How Did the World's Miners Not See it Coming?

With this simple question, posed to Professor Luis Garicano of the London School of Economics in November 2008, Britain's Queen Elizabeth famously summed up the layman's astonishment that an obscure part of the derivatives universe could trigger a global financial crisis.

A similar question might be posed of the world's miners right now.

Having collectively bet the house on a commodities "supercycle" only to see the "super" part of that cycle dissolve in front of their eyes, they are now fighting the numerous fires engulfing their overstretched balance sheets.

They simply don't appear to have seen it coming.

But then, if you believe Andrew Mackenzie, chief executive of BHP Billiton (BHPLF), they didn't see the original boom coming either.

Speaking at the AFR Summit in Melbourne earlier this week, Mackenzie confessed that the economic rise of China earlier this century "happened at a scale and a pace we simply didn't see coming."

"Many (including BHP Billiton) were unprepared for what has been the greatest commodities boom of our time."

Having failed to foresee the boom, they also failed to foresee the bust.

"While BHP Billiton anticipated emerging trends that signalled the end of the boom, we didn't expect the scale and the speed with which it happened."

Which is why BHP Billiton and other major iron ore miners are now engaged in a brutal "last man standing" war of attrition in a market that has not just stopped booming but is actually contracting.

But how did nobody see it coming?

HOUSING BUBBLES
The answer may at least in part go all the way back to that royal question on economics.

It's not just that the Crisis of 2008-2009 is still with us in the form of "whatever it takes" central bank intervention to prop up still foundering economies.

It's more that the current "slowdown" in China has its roots in the same collapse of the house of over-mortgaged U.S. housing cards.

Faced with an export shock rippling out from what soon morphed from a financial to a manufacturing crisis, Beijing unleashed its unprecedented domestic stimulus package.

The twin pillars of this gargantuan stimulus were infrastructure and housing.

It is an extraordinary fact that in just three years, 2011, 2012 and 2013, China used more cement than the United States did in the 20th century, 6.6 billion tonnes compared with 4.4 billion, according to figures from the U.S. Geological Survey.

And a whole lot of iron ore, steel, copper and just about every other industrial commodity you can think of.

In the short term Beijing's emergency measures did the trick in terms of both insulating the Chinese economy from the collapse in trade everywhere and firing up commodity-dependent economies such as Australia and Brazil.

It's the play-out of the longer-term negative effects that have caused the "super" to drop off the "supercycle".

Too much property was built too quickly, particularly in smaller, new cities. Too much capacity was built to feed what was an unsustainable rate of construction in industries such as steel. And too much debt, often of dubious quality, was accumulated in the credit binge.

Quite simply, one housing bubble, that in the United States, created another one in China.

It's the engineered deflation of the Chinese housing bubble that is now roiling the world's metal producers.

Beijing has made it clear that it expects property developers to run down unsold inventory, particularly outside of major cities, before embarking on new developments.

It could be a long process.

Analysts at Macquarie Bank estimate that Chinese steel usage in the construction sector peaked in 2013 and will be 20 percent lower by 2020. ("Commodity Comment - Chinese construction", March 11, 2016).

BUSINESS AS USUAL?
With hindsight the warnings of a potential commodities crash were there for everyone to see.

Rather than being hidden in the spreadsheets of market derivatives quants, as was the case in the U.S. housing crash, they were all too visible in the form of newly-built but eerily deserted housing complexes across China's lesser cities.

So why didn't the likes of BHP see them?

In large part, perhaps, because the 2009-2013 construction boom looked like a continuation of the pre-Crisis trend, which had been one of rapid industrialisation and urbanisation in China.

Beijing wasn't changing the rules of its economic game, it was simply accelerating them.

To the outside world, it appeared business as usual after a brief interruption caused by the Global Financial Crisis.

The longer-term trend line may have shifted shape, steepening in the short term, but the consensus was that it was still in place, which is why BHP and others were forecasting Chinese steel consumption only to peak some time in the next decade.

What those photos of Chinese ghost cities were telling us, though, was that this was not business as usual, even by Chinese standards.

As Macquarie puts it, "bluntly" to use its own word, "China got urbanisation very wrong."

"While developers and local governments built out provincial manufacturing hubs in expectation of the next wave of migration, in actual fact China has developed like any other economy - strong growth in the largest cities as the service industry boomed."

This has created a yawning gulf between the property market in major cities, which is once again showing signs of speculative life, and that just about everywhere else, where clearing unsold inventory has been designated a key "supply-side" priority over the next five-year plan.

DOING THEIR JOB
If Chinese central planners got urbanisation wrong, the world's miners were guilty of putting too much faith in Beijing's ability to engineer the Chinese economy in any way they saw fit.

Both misread just how profound had been the original Crisis and just how double-edged was the sword that Beijing wielded to tackle it.

As with the original financial meltdown, everyone involved saw it as business as usual and strove to do the best job they could, which in the case of BHP and its iron ore peers, meant digging more stuff out of the ground as efficiently as possible.

Because that was in fact the less-reported answer to the queen by Garicano.

Writing in an editorial for The Guardian newspaper shortly after, he explained that "what I told the Queen is that the reason the situation got out of hand is that those working at every point in the lending chain were eager to continue doing the job they were paid to do" from mortgage agents to lending banks to rating agencies to asset managers.

There had been, he added, warnings from economists but they had been muffled by the group-think.

And there were plenty of warnings from commodity analysts, particularly those who had spent time in those Chinese ghost towns.

But having failed to see the boom coming, the world's miners were in no mood to hear that it wasn't going to continue for a long time.

"Supercycle" has just turned into good old fashioned commodity cycle, albeit an extreme one predicated on the extraordinary events of 2008-2013.

The good times will come again. Just don't expect the world's miners to see them coming.
 

By Andy Home