24/05/2013 - 12:14

Time to give away the crystal ball

24/05/2013 - 12:14

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GUESSING GAME: Government forecasts about movements in the iron ore price seem overly optimistic

WHAT do you call a person who makes the same mistake year after year? ‘Fool’ is one suggestion, and it seems the same description certainly applies to governments.

Last week it was the Australian government making a fool of itself by bringing down a budget based on ‘forecasts’, a nine-letter word which ought to be classified as a four-letter word and banned from the English language.

Apart from the ridiculous attempt to predict the cost, over the next 10 years, of the new National Disability Insurance Scheme (as if anyone has a clue about how the world will look in 2023), there was the revenue nonsense associated with predicting future commodity prices (as if anyone has a clue about how commodity prices will look next week).

But predict the government did, thereby condemning itself and its successors to yet more apologies and explanations as to why it was wrong, and why the budget needs to be repaired.

The worst of the budget forecasts is that for a Western Australian specialty, iron ore, with Treasurer Wayne Swan courageously predicting an average iron ore price of $US110 a tonne for next financial year (2013-14), before falling to around $US100/t in the following year, and then rising again to $US115/t.

At first glance those price forecasts (let’s call them guesses, because that’s what they are) do not look too optimistic because the latest price for 62 per cent, low-impurity iron ore is around $US126/t.

The problem starts with the next leg of the iron ore guessing game, which is an assumption that even with a lower price than today, the Australian iron ore industry will pay much more in tax thanks to the Minerals Resource Rent Tax being more effective.

Why will the total tax take being higher if the price is going to be lower?

Because, says the government, the volume of production will rise by 40 per cent, and mining companies will have fewer tax deductions because they will have completed the capital expansion phase of their operations.

Perhaps those assumptions are correct, but one lesson all first-year economics students learn is that as supply of a commodity rises to meet demand the price falls; and when there is a glut of a commodity the price falls rapidly – which is what is highly likely to happen if the budget’s 40 per cent increase in Australian iron ore production is correct.

So there lies one of the great contradictions of modern government budgeting. An assumption more tax will be paid by an industry that is dramatically increasing production, and that the increase (plus more iron ore from overseas producers such as Brazil) will have minimal effect on the price because China will continue to demand ever-higher volumes of iron ore.

A drover’s dog can see that this latest price (and tax) exercise is pure guesswork, including the assumptions about China, which is switching from an investment-driven economy to a consumption-driven economy –hardly the basis for an assuming that the MRRT will jump 10-fold over the next few years to a handsome $2.2 billion in the 2016-17 financial year.

Perhaps it will and perhaps it won’t, but that is certainly not the way to run the finances of a country that has slipped deeply into debt.

If a forecast for the future iron ore price is required to complete the budget process then it would be a lot safer to use the lowest forecast price rather than concoct an amalgam of forecasts from investment banks and commodity traders who have a vested interest in convincing themselves and their clients that prices will not fall too far.

Unfortunately for the government, the lowest long-term price forecast for iron ore is around $US72/t, a level at which virtually no mining super tax will be collected at all.

No guesswork

THERE is a solution to the problem of forecasting for budget purposes and it’s a method that one of WA’s more successful businessmen applied rigorously when in charge of the state’s most successful company, Wesfarmers.

Michael Chaney, at his analyst and media briefings, was routinely asked about the future price of commodities important to Wesfarmers, such as coal and gas.

His answer was consistent: “We don’t forecast”.

That was probably a variation of the absolute truth, because deep in the bean-counting department of Wesfarmers there would have been people working on spreadsheets that required a degree of best guessing.

What Mr Chaney meant was that Wesfarmers does not discuss in public what its commodity price forecasts might be because everyone in the business knew that price tips always come unstuck.

The Wesfarmers approach, and the approach of all well-run businesses trading in commodities, is to focus totally on costs because they are all that a commodity producer can control. The price of the commodity is entirely under the control of world markets.

Australia is really nothing more than a giant commodity exporting company making the horrendous mistake of not controlling costs and hoping that it gets its price forecasts right.

That is an absurd way of doing business, and essentially no different to having a punt at the races.

In jeopardy

SPEAKING of costs and the need to focus on them, there seems little doubt that some of WA’s better-known resources projects could soon have new owners, or face the prospect of closure.

BHP Billiton’s nickel division is a prime target for the internal razor gang as it continues to struggle with the low metal price and high internal costs.

That scenario almost triggered a sale (or closure) a few years ago, but when combined today with new management keen to please investors, it might finally bring down the curtain.

The same goes for the Argyle diamond mine, which is being bundled up as a ‘job lot’ sale by Rio Tinto, which is keen to concentrate on bulk commodities, a focus that might save its tiny salt-making business that sits very oddly alongside the giant iron ore operation in the Pilbara.

 

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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