Commodity price slide changes the rules

It’s a shame no-one seems to be listening to the advice of John Maynard Keynes about adjusting to changing circumstances. 

JOINING the dots that connect the value of the Australian dollar with the country’s terms of trade is a relatively simple exercise. If that’s the case, however, surely it is just as easy to join the dots that connect government budgets to the terms of trade.

It is, and that’s the point about the position investors and governments find themselves in today – falling commodity prices have changed the rules of the game, and some people are reacting faster than others.

Take the dollar, for example. A few months ago, when commodity prices were much stronger, it was easy to explain an exchange rate of $US1.05, and tip that it could reclaim a high of $US1.10.

Then came the slide in coal and iron ore prices, slashing Australia’s terms of trade and setting the scene for a sharp fall in the dollar, which has been delayed until more evidence comes in about the slowdown in the Chinese steel industry.

As the 20th century’s greatest economist, Lord Keynes, so provocatively asked of a changed equation: “When I receive new data, I adjust, what do you do?”

Iron ore miners, undoubtedly as an exercise in self-promotion, persist with an argument that prices will recover later this year, and there is no need to adjust.

What of the Australian government’s budget, which faces the double-whammy of a reduced carbon tax take after its shock cut in the carbon price, and the prospect of no revenue from the super-tax on iron ore and coal profits, because those profits are going up in smoke?

The last official word from the government is that the budget will still be balanced, despite falling revenue and the rising cost of pre-election promises.

Perhaps both the iron ore miners wishing for a Chinese-led price rise, and the federal government wishing for an iron ore profit rise should consider another saying from Lord Keynes, this time about markets, which can “remain irrational longer than you can remain solvent”.

For investors with a nose for trouble, it is interesting to connect the iron ore price problem with the recent failure of coal entrepreneur, Nathan Tinkler, to deliver on a proposed $5.20 a share takeover bid for Whitehaven Coal.

Mr Tinkler’s problem, which is the iron ore problem, which is the Australian government’s problem, is that cash flow and budget predictions have been torpedoed by the sharp falls in commodity prices.

In Mr Tinkler’s case, he was unable to complete banking arrangements to ‘privatise’ Whitehaven, meaning he now faces real pressure in maintaining his position as the coal miner’s biggest shareholder given the debt level he has already incurred to amass a 21.4 per cent stake in the company.

Roll forward a few steps with that thought about the troubles of Mr Tinkler and it is possible to see a list of other trouble spots emerging, such as:

• Fortescue Metals Group running into problems with a debt-driven iron ore expansion program as the iron ore price falls and debt costs rise;

• Gina Rinehart facing a surprise hiccup in funding her planned Roy Hill iron ore mine because of the price fall, and banker disquiet over her high-profile assault on Fairfax Media and unionised labour, making her (and Roy Hill) a magnet for industrial unrest;

• Prime Minister Julia Gillard facing an income shortfall, which has the potential to destroy her promise of a balanced budget; and

• Premier Colin Barnett facing a similar problem as iron ore royalty payments start to shrink.

Not all commodities, it should be said, are suffering from falling prices. Copper and gold, also important Australian exports, have not fallen in price over the past six months; they are steady or up slightly.

 The same can be said of wheat, wool and beef, all of which are important Australian exports.

The problem with agricultural exports and minor metals, however, is that Australia’s top two bulk mineral products – iron ore and coal – generate far more revenue.

It is prices for iron ore and coal that attract the attention of international currency traders, who are poised to press the ‘sell’ button on the dollar, perhaps driving it down to as low as US75 cents, and while exporters will welcome a more competitive position as a cut in the currency value implies there will be very few people smiling in Canberra and Perth.

As Lord Keynes said, new data means it is time to adjust.

Digging down

HOW low can the iron ore price go? Well, for a glimpse into the future it is worth a trip into the past, because as recently as May, when iron ore was trading at around $US130 a tonne, there were a few forecasts floating around of $US77/t.

One of those came from the investment bank Goldman Sachs, which was telling clients that $US77/t was the likely long-term price of iron ore from 2016.

Three points can be made about what Goldman had to say three months ago.

Firstly, the bank that likes to think of itself as the smartest in the business failed to see the current sharp correction, and was predicting a 2012 iron ore price of $US150/t (oops) and a 2013 price of $US165/t (close to double where it is today).

Secondly, and in defence of Goldman, what appears to have happened is that economic events have accelerated. Europe has plunged deeper into depression, the US remains perilously close to recession, and China is struggling to avoid its own form of recession – annual growth below 8 per cent.

Thirdly, at $US77/t, an alarming number of WA iron ore miners will not be profitable, so not only will tax and royalty income dry up for governments but investors will have problems, as will employees who have spent their high wages on booze and fast cars, and forgotten to save for a rainy day.

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“The use of money is all the advantage there is in having money.” 

Benjamin Franklin