Issue: 316
Sent: 12-09-2012 15:08:02
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Australia to Face More Price CyclesSMSF story in the Weekend Fin Review
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Australia to Face More Price Cycles

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

The government flip flop on the floor price for carbon makes the Australian economy more vulnerable to volatile commodity price cycles just as governments, policy makers and company executives are calling for more certainty.

The sharp decline in iron ore prices in the last month has had a sobering effect on the public discourse as it seemingly caught many by surprise. A 30% fall in iron ore prices has implications for company profitability, the government's fiscal balance and the performance of the Australian economy.

In announcing labour cuts, spending reductions and postponed additions to mining capacity, Fortescue Metals chief executive Nev Power asserted that "the fall [in iron ore prices] has been much sharper than anyone anticipated".

It is as though, like the Men in Black movie, someone neuralyzes all mining executives after the completion of each price cycle. Having lost all previous memory of how prices always converge on costs in a rapid cyclical adjustment once supplies catch up with demand, executives overreact to the change when it next happens.

Their panicked responses plant the seeds of the next cycle when they are, once again, confronted by an unanticipated shortage of product and eventually higher prices at which point a mysterious man in black appears, flashes a bright light in their eyes and their memories of the cycle are again obliterated.

A cyclical decline in raw material markets has been evident since the beginning of 2011. Since then, supplies have been catching up with demand in a typical cyclical adjustment which puts a lid on prices and then pushes them sufficiently low to cause markets to balance.

Commodity markets have always behaved in this way. The only surprise is how anyone seriously involved in these markets could have been surprised.

The iron ore segment lagged most of the non ferrous metals in the timing of its ascent as well as the beginning of its decline but the cycles are converging as all the markets are adjusting to slower demand and the effects of decisions to expand production taken in prior years.

Just as the government was coming to terms with the fall in iron ore prices and the consequences for national economic policy, it was forced to abandon its plans to apply a floor price for carbon.

Business executives had been especially critical of the government's plans because the European carbon price had fallen well below the Australian mandated floor price of $15 a tonne that was to be effective from 2015 once the transition from a fixed $23 a tonne price to a market based mechanism was to occur.

The carbon price, like the price of iron ore, is going to be cyclical reflecting changes in the balance between how many permits are sought and the available supplies.

Europe is near a low point in its own economic cycle. Demand for carbon permits is correspondingly weak but, at some stage in the coming five to seven years, an acceleration in European economic activity will be accompanied by a cyclical rise in the production of carbon. Meanwhile, the supply of permits will have been held back by the reluctance of business to invest in new technologies, all of which makes for a typical cyclical market.

The inclination to assume a low carbon price when Australia moves off its current tax based fixed price in favour of a market price may prove as misplaced as the assumption of continuing high iron ore prices is proving to be.

Drawing inferences about future conditions in inherently cyclical markets by extrapolating current prices is to mistake the nature of these markets.

There is no guarantee that a carbon pricing mechanism is going to achieve a meaningful cut in carbon emissions. Markets achieve their beneficial welfare effects by keeping prices as low as possible under the given demand and supply circumstances.

The iron ore price will move to the lowest possible level consistent with meeting the demands of the steel making industry. Neither the profitability of the iron ore miners nor the fiscal needs of the Australian government will influence the outcome. The government could only affect the price if it chose to reduce the amount of iron ore it allowed Australian miners to ship.

Similarly, a pure market offers no guarantee that the carbon price will be high enough to wean industry off carbon generating technologies.

The market has no interest in the carbon intensity of the economy. If the price is not high enough to do the job, the government will have to step in to keep mandating lower and lower emission targets so as to raise the carbon price to the necessary level.

Calls for policy certainty may be showing how naive governments and business are about how markets operate.

Australian industry will now get all the certainty of a Chinese steel maker buying iron ore on the open market.

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