The 2016 Commodity Story: Russell

If 2015 was the year in which the growing oversupply of key commodities led to a rout in prices, will 2016 bring the point of capitulation, leading to consolidation and the start of recovery?

That would certainly be the hope of many beleaguered commodity producers, be they members of OPEC, shale gas drillers in North America or the big companies that bet their futures on what they thought would be China's endless appetite for coal, iron ore, copper and liquefied natural gas (LNG).

But the problem with hoping for a rationalisation of supply is that everybody wants someone else to shut down or cut production.

Everywhere in commodity markets, producers are still following the tactics that have largely failed for the past few years.

That is to cut costs while increasing output, in order to keep, or increase, market share while lowering the unit cost of production.

This is a great strategy as long as your company is the only one able to pursue it successfully, but if everybody is able to do it, all that happens is prices continue to fall as more supply hits the market.

Coal is probably the major commodity most advanced in this process, with 2015 representing a fifth year of declining prices that has seen the Asian benchmark Newcastle index lose almost two-thirds of its value since January 2011.

Yet, despite this massive loss in the value of coal, output hasn't declined significantly in major exporters such as Australia and Indonesia, with cost-cutting and weakening currencies allowing producers to keep mines open.

This dynamic is also playing out in iron ore, where the big three miners that dominate global trade, Brazil's Vale and the Anglo-Australian pair of Rio Tinto (RTNTF) and BHP Billiton (BHPLF), have managed to lower costs so much that they can still make decent profits.

Iron ore has become a race between who can last longer, the big three's higher-cost and smaller rivals, or the patience of shareholders angered by a collapse in the value of their investments and concerned about the increasingly likelihood of cuts to dividends.

The chief executives of the large miners will be hoping that supply will be cut as smaller companies are forced from the market, but even if this does happen in 2016, it's possible that not enough supply will leave the market to allow for a recovery in prices.

Spot iron ore <.IO62-CNI=SI> fell to the lowest since assessments began in 2008 earlier this month, dropping to $37 a tonne, about one-fifth of what it fetched at its peak in early 2011.

While Vale, BHP and Rio can still make profits at this price, it's unlikely they can make enough to keep increasing the dividends to shareholders.

If companies such as Rio and BHP are forced to curb payouts to shareholders, expect to see leadership changes as the current management has repeatedly said dividend policies will be maintained and the tactic of dominating the market with low-cost supply will eventually work.

WAITING FOR YOUR RIVALS TO DIE
Another group of increasingly nervous producers are those in the Organization of the Petroleum Exporting Countries (OPEC), as they also await the exit of higher-cost crude from the market.

While top OPEC producer Saudi Arabia still has sufficient financial reserves to weather another year of low prices, the budgets of other countries, such as Venezuela and Angola, are starting to look increasingly vulnerable.

Fiscal and economic turmoil generally leads to political upheaval, and if low prices persist, it's likely that the populations of many of the weaker commodity producing countries will become increasingly restless.

But like coal and iron ore, hopes for a rationalisation of crude supply may be optimistic, especially in the light of Iran's likely boost to output as Western sanctions are lifted and plans for increased exports from neighbouring Iraq.

The coal and iron ore experience also make it likely that U.S. shale oil drillers, and other higher-cost producers such as Canadian oil sands, will be able to cling on for longer than the market generally expects them to.

If many commodity producers are waiting for their rivals to go out of business, LNG producers will be dreading the arrival of new competitors, as both Australia and the United States ramp up output of the super-chilled fuel.

Similar to other commodities, LNG struggled in 2015 and is less than a third of what it was at the peak in February 2014.

It's hard to build anything other than a bearish case for LNG, given the new plants are likely to run at close to maximum rates no matter what the price, as they need cash to repay the enormous capital investment.

Oversupply also plagues beneficiated commodities, such as steel and aluminium, with too much capacity remaining online in China as loss-making companies are allowed to survive because politics trumps economics.

Like other commodities, this isn't a new situation and oversupply has been building for some time.

While 2015 was the year that the excess capacity finally hit home, it is far from certain that 2016 will be the year of capitulation.

It may take another year of producers grimly hanging on before they start to topple over, and if history is any guide, it always takes longer for the point of maximum pain to be reached than the market anticipates.

Many resource companies will be hoping for a slightly better demand profile in 2016, especially if China's spending on infrastructure and housing construction does pick up in tandem with a slightly brighter economy in the rest of the world.

But demand isn't the main issue for commodities, and even the most optimistic scenarios for the global economy are unlikely to spur enough consumption to overcome excess supply.

If commodities are to stage any sort of recovery in 2016, it's likely to take the form of a fairly brutal first half followed by a brighter second, but this scenario only holds if sufficient supply is forced from the market because of ongoing low prices.

By Clyde Russell