Back before coronavirus knocked “normal” out cold, the key issues for miners were sub-investment prices, rising requirements for ESG and decarbonisation. How things change. So while our base case view is that the recession is short and sharp with a return to “normality” from 2021, it may well become a slump lasting five years or more.
My slump scenario combines a recession of the severity of 2009 (without the sharp recovery) and the low growth rates of the early 1980s or 1990s. What does this grim economic outlook mean for the world of mining and metals? It certainly has the potential for massive demand destruction, an extended period of oversupply and prices that chase costs downwards.
Our base case economic outlook assumes a deep downturn and a slower recovery, despite stimulus measures leading to a hybrid V- and U-shaped recovery. How China recovers is critically important and the signs here are positive, with activity levels quickly returning to the equivalent period in 2019. Key questions remain, however: will the country suffer a second wave of infections? How much of China’s economic recovery will be export-oriented? And will the rest of the world be able or willing to return to the pre-virus ‘normal’ – that is, an overreliance on extended supply chains focused around China?
For the rest of the world, our base case assumes countries enact relatively short lockdown periods and that we return to 2019 activity levels in 2021. This return to “normal” translates into industrial production (IP) attaining 2019 levels in 2021. By 2025, global IP will be about 10% higher than in 2019, a positive outlook indeed.
But what form these exit strategies take matters. Outside of China, lockdown measures encompass phased unlocking to ensure health systems (at least in the developed economies) are not overwhelmed. This situation will persist for at least 12 to 18 months until a vaccine is developed. Add to this massive government debt levels that will need to be paid down. A long period of austerity translates to an era of low growth, and cost and price deflation – my slump scenario.
The economic implications of this rather grim outlook are stark. Instead of a sharp bounce back, we could be facing a recession of the severity of 2009, or worse, to be followed by an extended period of low growth, like that of the early 1990s.
What could this mean for coal, steel, iron ore and base metals?
Seaborne thermal coal exports, while taking a hit due to low levels of economic activity and concomitant power production and demand, remain relatively well supported. This is due to a preference for high-quality coal from, say, China, plus an assumed significant sideways drift in the energy transition. Put simply, with debt levels ballooning and growth subdued, the cheapest power fuel – coal – will be the go-to option during this period.
Finished steel, already on a sub-1% growth path under our base case, sees its average growth decline to minus 1%. Overall economic activity levels and infrastructure spend are constrained by austerity measures and low levels of spend on fixed asset investment. This is despite countries seeking to boost activity on infrastructure projects as much as their debt levels allow. We are already forecasting China peak steel consumption in 2022. The upshot of these developments is that global finished steel demand falls by some 200 Mt in 2020 and only recovers to 1630 kt by 2025, never again reaching its 2019 level.
Seaborne iron ore and metallurgical coal fare better than base metals or their bulk cousins. The seaborne market for these raw materials will remain relatively well supported due to China’s continued preference for high-quality imported material to feed its coastal blast furnaces. That comes at the expense of lower quality domestic concentrate sources, many of which face permanent closures. We also believe that India continues to expand its steel sector on an integrated basis, which supports higher levels of metallurgical coal imports. Elsewhere, a significant proportion of EU blast furnace curtailments become permanent.
Base case growth rates for base metals can be described as “slower for ever” with all markets experiencing low single-digit growth. Not surprisingly, the slump scenario shifts base metals growth to alarmingly anaemic rises from 2020 to 2025.
A sobering outlook for prices in the slump era
To assess the outlook for prices, we look to the cost structure of the industry and the supply-side response to above-normal stock levels.
The relationship between prices and the cost structure of the industry is remarkably consistent during downturns and we assume these hold for our extended slump scenario. We forecast stock levels will rise and remain at elevated levels consistent with previous downturns, which helps subdue prices. This, in turn, leads to supply attrition, ultimately keeping the industry “honest”.
The price outlook across the commodity space, then, is a sobering one with prices on a declining trend to 2023. This trajectory is caused by low growth, excess supply and the need to shutter marginal production. The spectre of prices chasing costs downwards is a real one and companies need to position themselves for this.
Bulk commodities experience a period of market weakness under our base case outlook as some 100 Mt of domestic Chinese iron ore needs to close, never to return. The slump era just keeps prices subdued for an extended period.
While demand will remain robust in the seaborne metallurgical coal market, given Chinese and Indian needs, the challenge will be the excess of supply coming onto the market. This will put even greater downward pressure on prices. With iron ore and metallurgical coal prices declining and margins flattening, Chinese HRC prices fall over the period, albeit marginally so.
For base metals, there are two outliers: copper and zinc. Copper won’t be immune from the slump in demand, with prices expected to touch marginal costs twice during the period. For scrap, we have assumed that supply, while constrained by low levels of economic activity, reaches equilibrium over the period.
The 2020 slump is a result of the collapse in demand which requires supply curtailments to prevent unsustainable stock build. The drop in 2023 reflects low growth and the new supply previously greenlighted (assuming, of course, they are not suspended).
From the latter part of 2024, as the market moves into the post-slump era, prices will accelerate, but at levels still well below incentive prices.
In the case of zinc, the cataclysmic fall in demand in 2020 heralds an era of low and falling prices, with capacity curtailment and short-life, high-cost mines permanently closed. This sets up the market for chronic undersupply, even at the low growth rates projected. From 2024 onwards, the market will anticipate structural shortages, which boosts prices to well above incentive levels, so the good times will return.
Aluminium is always an underachiever due to structural overcapacity and an inelastic response to low prices. This continues with an extended period of low prices and a significant proportion of the industry under water, despite cost deflation. The only saviour could be an extensive stock purchase programme by government agencies in China, allied to rent finance deals at the low interest rates that are likely to prevail during the slump period. But, even then, this is just kicking the can down the road.
Lead is the metal most immune to the cycle, given the embedded demand for after-market (AM) batteries. The drop in original equipment market demand (OEM), particularly in 2020, will be seen in prices. When the world starts travelling again, demand will pick up but significant additional supply is expected, weighing on prices. Whether the primary supply is needed is a moot point – it will be coming anyway.
Survival mode is kicking in
Our slump scenario paints a picture of the industry moving into survival mode, with prices just sustaining the industry for the medium term.
Unsurprisingly, the extended period of declining demand or subdued demand growth and low prices means industry revenues will fall dramatically.
In 2019, the industry generated around US$1.7 trillion in revenues. Compared to our base case view, the cumulative loss of industry revenue to 2025 amounts to US$900 billion with obvious implications for profitability, and capex, particularly for marginal producers. This has truly eye-watering implications for the industry and its ability to fund the necessary investment to meet future challenges.
A test to the resilience of metals and mining
So what will be the response of the industry to improve resilience – cut costs, accelerate restructuring or consolidate? If we experience a slump scenario, then a new wave of cost-cutting will follow – in operations, but also in capex.
Given lead times for development, big cuts in capex could lead to severe underinvestment. That has implications for meeting the needs of the energy transition where structural surpluses could be replaced by structural deficits.
The other two options to improve resilience – restructuring and consolidation – will certainly be to the fore as companies optimise their portfolios. Well-capitalised companies, such as the major multi-commodity houses, are likely to focus on growth through acquisitions rather than organic expansion. Ultimately, fortune will favour the brave – that is, those that can afford to take the long view.
Source: Wood Mackenzie
