Sent: 28-08-2012 13:17:02
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The End of the Resources Boom
Martin Ferguson rained on the resources boom parade but Julia Gillard and Penny Wong had umbrellas handy. So did central bank head, Glenn Stevens. Belying his background as a 1980s union heavyweight, minister Ferguson shines as a beacon of good sense.
The BHP Billiton decision to stall development at its giant Olympic Dam mining project was a catalyst for a series of sharp exchanges about whether Australia remained in the midst of a resources boom.
As the biggest in the sector, BHP Billiton needs very big projects to make a meaningful impact on its value. Very big projects, like Olympic Dam, are hugely expensive. Because they are so big, they can also have a negative impact on prices when their output first hits the market. Their rates of return look skinny when the numbers are crunched on a realistic set of assumptions.
The predicament of BHP Billiton is hardly typical of the industry. It is the giant facing the prospect of simply being too big to succeed.
Olympic Dam is such a wonderful project it might never realise its potential. Smaller, less capital intensive projects with less potential impact on market conditions are likely to go ahead more quickly and offer superior investment returns.
We should not confuse what is happening at BHP Billiton with whether or not there is a resources boom.
Happily, the Prime Minister clarified the comments by her resources minister about the boom. Apparently, he was only talking about the trajectory of commodity prices when he observed its passing.
Prices, Gillard and her other ministers averred, are not the most important aspect of a resources boom. The level of investment, supposedly a far superior measure, was yet to peak, according to some.
Others began defining a boom in terms of exports. Exports will continue to rise well after prices and capital spending had both begun a descent from their elevated levels. So, on this measure, the boom has legs yet.
The term "boom" conjures notions of new and unexpected frontiers in financial and industry outcomes. It suggests a paradigm shift in terms of previous sizes but also momentum and longevity. A boom should be something more than simply a periodic cyclical upturn that will be repeated from time to time.
At the heart of a resources boom must be prices. Only higher prices generate the quick profits that raise equity values sharply, rapidly alter expectations and fund levels of exploration and mine development that had not previously been thought likely. They offer fiscal windfalls that permit tax cuts and more generous spending commitments by governments spurring economic growth.
The danger in an overly cavalier use of the term comes from the behaviours that are fostered. Not having to work for higher prices, companies take them for granted becoming less conscious of the need to contain costs and less rigorous in their assessments of business prospects.
Companies initiate projects that might struggle in a cyclical downturn, if they believe none is likely to recur. Projects end up providing an inadequate return on capital, making for a less efficient economy. Governments apply temporarily inflated tax revenues to permanent spending programs setting the scene for a potential fiscal imbalance in later years.
Talk of a boom lures entrepreneurial talent and small scale risk capital into high risk exploration that could otherwise move into manufacturing or other economy diversifying investments that support improved longer term growth prospects.
Ferguson is right to worry about these consequences, express greater caution and urge a more realistic view on all stakeholders about the industry's performance.
In equity markets, thoughts of a resources boom dissipated long ago. Over the year to June, for example, the median return from an investment in the ASX listed sector was a daunting -45%.
The yawning gap between project costs, on the one hand, and the prices investors have been prepared to pay for new projects, on the other, was one sign that ongoing talk of a boom was becoming increasingly misplaced.
At current equity values, many developments now underway would not have commenced. The capital spending cycle is continuing in part because prior commitments cannot be scaled back easily.
As for exports being the benchmark for a boom, it would be a very disappointing result if exports failed to rise for a decade or more after the currently anticipated levels of investment spending.
Unfortunately, the marginal productivity of the capital now being invested by the industry has already started to decline. There is less output (and less exports) for every dollar being invested.
Large capital commitments will generate short term construction jobs but look set to generate poor investment returns over the medium term. There is no boom in financial outcomes. They are becoming downright ordinary.
A "boom" should be unequivocally good news. It should summon ideas of rapidly increasing prosperity. Positive momentum should be readily evident in market values.
Huge amounts of capital going into investments struggling to offer competitive returns well after commodity and equity prices have begun to sink do not meet these tests.
We had a very strong cyclical upturn. There will be more in the future but, for now, it's over. The rhetoric should change. And we should be thinking about managing the aftermath.
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