Boom will return, don't ask when

ERIC REGULY AND ANDY HOFFMAN

Globe and Mail Update

October 24, 2008 at 9:14 PM EDT

ROME, TORONTO — The commodities massacre took even the biggest, the best and the allegedly brightest by surprise.

Take Companhia Vale do Rio Doce, or Vale for short, the Brazilian iron ore giant that owns Canada's Inco. In August, the company shocked its Chinese customers when it told them it wanted to renegotiate iron ore contract prices.

It was an unprecedented move; in February, Vale had boosted contract prices by more than two-thirds. But the company and CEO Roger Agnelli were bullish on iron ore and argued that the Chinese, and other Asian customers, should pay more.

Mr. Agnelli's timing could not have been worse. Just as his company was trying to make its case, iron ore prices began to slip. Now they're plunging. In August, iron ore going into China was priced at about $140 (U.S.) a tonne. It's now about $80 and could easily drop further.

Vale chief Roger Agnelli

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Guess what? The Chinese are now happy to renegotiate, but for lower prices, not higher. “The Chinese want retribution,” said Michael Komesaroff, a former Rio Tinto executive who owns Australia's Urandaline Investments.

Mr. Komesaroff's consulting firm advises some of the mining world's top players. “They [the Chinese] will exact their revenge.”

Mr. Komesaroff has worked in the industry for 30 years and said he has never seen a price collapse as swift and deep as the one now clobbering commodities. The prices of most have fallen between 50 and 70 per cent since the summer as the financial crisis, sputtering economic growth and the rising U.S. dollar sap demand and buyers' confidence. He, and others, think the exodus of the hedge funds and other commodity speculators are only accelerating the fall. “I don't think we've seen the bottom,” Mr. Komesaroff said. “There's more to come.”

Indeed, in the past 24 hours, the commodities drubbing has gone from bad to worse. Asian and European stock markets were hammered again yesterday. Copper traded as low as $1.66 a pound yesterday, its weakest level in more than three years. Peak oil? Try weak oil. The price of crude slid as much as 7.7 per cent to below $63 a barrel on the belief that a full-blown global recession will squelch demand.

The commodities bust is sure to be devastating for Canada. Mining is among the country's largest industries, accounting for more than $42-billion (Canadian) of gross domestic product (GDP) in 2007 and nearly 400,000 jobs. The seven-year runup in prices, particularly oil and gold, has been a major driver of Canada's economic strength and the loonie's recent rise in value above the U.S. dollar.

Globally, more than a trillion dollars in equity value has evaporated from the mining sector in the past few months. In Canada, major producers have seen their stock prices decimated. Just a few months ago, Potash Corp. of Saskatchewan briefly held the title of Canada's most valuable company when its stock peaked at $246 a share and its market value was $77-billion. Yesterday, Potash shares changed hands for about $84, meaning the fertilizer producer's value had plummeted by more than $50-billion to about $26-billion.But mining analysts, executives and investors are not entirely pessimistic. Already dozens of mining and smelting operations are being shuttered as prices fall faster than costs. Investment in new projects are being scaled back or cancelled. The pace of closings, as one top commodity trader said, “could go from a trickle to a flood.” If it does, the supply-demand balance could be restored fairly quickly, depending on the recession outlook.

And China, the main source of the commodities demand growth in recent years, could surprise the markets with renewed buying. China's growth rate is falling, but it's still spectacular by European and North American standards. Urbanization means that millions of new homes have to be built every year. As commodity prices fall, metals production will slow, putting upward pressure on prices.

But when might this happen? The “stronger for longer” theory about commodity prices, coined by Mick Davis seven years ago as he and his Glencore International backers launched Xstrata, may require some fine tuning. All bets are off in the next few quarters, perhaps longer.

Projects shuttered

The global commodities selloff is claiming new victims every day. Since Oct. 10, the rolling tally of curtailed or abandoned mining operations and projects has grown to about 25. And with credit markets all but boarded up, corporate spending is falling of a cliff.

Until a few weeks ago, Lukas Lundin still believed his industry could escape the downdraft of the U.S. financial crisis. Now, he concedes he's witnessing the worst resource sector correction in half a century. His companies, including the flagship Lundin Mining, have been forced to take drastic action. “We're cutting costs and we are making sure that operations are at least cash flow positive. If not we will shut them down,” he said.

Mr. Lundin has plenty of company. This week, Freeport-McMoRan Copper & Gold reduced planned capital expenditures by about $370-million (U.S.) at its Arizona mines, and Canada's FNX Mining suspended commercial production at its Levack nickel site. Last week, Russia's Norilsk, the world's largest nickel producer, halted production at the Cawse nickel operation in Western Australia and China's Chalco said it is shutting one million tonnes of annual production at its Shangdong alumina refinery.

The precipitous fall in commodity prices has come as an unpleasant surprise to the ore-rich developing countries that were on the verge of opening new mines and raising the living standards of their workers.

One big potential victim is the Democratic Republic of the Congo. High debt, low copper and zinc prices, corruption and a civil war nearly killed state-owned mining company Gecamines. But after 69-year-old Quebec lawyer Paul Fortin became managing director in 2006, production climbed and was set to soar as dozens of mining joint ventures with foreign companies of various sizes were created.

While production has yet to slow, Mr. Fortin said in a phone interview that he fears the financial crisis will stall some of the dozens of new development projects, although not those with bigger, well-financed partners. “The ones I expect problems with are the small companies that will have trouble raising money in the marketplace,” he said.

Commodity prices are sinking every day. This week, copper slid well below $4,000 (U.S.) a tonne, less than half of the summer peak of $8,900. Incredibly, copper has held up better than most other commodities. Palladium had gone from the April peak of $587 an ounce to less than $170. Platinum has also shed about two-thirds of its value since then. Aluminum has gone from about $3,300 a tonne to less than $2,000.

Nickel prices are so low – the price has gone from more than $33,000 a tonne to around $9,000 – that analysts and some industry executives think more than half of the global production is unprofitable. Mining giants like BHP Billiton are probably losing hundreds of millions of dollars a year on nickel, they said. Much of global zinc and lead production is also failing to clear its production costs.

“We are stopping every expenditure we can stop,” said Jowdat Waheed, CEO of Sherritt International, the Toronto-based nickel, cobalt, coal and oil producer.

The planned expansion of the company's Moa nickel mine in Cuba and its refinery in Fort Saskatchewan, which is already one-third completed, is now under review and likely to be halted. The company's major nickel foray, the $3.3-billion Ambatovy mine in Madagascar, of which Sherritt owns 40 per cent, is still going forward despite the plunge in nickel prices.

Birth of a bubble

Commodity prices began to take off in 2002 after a long period in the doldrums. The triggers were simultaneous growth in most regions, from Russia to India, explosive industrial development in China and urbanization. China's urbanization rate is 1 per cent, meaning 13 million Chinese have to find city homes every year.

The trend created unprecedented demand for everything from copper (electrical wiring and plumbing) and stainless steel (appliances) to platinum (automotive) and coal (power generation). Investors bought into the story big time.

Prices soon doubled and tripled. Hedge funds jumped on to the bandwagon, pouring billions into the mining space, much of it leveraged. The funds added buoyancy to metals by buying both shares of producing companies and the commodities themselves, thereby creating a self-fulfilling upward drift. Xstrata and other companies based their “stronger for longer” theories on their unwavering belief that the long-term trend was up.

None expected last year's subprime mortgage meltdown in the U.S. to erupt into the global financial crisis that now seems on the verge of plunging much of the world into recession.

China's GDP growth is going from low double-digit to high single-digit rates, which alone has been enough to hammer prices lower. Standard Chartered Bank has revised its forecast for Chinese primary aluminum consumption growth to 14 per cent in 2008 from 38 per cent last year. The recent rise in the U.S. dollar – commodities are priced in dollars – has added momentum to the price plunge.

Don Coxe, a commodities bull and global portfolio strategist at Bank of Montreal in Chicago, never saw the crash coming. In June, he helped launch a commodities investment fund called the Coxe Commodity Strategy Fund, which raised just under $300-million. In the past month, more than a third of the fund's unit price has been wiped out.

“I have been battered from pillar to post over the last few weeks,” Mr. Coxe said.

Governments in the U.S. and Europe are pumping more than a trillion dollars into banks to prop them up and encourage lending. The government intervention, Mr. Coxe believes, forced the hedge funds to unwind their most popular trade – buying commodities while shorting the banks. A cascade of hedge funds going bust liquidated their positions in commodities and commodity stocks, exacerbating the selloff.

There is general agreement that the conditions for an eventual rebound will soon come into play. Mine and smelter closings, and delayed projects, will soon start eating into supply. The inability of junior mining companies to obtain financing means new projects will have trouble getting started.

But the big hope is China. While exports are falling, domestic consumption – a far bigger component of GDP – is rising as the Chinese middle class expands. Interest rates are falling and fiscal stimulus packages are being put into place.

“China will use fiscal policy as America did with FDR in the '30s and as Japan did in the lost decade of the '90s,” said Gerald Lyons, Standard Chartered's chief economist, who expects Chinese GDP growth to hover at 7 per cent in the next two years.

Battered and bruised, Mr. Coxe says he's suddenly more sanguine about the resource sector's prospects than he has been in months.

“Once the global economy has come back, force fed by these trillions of dollars that are being pumped into banks, when it comes back there is not going to be much stuff around to buy,” he says.

There are already promising signs. The beleaguered price of nickel shot up more than 9 per cent in London yesterday after Vale and Mr. Agnelli announced the company's nickel production in China and Indonesia would be cut by 65 and 20 per cent respectively. Sudbury production is safe for now but development projects such as Inco's Goro project in New Caledonia will be delayed.

“We won't sell at any price,” Mr. Agnelli said on a conference call.