive cooling, we have to return to looking at global growth. Unfortunately, money supply is contracting, with governments running austerity budgets and corporates returning cash to investors. Commodity consumption cannot grow when investment is spurned.
