A Boom in Pork Chops

If you need any further evidence that the bulk commodity bubble has burst all over the place, look no further than the actions of the Queensland government. These bozos announced their budget on Tuesday, ratcheting up the royalties on coal production.

For coal prices above US$100 per tonne, the royalty increases from 10% to 12.5%. If prices rise above US$150 per tonne, the royalty take jumps to 15%. The government thinks this new take hike will generate around $1.6 billion in revenue over the next four years.

Coking coal (used in steelmaking) prices are currently around US$150-$155 a tonne, while the thermal coal price out of Newcastle is around $90 per tonne. Clearly, the QLD government thinks coal prices will rebound to previously high levels, providing a windfall for them in the process.

That in itself should be reason for concern if you’re a continuing bulk commodity bull. It also goes to show that bubble psychology is in full swing. It’s something we’ve been giving a lot of thought to lately. That is, what makes a bubble and its bust aftermath so hard to see when you’re in the thick of it? Why do we need the benefit of hindsight to provide the clarity that should have been apparent at the time?

If there was genuine concern about China and the future direction of bulk commodity prices (coal and iron ore) then at best QLD would have left royalty rates unchanged. Coal is the state’s biggest export and one of its largest employers. Are its political managers really that stupid that they would increase taxes at a time of falling prices and marginal profitability for many producers?

We know, we know. You’re inclined to think, ‘Yes, they are that stupid.’ But we would suggest another form of stupidity. That is, a belief that the boom will continue indefinitely. A belief that what drove coal prices to record levels back in 2011 was not the result of a crazy China credit boom, but something more sustainable. That these politicians believe the recent price drop is an aberration gives us confidence in our belief that the boom is well and truly over.

But bubble psychology says we are probably still in a minority. The bounce in coal and iron prices over the past few days gives rise to the view that the ‘worst is over’. Producers and industry observers believe prices will head back to ‘more normal’ levels.

Maybe they’re right. After all, no one knows the future. But we think this represents a very Aussie-centric view of the world. By definition, a commodity is something that has global characteristics. There is no ‘brand value’ associated with it. The copper produced at Olympic Dam is indistinguishable from the copper produced at Escondida in Chile.

Bulk commodities are slightly different though. Quality does play a part. Australia has the advantage of having high quality coking coal, predominately from QLD, and iron ore, from Western Australia. The huge quantities of the stuff allow for economies of scale, which traditionally has seen Australia as a high quality, low cost producer.

While the quality remains, we are no longer a low cost producer. For many reasons, costs to find, develop and extract ore have surged over the past decade. According to Jennifer Hewett, writing in today’s Australian Financial Review, the average cost of coking coal production in Australia is US$150 per tonne.

If prices continue to decline after the dead cat bounce you’re seeing now, more mine closures and job losses will result. And for increasing royalties in the eye of the storm, the QLD government will look like the biggest bunch of pork chops* going around.

Having enjoyed a long boom on the back of the rapid industrialisation of China, we tend to forget that you can dig up high quality coal and iron ore from all over the earths’ crust. As always happens with commodities, the price boom brought about a global supply response. Iron ore and coal aren’t exactly scarce or hard to find. These deposits do take a few years to develop, but once that happens, supply invades the market, pushing prices back down.

If supply hits at the same time as demand cools, as appears to be the situation with China’s rapid slowdown, it tends to cause a bit of havoc in the industries concerned.

We’re not suggesting Australia’s big iron ore or coal mines are under threat of closure. Due to their size and quality they will produce throughout the cycle…only their profitability will fluctuate. But many marginal players will certainly feel the pinch in the years to come. Mines will close and jobs will go.

One of the major reasons for Australia’s continuing lack of competitiveness is the strong Aussie dollar. Normally, when commodity prices fall sharply in US dollar terms the Aussie dollar falls too. This cushions the blow and ensures revenues don’t fall too far, too fast.

But not this time around. The Aussie dollar is not acting like the shock absorber it usually is. So miners’ revenues fall while cost pressures remain high. The result is a margin crush. Because companies can’t control the revenue line they go to work on costs, something they can control. And that means job losses, mine closures and putting expansion plans on hold.

While the QLD government surely know all this, the fact that they go ahead and introduce an incremental cost increase anyway is idiotic. Either that or they think the boom is just having a rest…which is, as we’ve argued, idiotic too.

*For those unaware, a pork chop is an Aussie term for a bit of a buffoon.


Greg Canavan
for Markets and Money

From the Archives…

The ECB’s Outright Monetary Madness
07-09-2012 – Greg Canavan

Who Knows What’s Going on in China’s Centrally Planned Economy?
06-09-2012 – Greg Canavan

The Australian Dollar is Not the Euro
05-09-2012 – Dan Denning

Australia’s Unbalanced Boom
04-09-2012 – Dan Denning

Why a Monarchy Beats Modern Democracy
03-09-2012 – Bill Bonner

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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