Unparalleled Clarity and Perspective on the Commodity Markets
As I have noted previously, the management team at mine equipment manufacturer Joy Global possesses the most comprehensive understanding of the global commodities markets and macroeconomic trends of any company I've encountered, and they continue to do an amazing job of conveying that insight to investors through the discussion within their earnings reports. Whether you have interest in this particular company / sector or not, I consider their statements incredibly valuable for anyone with exposure to the commodities space. I include excerpts from their recent quarterly results here for your consideration, and hope you find them as useful as I do.
Global economic conditions continue to deteriorate, with many forecasts now predicting marginal to possibly negative global growth in 2009. Those forecasts expect each of the major Organization for Economic Cooperation and Development (“OECD”) countries to experience contraction and the collective emerging markets to experience significantly reduced rates of economic growth in 2009. This declining growth is translating into reduced demand and putting commodity prices under pressure. Although most commodities are traded under contracts for physical delivery, spot prices can be an indicator of future pricing directions. Spot prices for commodities have dropped by 40 to 70 percent since early 2008. The largest declines have been in oil and copper, and these commodities are now trading below their 2007 price levels. Both metallurgical and thermal coal are down significantly but still trading above their 2007 levels. The steep decline in iron ore spot prices has offset a strong run-up last year, and iron ore spot prices are now only 20 percent below current contract levels. Contract prices increased 80 percent last year and are therefore expected to remain well ahead of 2007.
Although many of the commodity prices are ahead of their 2007 levels, they have given up much of their 2008 gains. Most of the Company’s customers have significantly reduced the mine expansion plans and capital expenditures that they had set under the higher pricing levels of early 2008. Those reductions vary by customer and commodity, and go up to the 50 percent range. However, the reduced level of capital expenditure should accommodate both sustaining requirements – such as normal machine replacement – as well as the completion of projects already underway. The Company believes there could eventually be further reductions in capital expenditure levels if commodity pricing and demand do not improve during 2009. The demand for the Company’s original equipment comes largely from mine expansion programs, and the Company expects that orders for its original equipment could continue to be reduced as a result of its customers’ announced reductions in capital expenditures.
Declining commodity demand is putting pressure on production volumes as well as price, and the Company’s customers are acting quickly to keep current supply balanced with demand. The Company believes that mine production levels, rather than mine expansion programs, primarily determine the demand for its aftermarket products and services. Announced cuts in production levels by commodity range up to 20 percent of worldwide capacity. If these cuts are sustained, the Company believes it would result in reduced levels of aftermarket demand. However, the Company also believes that the early cuts have often been deeper to enable de-stocking and that production will recover partially once stock levels are drawn down.
The Company does not expect production cuts from existing oil sands operations, but does expect delays in some expansion projects. An established oil sands operator recently announced a quarterly loss that caused it to suspend work on the bitumen processing plant that was part of its major expansion project. This is consistent with the Company’s belief that existing operations are modestly profitable at recent oil prices, but that expansion projects will require the expectation of future oil prices reaching $70 to $80 per barrel for approval or funding. As a result, the 2009 expected funding for oil sands expansion projects has been reduced from Canadian $20 billion to Canadian $11 billion.
Announced production cuts for copper have reached four to six percent of global capacity. Most of the cuts are occurring in high cost regions, such as North America, at the same time that expansion projects are continuing in lower cost regions, such as Chile. The Company believes that around 15 percent of the global copper capacity is unprofitable at prices below $1.50 per pound. The Company’s customers are using this price level for plans and budgets, and therefore they do not expect copper prices to recover in the near term. As a result, the Company expects the high-grading process to continue, with higher cost mines continuing to be taken out of production while new, lower cost mines continue to be brought on line.
The global production level for steel creates demand for both iron ore and metallurgical quality coal. By December of 2008, global steel production had declined by 30 percent from its peak in May of 2008 and China steel production had declined by 17 percent from its peak in June of 2008. If these cuts are sustained, steel production in 2009 would fall to 10 to 15 percent below 2007 levels. However, the early cuts in steel production are expected to be more pronounced to accomplish destocking of finished steel inventories. As a result, the Company expects global steel production in 2009 to be five to ten percent below that of 2008. The Company expects metallurgical coal and iron ore production changes to mirror that of steel. Consistent with that expectation, announced production cuts for both iron ore and metallurgical coal have been 15 to 20 percent of their global capacity.
Ninety percent of thermal coal demand is for power generation, and changes in power demand are highly correlated to changes in economic activity. With expected economic growth in China slowing to five percent in 2009, the Company expects power generation and thermal coal demand in that market to slow to a similar rate of growth. Likewise, with economic growth expected to be negative by an average of one-and-one-half to two percent in OECD countries, the Company expects similar rates of reduction in thermal coal demand in these countries.
There are indications that supply cuts are achieving their objectives, and that commodities are reaching a point of stability. Lower commodity prices are allowing some marginal steel mills in China to return to production. As a result, iron ore stockpiles at Chinese ports have peaked and started to decline. China’s imports of scrap steel and scrap copper started to increase late in 2008, and China’s steel exports showed modest sequential growth at the same time. Copper prices reached a low of $1.25 in December of 2008, but have recovered to over $1.50 since. Steel inventories in the U.S. are down 23 percent since last August, and mill lead times are increasing. The Company cautions that it is too soon to draw conclusions from limited examples, and in addition would see these as signs of demand stabilization rather than demand recovery.
Although the Company continues to believe that the path toward industrialization of emerging markets will drive high rates of commodity demand over the long term, it also expects the near-term markets to remain uncertain and volatile. The Company continues to take precautionary steps to reduce its risk exposure through expense controls and reduction of operating costs. These efforts include hiring freezes, control of discretionary expense, aggressive management of its supply chain, and more critical reviews of the financial stability of its operating partners, including suppliers, subcontractors and customers.
Just as the Company expects the conditions of uncertainty and volatility to persist through 2009, it also expects the booking rates for its original equipment during this period to remain substantially below the comparable booking levels of 2008. The Company believes that lower demand for its original equipment could persist for a period longer than that covered by its current backlog, and is therefore developing plans to ensure it fulfills its commitments to customers and investors during 2009 while reducing the scale and scope of the business to be appropriate for the range of market conditions that could exist in fiscal 2010.