Are the commodity boom times over for Australia?

Commodity prices once again cushioned the Australian economy from a global slowdown

Australia has weathered COVID-19 and rebounded strongly from the lockdowns in 2021 and 2022 although the health impact continues to be harsh on sections of the community. A significant factor aiding the Australian economy over the past two years has been elevated commodity prices. Commodity prices (both rural and non-rural) have risen by nearly 65 per cent compared to pre-COVID-19 levels driven by the stronger than expected global rebound in economic activity, supply chain issues, the war in Ukraine and limited new supply.

Elevated commodity prices coincided with very loose monetary policy around the world and large amounts of fiscal spending. There were large investments in property and infrastructure projects, particularly from Australia’s largest trading partner China. Prices were impacted by the supply side too, as new producing capacity was not as forthcoming as in previous cycles, in part due to concerns about emissions.

Australia’s terms of trade reached record highs, boosting the resources and agricultural sectors, allowing profits to flow through to government revenues, assisting COVID-19 public sector emergency measures like JobKeeper. 

Have we passed the peak?

Central banks are having to make larger than expected increases in rates in response to more persistent inflation. The trade-off is lower economic growth, all while the global economy faces capacity constraints and disruptions from the war in Ukraine.

Movements in base metal prices can be a useful gauge of investors’ expectations about broader economic conditions, as they see a slowdown in industrial production as a harbinger of falling aggregate demand.  It is worth noting that while demand may be softer if industrial production falls, copper and aluminium inventories are at 15-20 year lows, which could help offset price falls in base metals. Some fall in commodity prices is inevitable in these circumstances (and suggested by futures prices) but what will determine Australia’s economic growth in the coming year is the extent of the declines.

At the same time, it’s important to note that commodity price movements are impacted by a variety of global factors, such as the war in Ukraine shows. We acknowledge the unknowns. 

Currency movements matter

Movements in commodity prices are important, but so is the value of the US dollar, which has reached a 20-year high (measured against a basket of other currencies). This has been assisted by the large rate rises by the US Federal Reserve and global turmoil pushing investors from higher risk assets into safe-havens. Given most commodities are traded in US dollars, when it appreciates, the cost to global buyers is higher, reducing commodity demand. On the other hand, a weaker Australian dollar (which reached a two-year low in mid-July at USD0.67 before rising recently to around USD0.70) further supports Australian miners, as exchanging the US dollar into AUD offers an extra profit boost. 

Iron ore

Australia is also the world’s largest exporter of iron ore and is Australia’s largest export, making up 23 per cent of our goods export proceeds in 2022 so far.

Iron ore experienced volatile price movements in 2021, reaching a record high of over $US230 per tonne in May, before falling to a low of just over $US85 per tonne in November due to China’s emissions driven steel production cuts and a slowdown in the Chinese property sector. Prices recovered in 2022 (to just over $US160 per tonne) as the Chinese Government promised large amounts of infrastructure driven stimulus – allocating CNY3.65 trillion in local government special bonds for 2022. 

Chinese steel producers ramped up production and built-up large stockpiles in the first half of 2022, anticipating the surge in demand. However, weakening steel demand from both the infrastructure and property sectors (which each account for around 30 per cent of steel demand) has led to a fall in steel prices (and profitability) with steel mills slowing production, pushing the iron ore price lower to just over $US100 per tonne currently.

Sentiment has been deteriorating on China’s ability to execute its promised infrastructure driven stimulus in an economy that could be partially locked down, as many countries face the impact of the latest COVID-19 wave. Concerns also remain about the Chinese property sector in particular. Financial stress in highly leveraged property developers could lead to spillovers in both the Chinese economy and financial system.

The supply side story remains relatively unchanged with Australia’s major miners operating close to capacity and the recovery of Brazilian iron ore production continuing to lag, following the 2019 tailings dam disaster. Hopes for new supply entering the market are far off with projects such as the Simandou iron ore project in West Africa unlikely to start producing for several years. Despite elevated iron ore prices, major Australian producers have not committed to greenfields projects, but have focused on infill projects to maintain current volumes. [1]

These factors are likely to keep downward pressure on iron ore prices moving forward. One possible offsetting factor though is China accomplishing its GDP and government spending targets, given the capacity constraints in iron ore supply. This could push iron ore prices higher. Consensus forecasts have iron ore prices reaching $US103 per tonne by the end of the year before falling to $US97 per tonne by mid-2023. [2]

Coal

Australia is the world’s largest exporter of coal in 2022, with coking coal and thermal coal Australia’s second largest export. [3]

China’s implementation of new technical barriers for coal imports from Australia in late 2020 disrupted the industry, and exports to that country fell to virtually zero. Australian coal producers were able to diversify into new markets quickly and even increase their coal exports. At the same time, the informal import ban harmed power generators and steelmakers in China as Australian coal tends to be of better quality than competitors.

While price falls were expected, prices actually increased in the following months, especially for coking coal. Beijing is currently considering an end to its nearly two-year ban on Australian coal, which would increase prices in an already tight market.

Australia has benefitted from price movements as it has opened to new markets. Coal prices increased due to a global rebound in economic activity and supply disruptions, including COVID-19 workforce disruptions. China specific factors lifted thermal coal prices in mid-2021, as there was a substantial increase in electricity demand and some disruptions to its domestic supply.  

The war in Ukraine drove coal prices higher as European countries attempted to substitute Russian gas with other sources such as US LNG and thermal coal. On top of this, disruptions in the gas industry pushed up demand for thermal coal (see Energy).

Coking coal has recently started to come off its highs. Some of the drivers are the omicron outbreak and tighter steel production quotas in China, impacting coking coal and steel prices. 

Thermal coal prices are likely to remain elevated in the short-term as European countries scramble to find alternative sources of energy before the European winter. In the long term however, once trade flows reorganise and European countries find reliable energy sources elsewhere, there will be downward pressure on thermal coal prices.

Consensus forecasts have coking coal reaching $US330 per tonne by the end of the year, before falling to $US277 per tonne by mid-2023. At just over $US400 per tonne currently, thermal coal is expected to reach $US310 per tonne at the end of 2022 and fall to $US238 per tonne in mid-2023. 

Energy

Oil prices rebounded in 2021, as oil demand rose, outpacing the reversal of production cuts. Concerns about a shortfall in supply were sparked by the war in Ukraine and Western countries taking measures against Russia.

Supply in energy markets is tight with world demand for crude oil far outstripping world crude production. OPEC has sought to increase production, but major OPEC producers are close to capacity.US shale producers have been relatively subdued in increasing production compared to previous periods of high prices. Oil supply is unlikely to increase significantly given the stronger drive by governments to reduce carbon emissions, with major producers reluctant to install new capacity given it might sit idle.  

Oil prices have been very volatile over the last month or so driven by both economic and political uncertainty (driven by Russia’s impact on tight energy markets), recently dropping on fears of a global recession. Consensus forecasts have Brent reaching $US101 per barrel by the end of the year, from just over $US90 per barrel now before falling to $US93 per barrel in mid-2023. 

LNG (Australia’s third largest export) prices, which are linked to oil prices, have spiked recently as supply tightened due to scheduled maintenance by Russia on the Nordstream pipeline in Europe, with gas flows failing to return to pre-maintenance levels. Gas flows were only at 20 per cent of capacity at the time of writing. This has led to several European countries substituting their gas needs from Russia to other LNG markets, such as the US, and increasing their use of coal to ensure a more stable supply (the EU is not equipped to import enough LNG to replace Russian gas entirely).

As China eases lockdown restrictions, demand for LNG is likely to rise adding further stress to an already tight market. Consensus forecasts have Asian LNG prices reaching $US33/MMBtu, before falling to $US28/MMBtu by mid-2023.

Global food prices

Global food prices have been rising for two years due to successive poor seasons for some major producers, while the war in Ukraine has impacted supply also. Higher energy prices have also pushed up food inflation due to higher fertiliser prices. 

Given Russia and Ukraine supply 28 per cent of globally traded wheat, 29 per cent of the barley, 15 per cent of the maize and 75 per cent of the sunflower oil, the conflict has devastating impacts on the lives of many people around the world. In particular, developing nations that cannot afford to provide support to its people and are large importers of energy (at very high prices).

Food prices have recently fallen due to beneficial weather in the northern hemisphere and a resumption of some Ukrainian agricultural exports.  However, the World Bank is expecting food prices to remain elevated for the remainder of 2022, before declining by 10 per cent in 2023. [4]

Falling commodity prices hurt government budgets

If commodity prices continue to fall, this will impact Australia’s terms of trade, company profits, GDP and government revenue. Using the Commonwealth budget sensitivities, a sustained $US10 per tonne decrease in the iron ore price will lead to a decrease in nominal GDP of $4.4 billion and tax receipts of $0.2 billion in 2022-23, and a decrease in nominal GDP of $2.3 billion and $0.6 billion in tax receipts in 2023-24.

Key commodity states will also be impacted by a $US1 per tonne fall in the iron ore price reducing Western Australia’s royalty income by around $81 million. While Queensland would see a $107 million fall in royalty revenue with a 1 per cent fall in the average export price of coal. However, given governments have implemented relatively conservative estimates for key commodity prices in the forward estimates, commodity prices have a long way to fall before they are lower than government forecasts.