Wednesday, November 25, 2015

Commodity cycle spells continuing trouble

Commodities are critical for the well-being of the Canadian economy as natural resources sectors in 2014 accounted for 20% of Canada’s GDP, with the energy sector accounting for half of that. No wonder, when oil prices entered a 12 month decline, Canada’s economy started to falter. The country’s GDP dropped by 0.8% in the first quarter and by another 0.5% in the second quarter of 2015. As the chart below of the Bloomberg commodity index shows, the commodity price downturn has intensified this year. In particular, the price of gold has dropped by 10% over the last year, while oil and copper have lost 47% and 31% respectively.

Bloomberg commodity index, 2010-2015 (source:

Is there hope for a recovery in commodity prices to support Canada’s economy? The consensus opinion seems to be quite pessimistic. The Conference Board of Canada expects that the WTI oil price, which is currently around $42 a barrel, will not return to the $70 a barrel level until 2019. According to a world leading metal trader and commodity researcher Kitco Metals, the current commodity sector weakness has not exceeded in duration periods of weakness in recent memory. The current downward trend is in its fifth year while on average periods of weakness in commodities since the beginning of the 20th century lasted for about 7-8 years. One severe commodity downturn lasted for around 15 years, from the late 1970s to 1992.

Although the current period of commodity weakness seems long enough for some investors, there are other fundamental reasons which indicate that it may still continue for some time: one of the world’s bigger consumer of commodities, China, is not showing signs of revving up its economy to the growth rates it saw only a year ago. The Chinese economy is slowing down, where authorities are lowering their expectations for growth considerably, below the 7% growth rate which was considered earlier to be a threshold level. quotes Carmen Reinhart, professor of international financial system at Harvard University’s Kennedy School of Government, that no other economy has the capacity to pick up the “demand slack” like China. The US economy has not had been as big a star in getting the global economy moving, growing by just 1.5% in the third quarter of 2015 (advance estimate by the US the Bureau of Economic Analysis), after the 3.9% increase in the second quarter. If the US Federal Reserve raises interest rates at its December 15-16 policy meeting, as San Francisco Fed President John Williams indicated on November 21, it may further lower the near term growth prospects of the leading global economy.
The price slump in commodities has made producers sharpen their focus on costs. The Conference Board of Canada’s recent report says that Canadian oil producers are not lowering their oil production due to low prices: over 840,000 barrels per day of oil sands capacity will be brought on line in 2015-2019, a 39% increase from oil sands production in 2014. Instead, Canadian oil producers are reducing operating costs by 15%-30%. In particular, they have lowered wages and eliminated 36 thousand jobs since the oil price decline started 17 months ago.
A similar situation is developing in the iron ore sector. The iron ore price has dropped by around 60% since its peak in 2011. Despite the decline, global iron ore production leaders, BHP Billiton, Rio Tinto and Vale have not significantly curtailed their production, focusing instead on cost containment.

Michael Zienchuk, MBA, CIM
Investment Advisor, Credential Securities Inc.
Manager, Wealth Strategies Group
Ukrainian Credit Union Limited
416-763-5575 x204

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