Disequilibrium | The Commodity Rout

It is no longer a bump in the carpet, with almost precision laser focus, the world of commodities has unwounded before our very eyes. The ferocity of the fall has shaken investors. Is the world going down in flames is a question being asked ever since the new year began? The shield of Achilles pierced for the time being as the world is sucking on the tailpipe of a commodity meltdown which in turn has resulted in an equities rout. Imagine, crude oil that hit an all-time high of $147 a barrel in 2008 slipped below the $31 level on Tuesday, down more than 30 per cent in 2015 to an 11-year low. In 2016 alone, it is down a further 15 per cent. WSJ reported on Tuesday that, "Forecasters now say there is a good chance oil will fall below $30 a barrel, as global inventories continue to increase and the dollar strengthens, pressuring commodities. A stronger dollar typically weakens commodities such as oil by making the dollar-denominated commodities more expensive in other currencies...The global crude market is expected to become more oversupplied as soon as this month if sanctions are lifted on Iran, allowing the country to increase its oil exports." The oil glut can send at least a third of US oils into bankruptcy.

Market watch which tracks these firms says, "Three major investment banks — Morgan Stanley, Goldman Sachs Group Inc. and Citigroup Inc. — now expect the price of oil to crash through the $30 threshold and into $20 territory in short order as a result of China’s slowdown, the U.S. dollar’s appreciation and the fact that drillers from Houston to Riyadh won’t quit pumping despite the oil glut." As many as a third of American oil-and-gas producers could tip toward bankruptcy and restructuring by mid-2017, according to Wolfe Research. More than 30 small companies that collectively owe in excess of $13 billion have already filed for bankruptcy protection so far during this downturn, according to law firm Haynes & Boone. The deleterious impact of commodity unwinding and a strong dollar can devastate the global economic landscape to a great extent. And here is why a doomsday scenario is predicted if demand for commodities doesn't perk up.

International gold prices, that hit an all-time high of $1921/ounce in 2011, slipped to $1050 in December, 2015. In India too, gold that had crossed the Rs 35,000/10 gm mark in 2013 plunged below Rs 25,000 level before recovering to Rs 26,000. The LME’s metal index dropped 24 per cent last year, reaching the lowest since 2009. The Bloomberg Commodity Index, a measure of returns for 22 components, reported a negative return of 25 per cent for 2015. Ergo with no money being made across set classes which are all bearing the brunt of a commodity crush, there is no investible ostensibly for anyone to invest in other asset classes. Traditional inflation or fish hedges like gold are also seeing no uptick. The world has gone mad is the common refrain.

So, why is everyone grouching, more so if you are an Indian. Best news for oil importing economies like India where every dollar the needle moves downwards results in a saving of close to Rs 8000 crore on the oil pool deficit. India has saved billions courtesy the crude rout and this is a positive on the fiscal deficit front. Crude has fallen over 65 per cent since the $107 level of June, 2014. Unfortunately India has not been able to use this advantageously, it could have pump primed government spending in infrastructure and other development areas to alleviate rural distress for instance and revive consumption. Sadly, it has been slow to take decisions and this massive downturn has seen a golden opportunity being frittered away. A whole year of savings on imported oil and other commodities and consequent low inflation has thus gone by without any transformative decision making. Centrum Wealth says that the big party pooper for commodities has been China, the biggest contributor to oil and metals demand growth in the past decade. China is gradually moving towards a new growth model that is less commodity-intensive. The recent slowdown has forced China to reduce its commodity consumption and imports. According to official figures, China’s Q3 GDP growth dipped below 7 per cent year-on-year (YoY), but many believe that the real picture is far more disturbing with growth around only 3 per cent this year. The Chinese National Bureau of Statistics reported that Chinese industrial profits fell to $103.8 billion in Nov’15 compared to the same period in 2014. China's recent devaluation of its currency suggests the economy of the world's biggest oil importer may be worse off than expected.


Crude Collapse Hurts
While many countries are celebrating this price crash, it is severely hurting oil producing economies. Saudi Arabia is staring at a record deficit of 15 per cent of GDP, the government has cut planned spending by 14 per cent for 2016. In Nigeria, unemployment hit 9.9 per cent in the third quarter of 2015, according to the National Bureau of Statistics. The Russian currency, Rouble has lost half its value against the U.S. dollar since the summer of 2014, when oil prices began to fall. Inflation in Russia remained above 15 per cent throughout 2015. Household spending dropped by around 9 per cent and 2.3 million more people fell into poverty in the first 9 months of the 2015. In US, the energy sector has cut more than 90,000 jobs. The broad commodities ETF traded on US exchanges ended 2015 down 27.59 per cent, led lower by oil and natural gas.

International oil companies are also paying a big price for the decline in crude prices. At ExxonMobil, earnings sank 48 per cent through the first nine months of 2015, from $26 billion to $13.4 billion. Conditions were even worse at Chevron, where earnings plummeted 67 per cent year over year during the same period, from $15.8 billion to $5.2 billion. At ExxonMobil, upstream earnings slumped by nearly $16 billion in the first three quarters of 2015. However, the company's bottom line was cushioned by a $3 billion increase in downstream and chemical profits. At Chevron, upstream earnings plummeted to a $600 million loss from a $14.2 billion profit a year earlier. Fortunately, downstream earnings more than doubled to $6.6 billion from $2.8 billion.

Metals Losing Sheen
In other commodities, industrial metals also sank last year. In 2015 on the London Metal Exchange (LME), nickel shed more than 40 per cent, zinc and copper fell more than 25 per cent and aluminium was down over 18 per cent. Iron ore prices tumbled 40 per cent in 2015, again due to global oversupply and shrinking Chinese steel demand. In coal, thermal prices fell almost a third in 2015, hurt by waning Chinese demand and the rise of renewable energy. Both iron ore and coal have shed around 80 per cent in value since their respective historical peaks in 2011 and 2008. This big crash in commodities is hurting both commodity linked world economies and companies.

Brazil, one of the world's largest iron ore producer and exporter, was a fast growing emerging market not very long ago. But the commodity crisis has paralysed the economy, which declined by 3.5 per cent last year, making it the worst performer among the BRIC countries. The Brazilian currency, Real has collapsed, government bonds are close to junk status and the stock market, in dollar terms, fell by 40 per cent last year. South Africa, another commodity producing country, has seen its currency fall by 25 per cent and markets by 23 per cent last year.

The stock of BHP Billiton, the world’s biggest miner, suffered a 35 per cent cut in 2015, while Rio Tinto, the world’s second-biggest iron ore miner, fell 23 per cent last year. Glencore and Anglo American, the world’s third and fifth biggest miners respectively, announced major cutbacks. Anglo American, which paid the Oppenheimer family $5 billion in cash for their stake in De Beers in 2011, today has a market cap less than $5 billion compared to over $50 billion five years ago. The $5 billion West Pilbara Iron Ore Project led by Aurizon, China’s Baosteel Resources and South Korea’s POSCO, has been halted.

In precious metals, gold slid to a near 6-year low in Dec’15. It ended 2015 with a 10 per cent cut, its third straight annual loss on a stronger dollar and prospects that higher U.S. interest rates will hurt demand for this non-interest bearing asset.

I know this makes for terrible reading, but harsh economic facts cannot be ignored. Let us take notice of this empirical data to put the wind in our sails and remain insulated in what appears to be the onset of a very scary economic tsunami.