The price-supply disconnect

The commodities cycle is all about supply and demand responding to prices.

To put it very simply, as prices rise companies invest and supply increases. Prices then fall, which leads to production cuts, and eventually demand increases, pushing up the market and the cycle starts all over again.

That is, at least, the theory. In practice the price signal usually takes time to take effect, especially in a market downturn. Although there are signs of oil producers responding to price declines, in some other commodities, such as metals, coal and sugar, the reaction has not been immediate.

Why do producers fail to respond to a falling market? Here are our “five Cs” — a list of some of the factors which prevent the prices of commodities from regulating supply.

Contracts

Many producers are bound by “take or pay” agreements, or contracts that bind them to the use of particular modes of transport or logistical infrastructure, such as a coal railway or an export terminal.

These contracts mean that the producers still have to pay for the usage even if they do not honour the contract, or pay a penalty rate. This makes stopping production less attractive.

Cash flow

The investment for production is a sunk cost and is possibly funded by debt. Producers need to keep on generating cash flow to pay off loans or interest and keep the operation running and will do so until production results in negative cash flow. This scenario is now playing out in the US junk bond market, with nearly a fifth of low-rated energy debt currently trading at distressed levels.

Capacity utilisation

Producers of commodities such as iron ore have tried to reduce costs by raising capacity utilisation. When everyone in the market does this, prices will continue to fall and it becomes a “last man standing” competition. In iron ore, for example, the result has been a near 50 per cent drop in the price of the commodity since the start of 2014.

Currency

Most commodities are traded in US dollars. The flip side of a strong dollar usually means weaker commodity currencies, which means producers can get more bang for their buck in local currency terms even if the commodity price comes under pressure.

Depreciating commodity currencies also lower the local cost base such as wages, helping margins at producers, who receive their revenues in dollars.

Costs

Lower fuel prices benefit the commodities sector, by helping reduce production costs. Crude oil producers, miners and farmers all benefit from lower fuel prices and energy costs. Fuel accounts for about 10 per cent of overall costs for miners, while for farmers, lower energy costs mean lower inputs such as fertiliser.

This article is part of an online series on commodities made easy

Further reading:

Rio raises iron ore shipments to 300m tonnes

Low oil prices do not ensure shale output cuts

Also read:

Commodities explained: Contango

Commodities explained: Qingdao