Practical analysis for investment professionals
13 January 2016

The Commodities Crash: A Supply-Side Perspective

The Commodities Crash: A Supply-Side Perspective

2015 was brutal for commodities. Even worse, they took another plunge at the start of 2016.

The Bloomberg Commodity Index, which covers a wide range of natural resources, dropped to its lowest level since June 1999. The collapse in commodity prices happened across the board, from crude oil to iron ore, coal, and industrial metals. Unfortunately, there is little sign of stability or recovery: Oil and iron ore prices dipped even further in December. As a result, mining stocks took a beating, and ratings on mining bonds were downgraded.

Weakening demand from China receives most of the blame for the tumbling prices. China was the main driving force behind the rising commodity prices, its fixed-asset investment growing at an average of 25% from 2003 to 2011. The high investment growth was led by property investment and related heavy industries, the biggest drivers of demand for commodities. In 2015, property investment and construction slumped due to market saturation after years of overbuilding. Since China accounts for half of global base metal and bulk commodity consumption, the slowdown was thought to be disastrous.

The real curse for commodity prices, however, is on the supply side. The last decade’s commodities boom has led to irrational investment in new projects. China’s demand for iron ore and coal declined only this year, but commodity prices have been dropping since 2011. These price declines reflect concerns about a persistent surplus as mining firms continue to expand supply. Global iron ore production is expected to have increased by 100 million tons in 2015 despite the declining demand from China, and further increases are expected over the next two years.

Therefore, it was the aggressive increase in supply that most influenced commodities prices, and the prices will not stop falling until a supply-side adjustment occurs. The good news is that we have witnessed some progress on this front. Low commodities prices have forced many of the smaller producers out of the market. Some large mining companies have already announced asset sales and output cuts. Last month, the global mining conglomerate Anglo American announced it will sell or shut down 60% of its mines — cutting 85,000 jobs — and will pay no dividend for at least 18 months. Rio Tinto will cut its capital spending again, already down by US$13.5 billion over the last three years, to US$5 billion in both 2015 and 2016. Glencore, a huge coal producer, announced it will cut coal production at an Australian mine in 2016.

China will play a key role in this process. In fact, China itself is the largest producer of many of the world’s commodities, including coal and aluminium. Coal production fell 3.7% in the first 11 months of 2015. Aluminium and nickel producers are lowering production. Wuhan Iron and Steel Group declared in December it will cut more than 6,000 employees before the end of February.

The supply cut, however, will be marginal. Large companies are reluctant to cut operational capacity and will seek more inventive ways to keep operations going. Some of them will even take advantage of the low prices to increase production and gain more market share. For example, Rio Tinto plans to expand one of the world’s largest copper mines. Oil production from OPEC countries accelerated in November. China’s nonferrous metal production rose 7.5% from January through November of last year. Local governments in China will postpone the elimination of oversupply by supporting state-owned enterprises for fear of large-scale unemployment.

Looking ahead, the price outlook remains gloomy for commodity producers and, according to some experts, it isn’t going to get better any time soon. Until the supply is curbed to match the weakening demand, it never will.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Janet Zhang

Janet Zhang is Content Director, China at CFA Institute, where she leads the charge in providing content in Chinese to local members and develops content focusing on China for the global member community. Previously, she worked as an economist at Gavekal Dragonomics as well as Teck Resources, covering macroeconomic issues in China. Janet holds a PhD in economics from Nankai University and was also a Post Doc Fellow at Tsinghua University.

7 thoughts on “The Commodities Crash: A Supply-Side Perspective”

  1. Nitin Gulati says:

    Although, commodity rout has been widely telegraphed, its implications have yet to surface in light of muted bankruptcies. This supply-demand adjustment is a long term process and for someone willing to invest, two key things should be clear. 1 ) Survival of the business through this downturn, be it if dividend cut or asset sales are required – look for management that is focused on turning the business around not on appeasing investor base. .2) Long- term investing patience – as I alluded earlier in my note, this adjustment is a long term process , and could be more painful in the short term.

  2. peter dylan says:

    The supply numbers we have seen for the last couple of years has been increasing. From what I have gathered, it is clear that these numbers are grossly overstated. I am expecting to see a mass revision of these numbers and they will be significantly lower. Among many other factors, the methods of collecting the input data are largely bogus. The measurements are wrong.

    When the revisions come out, the recovery will be violent.

    Peter Dylan

    1. Janet Zhang says:

      Hi Peter,

      Thanks for the information and it is good to know that. It is hard to know the exact number of the increasing capacity for every industry. My point is that supply play a bigger role in commodity prices collapse. Take iron ore as an example. Chinese iron ore import volume rose 2.2% in 2015 and hit a new record. In other words, Chinese demand continued to rise in 2015, while iron ore prices halved.

      But I totally agree with you that if these numbers are overstated and the market realizes it, the price will rebound.

      Thanks again and best,

  3. Ashutosh Tilak says:

    Recent crash proves that Infinite growth is impossible for long term. The rules of market are applicable to every thing

  4. Alex says:

    The metals market will not remain low forever. The demand for metals does not decrease, actually opposite. So it’s just a matter of time before the prices will go up significantly.

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