Sent: 26-06-2014 09:16:02
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Australia Faces Long Term Export Headwinds
Australia's major mining exporters are facing some strengthening structural rather than cyclical headwinds. Both iron ore and coal - which together accounted for 42% of Australia's 2013 export earnings - could be facing shrinking markets.
China's steel production over the first five months of 2014 accounted for just on half of total global output with the remainder spread over 60 other countries. Chinese steel production is pivotal to the fortunes of Australia's iron ore exporters.
Chinese steel production grew at an annual rate of 16% between 2000 and 2011, a rate which could not have been sustained under any reasonably foreseeable circumstances. A slowdown in growth was inevitable. Even so, the quantity produced has continued to increase. It was 4.9% higher in the five months to May than in the corresponding period of 2013.
Increasing Chinese steel production coincided with an increase in the contribution of investment spending to Chinese GDP and, within the fixed capital component of national output, an increase in the intensity of steel usage. Large scale construction and infrastructure programs, partly to accommodate a burgeoning urban population, were important drivers.
As is now widely acknowledged, some of this investment was deployed inefficiently by provincial officials seeking to meet growth targets. Improving the efficiency of investment spending would, on its own, reduce the quantities of steel required for any given economic outcome. Over and above this, government policies have been directed at rebalancing the economy to put a heavier emphasis on consumption as a growth driver.
The eventual trajectory of steel output will depend on how quickly these changes are implemented. The signs so far point to the change occurring more slowly than might have been inferred from government statements. In practice, officials have had to balance making the switch in economic emphasis with fulfilling expectations about overall growth outcomes.
The 7-7.5% GDP growth target set as official policy was always going to be hard to meet. With investment running at around 45% of GDP and set to fall, consumption spending would have to be rising at a nearly impossible double digit rate for the overall GDP growth target to be met. Reflecting some of these forces, GDP grew at an annualised rate of just 5.7% in the first quarter of 2014.
There are a range of feasible outcomes but Chinese steel output could be falling by 2019 as these adjustments continue. Such a possibility would be consistent with the following seemingly plausible scenario:
- Chinese GDP growth decelerating from 7.5% to 5.5%;
- the share of investment in GDP moving from 45% to around 38% where it had been in 2002-03 but remaining higher by several percentage points than in the mid 1990s; and,
- a decline in steel intensity closer to levels prevalent at the turn of the century.
Faster or slower changes in these variables would modify the steel production outcome but, one senses, the risks are on the downside for Australia's iron ore and metallurgical coal exporters and those seeking to open new mines in anticipation of continuing growth in demand.
A recent report by the International Monetary Fund highlighted another aspect of the Chinese economic adjustment that would affect the positioning of Australian companies from an investment perspective. According to the IMF, the pattern of raw material demand changes with changes in income levels. Demand for basic and low grade commodities, including copper and iron ore, will start to grow more slowly as key per capita income levels are passed in the coming 10 years. Demand for metals like zinc, aluminium and tin will rise more quickly.
As it happens, the metals with the stronger future growth prospects are ones that have been given a lower development priority by Australian miners over the past decade.
Earlier this month, the International Energy Agency published an updated report on the investment required to meet the world's energy needs over the next 20 years. The IEA has observed that the cost of producing and delivering a unit of energy has doubled over the last 10 years so that energy prices will have to continue to rise to justify the investment that will be required.
The IEA expects coal demand for electricity generation to rise from 3,796 million tonnes of oil equivalent to 4,398 million tonnes by 2035 if current polices are kept in place. Carbon dioxide emissions under this scenario would rise from 31.5 Gt in 2012 to 37.2 Gt. If governments put policies in place to limit global temperature increases to 2DegreesC over the next 20 years (with most of the effect occurring after 2020 given the time needed to seek agreement), the IEA has estimated that annual global carbon dioxide emissions would be reduced by almost 16 Gt. In this scenario, coal demand for electricity generation would fall 30% below currently estimated usage and 40% below the anticipated production in 2035 under current policies.
In a double blow for Australia, the IEA assessment suggests that the competitiveness of the Australian coal industry will be challenged. Australia will be among the most expensive places to produce steam coal over the next 10 years, according to the IEA study.
The IEA puts the average cost of steam coal production for Australian greenfield projects at $90-95 per tonne, including sustaining and development capital costs. US Powder River Basin production is expected to cost $20-25. The range between Australian producers and the lowest cost US production includes South Africa, Colombia, China and Russia. The IEA analysis suggests that prices will have to be high enough to support new production but, among the major producing nations, Australia is at risk of struggling for profitability indefinitely.
Of course, there is a substantial chance governments will be unable to agree on a plan to reduce carbon dioxide emissions in the coming year so that coal will not be hit so dramatically. Optimistically, too, carbon capture techniques might allow coal to continue as a cheap and abundant fuel source.
In any event, Australia is facing some important structural risks on the mining side of the economy at around the same time it faces important adjustments within its manufacturing base with the exit of its remaining car makers.
(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
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