Back in the summer of 2008, when crude seemed poised to take out $150, Goldman decided to declare the start of a commodity supercycle and boosted its oil price forecast to $200. Shortly thereafter crude cratered, plunging to the low double digits, and causing many to scratch their heads whether Goldman was merely taking advantage of the pre-Lehman panic to sell into the euphoria. The same questions, but inverted, will likely follow today’s just as seminal note, one which this time calls for the end of a supercycle, this time of iron, with “The end of the Iron Age.”
While intuitively this makes sense considering iron ore prices have tumbled nearly 40% YTD and were at multi-year lows at last check with the demand picture going from bad to atrocious, the reality is that a protracted period of deflation in this key commodity will have very adverse implications for not only China, where CapEx amounts to over half of GDP and will likely force the transition to a consumer-driven economy – something the Politburo has been delaying for years – but for the rest of the commodity suppliers countries, with the most negative impact hitting Brazil and Australia. Worse, for a country like China which has thrived on commodity oversupply and overcapacity, the collapse in the equilibrium price driven largely by demand, will mean thousands of suppliers will be left out in the cold and forced to liquidate with massive ripple effects through the fabric of the Chinese economy.
To be sure, for the time being local governments, banks and other SOEs, and the central bank, have been successful in isolating the assorted pockets of deflation that has hammered China in the past several years, but if Goldman is correct and if indeed a iron (and other commodities) are shifting from the “Investment Phase” to the “Exploitation Phase” as Goldman calls it, then watch out below not only China, but the rest of the world as well.
So what exactly does Goldman say? Let’s dig into their latest note:
The end of the Iron Age
Producers and investors have enjoyed a long period of supply tightness, cost inflation and above trend profitability; in our reports we have referred to this period as the Iron Age. In our view, 2014 is the inflection point where new production capacity finally catches up with demand growth, and profit margins begin their reversion to the historical mean; in other words, the end of the Iron Age is here.
Iron ore has entered a new exploitation phase
As we have previously argued3, a period of overinvestment in production capacity has ended, giving way to an exploitation phase where supply growth comes mainly from more efficient utilization of existing capacity. Production volumes grow with a certain time lag behind the investment decision; the lag in the mining industry between investment approval and production at full capacity is typically between 5 and 10 years. Based on historical trends, we believe that many market dynamics are reversed in the shift from investment to exploitation, and the current exploitation phase in iron ore could last for a decade (Exhibit 20).
