The unexpected and still largely unexplained plunge in the price of oil is enough to throw a scare into any commodity producer. When the world’s most vital and heavily traded raw material can lose half its value in six months—for reasons that are still being debated—no one in the business of digging stuff out the ground can feel secure about what the future holds.
However, outside of the oil patch, most of us should take a guardedly optimistic view. Oil’s fall won’t mark the end of the pain in the commodities sector, but it is likely to mark the end of the worst phase. From here on, cheap oil is likely to re-order the world economy in ways that could prove helpful to some miners. Here are seven aspects of cheap oil that Canada’s mining sector and others should keep in mind:
A jolt for the global economy: Falling petroleum prices will spur growth by providing the equivalent of a massive tax cut to anyone who drives or otherwise uses oil. Back in October, Citibank estimated that oil’s decline to US$80 a barrel would deliver the equivalent of a $1.1-trillion stimulus package to the world economy. Since then, of course, oil has fallen below $50 a barrel, making the potential size of the stimulus that much larger. That should help encourage growth and, with it, the demand for other raw materials.
An incentive to look further afield: Prices for bunker fuel, the type of oil used to power big ocean-going ships, have fallen in line with oil costs in general. As a result, it now costs far less to ship raw materials than it did just a year or two ago. The average cost of moving iron ore from Brazil to China, for instance, has fallen to $11 a tonne, less than half the five-year average of $23 a tonne, according to the Financial Times.
Lower shipping costs make far-flung suppliers more competitive. Paul Gait, an analyst for Bernstein, told the FT that the decline in transportation costs means that iron ore producers in Brazil will now be able to undercut their Australian rivals in China—the world’s biggest market for the industrial metal—despite the distance between Brazil and China. Expect to see other hierarchies of suppliers shaken in kind.
A bottom line boost: While cheap oil favours remote producers, it also means lower costs for everyone. Fuel costs represent 10% of a typical mine’s costs—far higher in the case of large open-pit mines—so the 50% fall in the price of oil over the past few months should provide a nice little boost for many miners’ bottom lines.
Oil’s decline is also going to help in another way: by keeping headline inflation down, it’s going to reduce pressure on central banks in the United States and Canada to raise interest rates. Easy money will be good news for many miners, especially ones with large debt loads.
Continued gluts: The downside of that bottom-line boost is that it will keep many marginal mines in production. Combined with the increased attractiveness of far-flung mines, it means that the surplus of many minerals is likely to persist.
The process of cutting back supply in some areas could get painful. Rio Tinto, for instance, is intent on running its Pilbara operation in western Australia flat out despite the falling price of the iron ore it produces. Rio’s goal is to shake high-cost producers out of the market. But its two major rivals, BHP Billiton and Vale, are also conscious of the need to produce in volume to keep costs low on a per-volume basis and pay their bills. The big three would be delighted if they could force Chinese iron ore mines to close but that’s difficult because the relatively inefficient Chinese mines are being kept open more for social reasons than for economic ones.
As all these players smack heads, aided and abetted by cheap fuel and cheap money, the only thing that seems certain is that small or mid-sized players without a state champion should watch out.
Merger, anyone? One way this oversupply could be brought to heel is with mergers that would allow dominant players to acquire other producers and thereby gain more ability to ration supply. Glencore, for instance, has already approached Rio Tinto. While it has been rebuffed for now, don’t be surprised to see it back at the table again. And don’t be surprised to see other miners contemplate their own mergers.
The golden mean: One bright spot in all of this is gold mining. Cheap oil’s ability to drag down interest rates—or at least prevent hikes—is good news for precious metals, because low rates reduce the opportunity cost of holding an asset that pays no dividend and offers no yield. As base metals continue to swoon, expect gold miners to hold up well.
A laggard, not a leader: It’s natural to fear that plunging oil prices foretell a similar fate for other commodities. More likely, though, is the opposite perspective. Plunging prices for many raw materials over the past two to three years provided early warning of slumping global demand, and oil may just now be catching up to the general weakness.
China, the big driver of world demand for raw materials, will determine what happens next. Prices for materials such as copper have long shadowed Chinese manufacturing and the tumbling prices for metals in recent years have accurately reflected the extent of the slowdown in Asia.
The good news, at least for now, is that China’s economy isn’t crashing, just gearing back in what looks like a planned deceleration. That’s not reason to cheer, but it is reason to think that the most painful part of this commodity cycle lies in the past.
Ian McGugan is an award-winning business journalist in Toronto and the founding editor of MoneySense magazine. E-mail: imcgugan4@ gmail.com.
Photography: Etienne de Malglaive/Redux.