Sent: 27-07-2010 10:18:10
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Government Speculates on Commodity Prices
In taking a big punt on the future of coal and iron ore prices, the Australian government is adding risks to the Australian economy that have not existed before.
The near 50% terms of trade rise which has added some $24 billion to Australia's real income since 2003 and an additional 1.3 percentage points to its 2.7% a year GDP growth rate has been primarily due to higher iron ore and coal export prices.
The prices of both products were hit by the global credit crisis in 2008. Nonetheless, coal export values in the March quarter of 2010 were 153% higher than in the final quarter of 2003 and iron ore export unit values had increased 191%.
Between 1960 and 2003, Australia's terms of trade moved higher by as much as 28% (in 1974) and lower by as much as 18% (in 1986) from their average value over that period of time but, overall, made no net contribution to Australia's real income. Periods of strength and weakness reverted to the norm quickly.
The government is now saying that the terms of trade are likely to be 9% higher in two year's time than they are today. In other words, officials are forecasting a continuation of an unprecedented historical strength in commodity prices.
Historically, the so-called bulk commodities of coal and iron ore had displayed less short term price volatility than prices for daily traded base metals. However, bulk commodity price volatility is set to increase permanently. The abandonment of annual contracts set by nominated negotiators on behalf of industry buyers and sellers needs to be taken into account in understanding future movements in the terms of trade.
Coal and iron ore miners had, in the past, been able to persuade potential buyers that they should agree to prices that would support the necessary amount of capacity. In most commodity markets, however, prices are set at the margin by the most desperate seller and the most anxious buyer fixing a price, not by consensus or a meeting of minds about average conditions. Sometimes, in more normal commodity markets, prices are set below costs of production and at levels that will not sustain existing capacity.
If the historical arrangements in the iron ore and coal markets are replaced by the pricing structures commonly found in other markets, iron ore prices could fall by as much as 30-40% to $45-50 per tonne without a serious threat to production. Chinese buyers, who now account for most of Australia's sales, would gleefully take advantage of the opportunity.
The downside risk in commodity markets usually plays strongly on the minds of investors who are used to this sort of market volatility.
Near the peak in the cycle, equity markets normally discount a continuation of high prices in favor of an assumed return to historical norms. Consequently, equity market values are now at odds with the view being taken by the government about future price trajectories.
One of these views is likely to be wrong. We should be bracing ourselves for a seriously large revaluation of Australian resource equities (if the government is right) or destruction of the underpinnings of the national budget (if the market is right).
The new resource rent tax arrangements are expected to raise up to $6.5 billion by 2013/14 by which time the government expects to have a budget surplus of $5.4 billion. Unfortunately, the government has not published any analysis of how sensitive its revenues will be to any change in assumptions about commodity prices.
Let's say, for our own purposes, that iron ore and coal export prices fall 30%. Without any other change, the value of annual sales from Australia's export mines would be cut by $19.3 billion, based on ABARE production forecasts for 2010/11. Assuming the sales decline goes straight to the bottom lines of producing companies with an effective marginal tax rate of 35%, government coffers would be worse off by some $6.8 billion a year.
Lower prices will not just be a matter for the companies and their shareholders. They will produce budget shortfalls that add to the risk of falling bond prices. As interest rates rise, equity values would probably decline across the board and the exchange rate would typically move sharply lower. Government spending would have to be cut and other types of taxes would have to rise to reach the desired budget targets. Employment would probably be lower, too, leaving companies with weaker earnings.
Paradoxically, since resource sector equity values have already taken account of lower prices than the government is assuming, the most domestically exposed parts of the economy such as banks and retailers might face the greater equity market downside if the government is wrong.
If the government took a leaf from the playbook of investors in the sector it might do something along the following lines:
- assume that prices will move more quickly than it currently anticipates toward pre-2005 norms;
- if this proves too pessimistic, put any unanticipated revenue gains into debt reduction; and,
- only commit to spend what is sustainable based on previous pricing outcomes.
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