abare.gov.au - Australian commodities – March quarter . volume 16 . number 1 2009

Energy and minerals overview

Robert New and Rebecca Petchey

Weak economic performance will reduce world demand for mineral resources and result in a slowdown in production growth in the short term.

Medium-term demand growth is projected to remain strong, underpinned by strong rates of economic growth in developing Asia.

World prices for energy and minerals commodities are expected to recover after 2010 in line with a broader economic recovery.

Australian export earnings from energy and minerals are forecast to decline markedly in 2009-10, but are projected to improve over the medium term, driven by recovering world prices and demand.

World price outlook

The short-term outlook for energy and minerals prices is forecast to be weak. Weaker demand, as a result of sharply slowing industrial production, particularly in developing Asia, has placed significant downward pressure on world prices. Over the medium term (to 2014), world prices for mineral resources are projected to recover in line with the assumed world economic recovery, and an improvement in commodity demand.

As a result of weak demand, there have been reports of a marked build up of stocks for many energy and minerals commodities. Consumers have been able to draw on stocks, which is contributing to falling production for a number of commodities, particularly iron ore and thermal coal. In the short term, growth in production for many commodities will be relatively limited because of high levels of consumer stocks.

The current downturn in commodity markets must be viewed in an historical business cycle context. A marked increase in new production capacity in response to the sharp rise in prices between 2004 and early 2008 is now, in combination with weaker demand, contributing to significant downward pressure on prices. As part of the business cycle, it will be reasonable to expect that a strengthening in demand over the medium term, underpinned by the assumed economic recovery, will once again place upward pressure on energy and minerals prices.

There is considerable risk to price projections over the next few years, which mainly stems from the uncertainty associated with the timing and strength of the assumed economic recovery. If, for example, the expected economic recovery proves to be later or weaker than currently assumed, there is a strong possibility the projected recovery of mineral resources demand will be significantly weaker than currently projected, leading to longer than expected weaker prices for energy and minerals.

Global demand outlook

Despite weaker demand in the short term, there are strong fundamental drivers underpinning global demand for energy and minerals commodities over the medium and longer term. Population growth, urbanisation and growth in industrial production, particularly in China, India and other developing countries, will continue to support demand growth over the medium term. In this set of commodity projections, world economic growth is assumed to begin recovery in late 2009 and early 2010, peaking in 2011 before easing marginally to levels closer to longer term potential in later years. Demand for energy and minerals commodities is expected to strengthen following this assumed timeline of world economic recovery.

China remains a key driver of demand…

China’s economic recovery will be a major factor supporting energy and minerals commodity demand over the medium term. China is an important consumer in the global market for energy and minerals commodities. For example, in 2007 China accounted for 33 per cent of global aluminium consumption, 27 per cent of global refined copper consumption and 44 per cent of global iron ore consumption.

The global financial crisis has resulted in lower Chinese manufacturing exports to the United States and Western Europe since mid-2008, which has had a negative effect on general economic activity in China. Demand from the United States and Western Europe is expected to remain weak in 2009 and China’s economic growth will need to be supported by domestic demand. This has been recognised by the Chinese Government in its implementation of a $US586 billion stimulus package.

Over the medium term, continued robust economic growth in China will lead to increased urbanisation and rising incomes. Continued urbanisation in China will result in increased energy and minerals consumption through construction of housing and infrastructure. Rising incomes will support the manufacture and use of consumer durables such as electronics and motor vehicles.

…with strong support from India

Robust growth in India’s consumption of energy and minerals commodities is also projected over the medium term, being underpinned by a growing middle class and increased urbanisation. India’s manufacturing base is not as large as China’s, hence it has a lower per person consumption of energy and minerals. Furthermore, India’s per person consumption growth is occurring from a much lower base, and the rate of increase in per person consumption is likely to be lower than in China in the next five years. However, compared with China, India has a lower electrification rate, which the government aims to increase. This will lead to increased consumption of materials used to construct electricity generation, transmission and distribution networks, such as steel, copper and aluminium. Increased electricity supply will require inputs such as coal, natural gas and uranium. The growth in India’s energy and minerals consumption over the medium term, through investment in infrastructure, will depend on its recovery from the economic downturn and the continued implementation of economic reforms.

Global supply outlook

Supply expected to contract in the short term

The short-term outlook for supply is weak, reflecting falling prices, deflationary input markets and an uncertain economic outlook. A recovery in production is projected over the latter half of the medium term in response to the projected recovery in world prices.

Falling construction costs

Falling prices have resulted in delays or deferrals of a number of projects. This in turn has eased the shortage of project inputs such as labour and equipment. While falling project costs will benefit project proponents, further delays are likely in response to the sharp weakening in the outlook for world prices. Also, some companies believe they can build projects for a lower cost in the future. For example, in January 2009, the Gladstone Port Corporation announced a reassessment of investment timelines for its Wiggins Island Coal Terminal, with a view to capitalise on falling construction costs. While some delays are expected, they are unlikely to significantly diminish capacity expansion over the medium to longer term.

Uncertain financial conditions

Uncertainty regarding the timing and pace of world economic recovery and the tightening of credit access in the short term may also result in further delays to investment. Lending conditions for mining firms appear to have become more restrictive because of falling asset prices. Firms are expected to take a more cautious approach to investment, which is likely to result in delays or smaller projects.

Industry consolidation over the medium term

Further market consolidation is expected over the short to medium term. Larger firms in strong financial positions will seek to capitalise on falling asset prices, and in doing so subsume smaller firms in the market looking to liquidate assets in light of weaker prices and reduced export revenues. Since 1990, the top five mining companies have almost doubled their combined market share, from 24 per cent in 1990 to 40 per cent in 2007. The market conditions in the short term are expected to reinforce this trend.

Price recovery to precede renewed supply expansion

Production of energy and minerals commodities is projected to expand in the latter half of the outlook period, underpinned by the projected price recovery and hence increased profitability of mining operations. The credit availability is also assumed to improve. Nevertheless, there could be a delay of production increases in response to the projected price recovery, as many mining companies are expected to delay their investment decisions in the short term, which in turn would delay their capacities to quickly increase production. This will increase the time lag between rising prices and a significant supply response.

Outlook for Australian energy and minerals

Declining energy and minerals prices have reduced the profitability of a number of Australian producers. In the short term, production cuts and the closure of production capacity are expected to result in a slowing of production growth and declining export earnings for a number of commodities.

Production of metals and other minerals is forecast to increase modestly by 0.8 per cent in 2008-09, as increased production of iron ore and thermal coal more than offsets production cuts for zinc, nickel and lead. For example, Oz Minerals’ zinc production expectations for 2009 have been revised down markedly. Announced zinc production at the Golden Grove mine in Western Australia has been reduced by 57 to 60 per cent from 2008 volumes to an expected 55 000 to 60 000 tonnes in 2009. In 2009-10, production is forecast to increase by 6.7 per cent, owing to a strong increase in iron ore production.

Production of energy commodities is forecast to increase by 4.3 per cent in 2008-09, driven largely by increased thermal coal, oil and gas production. Modest growth in production of 0.1 per cent is forecast for 2009-10, which reflects weak growth in metallurgical and thermal coal production and lower petroleum production.

Over the medium term, production of energy and minerals commodities is projected to increase by 20 per cent in 2013-14 compared with 2008-09 volumes, as rising demand and the subsequent increase in prices encourages investment in new capacity.

Export earnings from energy and minerals commodities are forecast to increase by 40 per cent in 2008-09, to $162 billion, as higher export earnings from bulk commodities and gold are partially offset by falling export values for base metals.

Expectations of lower contract prices for bulk commodities for the Japanese fiscal year 2009 (JFY, April-March), to take effect in April 2009, combined with lower forecast prices for base metals, are forecast to result in total minerals resource export earnings falling 21.2 per cent to $128 billion in 2009-10. This, together with lower export volumes, is forecast to more than offset the positive effect on earnings of an assumed depreciation of the Australian dollar.

Export earnings from energy commodities are expected to account for 70 per cent of the increase in total earnings from mineral resources exports in 2008-09, underpinned by higher coal contract prices. Contract prices for coal in JFY 2008 were settled in April 2008, and will carry through to the end of March 2009. As a result, the effect of weaker demand for coal will not be fully realised until 2009-10 when export earnings from energy commodities are forecast to decline by 34.2 per cent to $51 billion.

Export earnings from metals and other minerals are forecast to rise by 20 per cent in 2008-09 to $85 billion, largely because of strong growth in earnings from iron ore. This growth will be offset by falling base metals prices and weaker demand. Export earnings in 2009-10 are forecast to decline by 9 per cent to $77 billion, underpinned by expectations of lower iron ore and base metal prices.

Over the medium term, rising export volumes, accompanied by higher projected prices for most energy and minerals commodities, will offset the effect on earnings of an assumed stronger Australian exchange rate against the US dollar. Australian earnings from energy and minerals commodities are projected to grow at an average annual rate of 2.8 per cent to $140 billion (in 2008-09 dollars) in 2013-14.