Materials Risk

Iron ore is the second most important global commodity behind oil. Despite its status the market tends to get very little attention. Changes in the underlying price of the ore has a significant impact on the revenue of the mining giants. It would be a mistake for investors to ignore the lore of ore.

Seaborne iron ore prices hit a 6 year high in late August of over $130 per tonne. The 30-40% increase in iron ore prices since the start of 2020 has lifted iron ores share of steel costs to an all-time high. Iron ore prices have surged as Chinese port stocks have dropped sharply, production difficulties in Brazil and the prospect of surging infrastructure demand for steel.

Chinese imports of iron ore during the first 8 months of 2020 are already up 11% versus the same period in 2019. Despite the coronavirus (or perhaps because of it) imports show no sign of diverging from their longer term trend.

The increase in imports has in part been driven by domestic supply problems. Reduced supply of scrap steel has limited the use of electric arc furnaces and increased the reliance on iron ore to produce steel. The primary driver has been an increase in stimulus measures aimed at encouraging greater infrastructure and construction activity.

Related article: It’s time to build: Here’s what that might mean for commodities

Iron ore prices have been supported by fears over supply disruptions from Brazil, one of the key suppliers to China (the others being Australia and India). Coronavirus outbreaks have plagued its mining regions. As cases spiked during April and into May so did the price of iron ore.

Meanwhile, the Brumadinho dam disaster in early 2019 has also curtailed supply. Widespread stoppages occurred at other mines in southern Brazil due to wet weather. All told its been another case of a massive hit to supply at the same time as demand has rebounded sharply.

Domestic Chinese iron ore mines tend to be the most expensive and so are on the far right of the cost curve. With prices around $120-$130 per tonne that means even Chinese miners may be able to break a profit. High prices may mean that Chinese miners begin to increase output, but relative to seaborne iron ore they are very uncompetitive and so are unlikely to play anything more than a minor role in balancing the market.

Up until the end 2018 movements in the price of iron ore have been matched by the Aussie dollar (AUD/USD). Australia continues to be one of the two main suppliers of iron ore to China and the commodity is Australia’s single largest export and foreign exchange earner. Although the Aussie dollar has rebounded from its COVID induced lows it remains low relative to the price of iron ore.

The lack of any significant appreciation in AUD may indicate that the surge in iron ore prices is unsustainable. Or it may just represent the breakdown in the trading relationship between Australia and China. If that gets worse then it may mean China increases its dependence on Brazil and other major producers.

Iron ore prices (shown in black in the chart below) tend to be correlated but show much greater seasonality then finished steel prices. Iron ore prices tend to rise in the Chinese summer and winter ahead of peak construction periods in the autumn and spring. If the relationship continues to hold then the next couple of months may see iron ore prices weaken ahead of a rebound later in the fourth quarter.

High iron ore prices are typically a boon to mining giants like BHP and Rio Tinto. The latter previously said that an extra $10 per tonne of iron ore generates an additional $2 billion in free cash flow. Despite high iron ore prices the UK share price of both companies is almost unchanged year-to-date (+/- 5%). These mining giants are exposed to other commodities and so are not a true bet on the price of iron ore. The purest play on the price of iron ore is Fortescue Metals Group, listed on the Australian Stock Exchange. Since the start of the year its share price is up over 70%.

Overall then the iron ore market has been caught between heavily restricted supply conditions in one of its major suppliers. coupled with a surge in demand from its main consumer. Seasonal trends might point towards a weaker iron ore price over the next couple of months but with further stimulus likely in China over the next six months and an inflexible supply side then iron ore prices are likely to remain strong going into 2021.

When you think of gold you tend to think of it as an asset to protect against financial, economic and geopolitical Armageddon. Unbeknownst to many gold investors, one of the largest drivers of gold demand and the overall price level are Indian households. Demand depends on three key factors: demand for crop insurance, the Diwali shopping season and end of year wedding parties.

Around one-third of Indian gold demand comes from rural farmers, who have traditionally spent a percentage of their crop revenue on gold. The precious metal is held as a type of insurance and sold in times of dire need.

This insurance becomes essential when you start to realise how crucial the monsoon season is to India’s agriculture sector. During an average year, the Indian subcontinent can receive close to 80% of its total annual precipitation during the summer monsoon season.

When the rains fails to materialise (as we saw in 2014 and 2015) farmers suffer, gold purchasing drops or even reverses as farmers offload some or all of their gold (insurance) to pay for food and other necessities.

Diwali (also known as the Festival of Lights) is a major shopping season in late October or early November. Families typically splash out on gold jewellery. Merchants and jewellers purchase gold during the third quarter of the year in anticipation of a surge in demand .

Finally, Indian weddings are held in the fourth quarter (after mid-November more specifically) due to Hindu tradition. Although there is some movement towards other precious metals, gold remains the dominant metal of choice for a bride to be. As in other cultures, the wedding ring acts as a form of financial security for the bride.

With so much gold buying activity concentrated in such a short time period, recent economic activity and expectations for the future matter a great deal. And the factor that matters most is the monsoon season. A bad monsoon results in a poor harvest requiring a farmer to buy less gold or even sell some. A bad monsoon reduces the spare cash to treat their family to gold jewellery. A bad monsoon reduces the likelihood of weddings taking place and the potential money available for their guests to spend as a gift.

According to the Indian Meteorological Department (IMD), August 2020 saw the country receive 25% more rain than average (the highest August rainfall since 1976). This comes after recording 10% less rainfall than average in July. The IMD forecast that the monsoon may slow down in September.

Despite being hit badly by coronavirus, plentiful rain helped prompt Indian crop plantings to hit record levels. All things considered its been a good monsoon. With the rural economy accounting for 45% of India’s GDP that should be very positive for Indian gold demand.

It’s not necessarily a one-way bet. Long term holders of gold may be tempted to sell gold trinkets and coins in order to profit from the surge in gold prices that has taken the yellow metal to record levels. In past periods in which gold prices have surged, holders of gold have taken the opportunity to pocket some of the rise in prices before buying when the price fell back.

The decision to sell or not, will as ever be determined by expectations over the future value of gold and the need to hold it as an insurance. However, it could be argued that things are different this time. Gold’s role in the Indian economy and financial system has changed since the past gold peak in 2011-12.

First, young consumers have an increasing range of products to purchase or to receive other than gold jewellery. That might mean they are less willing to pay recent ‘high’ prices for gold and gold jewellery once Diwali and the wedding seasons approach.

Second, Indian consumers have been encouraged to open bank accounts. This might potentially reduce the opportunity cost of holding physical gold versus the convenience of a bank account.

Both of those factors are negative for gold demand. The third factor I believe will be an overwhelmingly positive driver of gold demand.

And so third and finally, gold can increasingly be used as collateral for relatively inexpensive loans. So instead of having to sell gold to release funds, farmers and other gold holders can borrow using their gold as security. This reduces the incentive to offload their gold to release cash.

Cash strapped families would often pawn their gold to informal lenders. With interest rates ranging from 25-50% this was viewed as a last recourse by many. The sky high rates would often cripple families not able to pay back the loan resulting in them forgoing their gold.

Now banks and other financial institutions are rushing in to lend money secured on the $1.5 trillion of gold owned by Indian households. The extra competition should result in much lower interest rates and provide an additional reason for households not to part with their gold.

Gold is intrinsic to the Indian economy and its culture and has been so for hundreds of years. That relationship is unlikely to disappear in the period since the last boom in gold prices a decade ago. Indeed, gold’s role as security is arguably becoming more important to the Indian economy than ever.

Related article: Gold prices: The top 10 most important drivers

The price of lumber hit a record high of over $800 per thousand board feet last week, an increase of over 300% since early April 2020. As coronavirus spread across North America mills cut production in expectation of plunging demand. The mills didn’t count on a surge in home renovation projects and an exodus from the cities as urban dwellers pined for a country retreat.

The lumber market is just one of many examples across commodity markets and other supply chains caught out by the bullwhip effect.

The bullwhip effect is a phenomenon that can occur in supply chains in which irregular or unexpected orders by consumers reverberate up the supply chain. As participants in the chain react to the new information the impact is amplified, resulting in wild swings in inventories.

The bullwhip (or whiplash) effect was first coined by Proctor Gamble in the early 1990’s when they noticed that erratic orders for nappies were amplified through their supply chain. The effect has been recognised in markets as diverse as computer memory, shipping containers and my favourite, beer. Each of them have seen orders in which the variability cannot be explained by fluctuating consumer demand alone.

There are four sources of the bullwhip effect – demand signal processing, rationing game, order batching and price variations. Demand signal processing is where demand fluctuates but players in the market use past demand information to update forecasts. The rationing game refers to the strategic behaviour of buyers when a supply shortage is anticipated. Order batching occurs when there are economies of scale from buying in bulk. Finally, price variations are exactly that, non-stable prices.

The bullwhip effect was first gamified into the “Beer Game” – an experimental game in which players make independent inventory decisions relying only on orders from the neighbouring player as the sole source of information. The task is to produce and deliver units of beer: the factory produces and the other three stages deliver the beer units until it reaches the customer at the downstream end of the chain. Try it out for yourself https://www.supplychain-academy.net/beer-game/.

The bullwhip meets the cobweb

The Cobweb Theorem was developed in the 1930s by two economists at the Bureau of Agricultural Economics, G.C. Haas and Mordecai Ezekiel. The two researchers were trying to make sense of the volatility they saw in the price of hogs, and help develop a model to help farmers adjust supply more rapidly to demand.

The theory shows how supply and demand responds in a market where the amount produced must be chosen before the price is observed. Agriculture is a great example of where the theory might apply, since there is an interval between planting and harvesting.

For example, because of unexpectedly bad weather, farmers go to market with an unusually small herd of hogs, resulting in higher prices. If the farmers expect these high price conditions to continue, then they will fatten up more hogs relative to other crops in the following season. When the farmers then go to market with the second year’s supply of livestock, supply will be high, resulting in a drop in the price of hogs.

And so it goes on. If farmers then expect low prices to continue, they will reduce the size of their herd for the subsequent season, resulting in a return to high hog prices yet again.

While farmers should become more efficient in their production choices over time – something called adaptive expectations – there is no guarantee that will happen. Indeed, Haas and Ezekiel noted that you only need to make small changes to the underlying assumptions for the price to become increasingly more volatile, moving further and further away from equilibrium.

Traders in lumber futures and investors in the companies that supply timber should be aware of how quickly the bullwhip can snake in the opposite direction. The lumber market is one of the most thinly traded of all commodity futures markets. Lumber’s price history suggests gravity reasserts itself quickly and violently.

Related article: Why are commodity prices volatile?