The factors that gave rise to the initial commodities boom remain in force, slowed only temporarily by the financial crisis, says diversified mining company Xstrata CEO Mick Davis.

The commodities ‘supercycle’ is the prediction that commodity prices will be higher for longer and was widely accepted from late 2003 up to the impact of the financial crisis on mainstream economies in 2008. Lower commodity prices in late 2008 and early 2009 prompt the suggestion that the ‘supercycle’ will not happen.

The supply side of the industry is fractured and incapable of rapidly increasing supply. Demand for commodities will rise signifi- cantly, meaning supply will not be able to match demand over the medium term, reversing a multidecade trend of falling commodity prices, says Davis.

A few months before the collapse of global financial services firm Lehman Brothers, Xstrata’s coking coal customers had agreed to record contract prices. Similar deals were struck for iron-ore, ferrochrome and other commodities and the mining industry and logistics infrastructure simply could not supply commodities quickly enough to satisfy demand.

“All of this indicated that our customers in Asia and elsewhere were also expecting a continuation of tight market conditions and strong demand for some time to come. A matter of weeks or even days later, the situation had sharply reversed and demand almost completely collapsed,” Davis explains.

The mining industry endured a long period of low prices throughout the 1990s and the early 2000s. The weak commodity prices meant that investment in exploration had declined, fewer new mines were com- missioned and the industry attempted to curb the overcapacity that had been built up in the preceding years and decades, he says.

New capacity was not built and exploration spending remained very low. This inability to ramp up new sources of production proved to be important, because of rising demand from countries outside the Organi- sation for Economic Cooperation and Devel- opment (OECD) bloc owing to secular changes in demand patterns.

Secular changes in demand occurred previously in the industrialisation of the US at the turn of the twentieth century, during the reconstruction of Europe after World War II and during the industrialisation of Japan in the 1960s and 1970s, he states.

“The difference with the current secular change is its sheer scale. We are dealing with the urbanisation and industrialisation of over one-third of the world’s population in China, but also in India, Brazil and other developing countries, especially in South-East Asia. In fact, over 400-million people are expected to move to urban centres over the next ten years. And, as countries industrialise, the intensity with which they use metals and energy increases,” Davis explains.

The ‘China effect’ ignited demand for commodities and boosted commodity markets a few years later. The impact of this effect could lead to a period of higher average commodity prices.

As a result of the lack of cap- acity, the mining industry could not provide new supply in response to the burgeoning demand from China, the impli- cations of which continue to reverberate today, he adds.

Increased demand from developing markets is depleting mines, while exploration for new significant mines has not been as successful in the last decade as in the one before. Pro- jections of copper supply, initially made in 2007, of new copper expected to come on stream by 2020, had fallen by a cumulative amount of 21-million tons in 2009 projections on an average of two-million tons a year. This is for an industry that only produces 18-million tons a year. The mining industry cannot supply projected long-term demand for commodities, he says.

“One of the most significant impacts of the recent downturn for the mining industry has been the extent to which it has exacerbated the supply constraints that already existed. “Cuts to expenditure on exploration, projects and infrastructure in response to the financial crisis have delayed the onset of new capacity by at least 18 to 24 months and means that the supply side will fall further behind in its ability to supply even modest increases in future demand,” explains Davis.

Sustained Demand for Commodities

Xstrata’s analysis, conducted after the global economic downturn, shows that the factors driving increasing demand and increasing prices are still present. Demand from the OECD countries is lower and may take some time to recover but the driving forces of constrained supply and strong demand will, at some point, return, he says.

The global economic slowdown led to an unprecedented period in which companies preferred to deplete stocks of commodities without restocking. But even at the nadir of the crisis, commodity prices did not test historic lows. Very weak demand from OECD economies was partially offset by ongoing demand from China, India and Brazil, albeit at lower levels than in previous years. The downturn also under- lined China’s position as the dominant global user of com- modities, with China accounting for over 100% of the growth in consumption in 2009 in a number of metals, including copper and zinc.

The downturn exacerbated the growing gap in relative growth between the developing and the OECD economies. The OECD consumers are currently pursuing reduced debt levels and increased savings, resulting in an extended period of weak domestic consumption. Simultaneously, infrastructure investment, industrial investment and growing domestic demand underpin developing market growth, says Davis.

Concerns over sovereign risk, the scaling back of quantitative easing and the fragility of the global financial system are likely to constrict economic growth in 2010. These factors indicate that the world will remain in a period of volatility and uncertainty with regard to the OECD recov- ery. However, demand for commodities is likely to benefit from further restocking taking place, early signs of which are already in evidence, following the severe destocking that took place in 2008, providing support to commodity prices before a more sustainable recovery takes hold.

Africa is home to some of the richest untapped mineral deposits in the world. In due course, these resources will be developed as the world looks for new sources of supply. South Africa has the opportunity to become the centre of mining finance for the continent.
In China, India and Brazil, the most important economies for growth in commodity demand, leading indicators of industrial production remain robust. In China, private investment and domestic spending are likely to continue to offset reduced public expenditure resulting from the gradual withdrawal of stimulus and anaemic exports, which depend to a large extent on the US consumer. China exceeded its target of 8% yearly gross domestic product (GDP) growth in 2009, despite a year of negative export growth, and looks set to continue to grow at a similar rate, or higher, this year. Indicators suggest that India, similarly, will continue to enjoy strong economic growth in 2010, he explains.

For China, the key risks are inflation and potential overheating, given the volume of liquidity injected into the system ($2,5-trillion, or 12%, of Chinese national GDP), set against the risk of a too sudden withdrawal of stimulus spending, which could reverse the recovery under way. Inflation was close to 3% in February and measures by the Chinese government to tighten lending and reduce the risk of real estate bubbles reflect a clear desire by policymakers to attempt to balance these competing risks and keep the economy growing at a sustainable rate between 8% and 10%, concludes Davis.