Commodity prices rally, stoke earnings, inflation worries

Commodity prices rally, stoke earnings, inflation worries

Mumbai: A sharp rise in the prices of industrial commodities in the past three months following the return of liquidity to the global financial system has raised concerns over inflation and an earnings squeeze for companies, but analysts say the impact will be felt only after a quarter or two.

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Since June, the prices of industrial commodities such as steel, aluminium, copper and rubber have gained significantly as the economic recovery or talk of the economic recovery has gained traction, resulting in an increase in demand.

China, the third largest economy in the world, reported that its economy expanded by an unexpectedly high 7.9% in the three months ended June. This has spurred the manufacturing powerhouse to stock up on materials, leading to a rise in the prices of several commodities.

According to data from the London Metal Exchange, the spot price of aluminium has risen 36% since June to $1,961 (around Rs93,932) per tonne. And Bloomberg data shows that domestic prices for hot-rolled steel, used to build ships, gas containers and other products, has gained 19.8% since June to Rs30,250 per tonne.

Coal prices at Australia’s Newcastle port, an Asian benchmark, have climbed 27% since the end of March and were at $76.58 a tonne in the week ended 21 July, reported Bloomberg, citing the globalCOAL NEWC Index.

The price of crude oil too has risen in the past four weeks. It is now trading at around $71 a barrel on hopes of economic recovery.

To be sure, despite the spurt in prices, most commodities now cost less than they did a year ago, but according to the International Monetary Fund, or IMF, the rebound in prices (in the past two months) is “ahead of the recovery which is expected to get advanced". This means the trend of increasing prices is here to stay.

“The recent rally in commodity prices has been strong and broad-based, reflecting improved market sentiment, US dollar depreciation and commodity-specific factors," IMF said in an 8 July note.

In the first quarter ended June, the earnings of many Indian firms exceeded expectations, mainly on the back of higher profit margins, much of which was driven by savings on raw material prices and higher realizations. Rising commodity prices could, therefore, lead to a potential earnings squeeze for companies.

To add to the woes of companies, consumer demand hasn’t picked up across sectors. A Mint analysis of the performance of 43 of 50 firms that constitute the National Stock Exchange’s Nifty index shows that at an aggregate level, these companies reported a 7.76% fall in revenue, the steepest in three years. Despite this, their profits expanded the most in four quarters, year-on-year, in the three months ended June as they cut costs and benefited from lower raw material prices.

A Citigroup study of 412 of the top 500 Indian companies by market capitalization shows that at an aggregate level, revenue fell for the first time in many quarters—by 7% in the June quarter. The outlook on the revenue front is not hugely optimistic as yet, with an insufficient monsoon threatening to affect rural demand.

And rising raw material prices could put an end to the surprises on the earnings front too.

“It would be difficult for auto makers to give positive surprises from here on," said Joseph George, who tracks auto firms at BNP Paribas Securities India Pvt. Ltd. As a group, auto companies reported the biggest earnings surprise for the three months ended June, mainly on account of savings on materials such as steel and rubber. Steel accounts for 20% of the cost of auto firms. Tata Motors Ltd, India’s largest auto maker by revenue, reported a 57% increase in profit. Hero Honda Motors Ltd’s performance was even more impressive—its net profit after tax gained 83%.

The earnings of these firms and others are now under threat. Last week, domestic steel makers raised prices by Rs2,000 a tonne. Ankit Miglani, director, commercial, at Mumbai-based Uttam Galva Steels Ltd that supplies value-added steel products to several industries, said global steel prices have shot up 50% in the last two months. “We see a big jump in domestic prices, going forward."

Ravi Sud, chief financial officer at Hero Honda Motors, is, however, not worried as he expects the prices of commodities to remain benign in the next two quarters. “With (the) global economy still under recovery, demand for commodities from the user industries continues to be sluggish," he said.

Consumer goods makers are another group watching commodity prices closely. Ruchika Batra, spokeswoman of Samsung India Electronics Pvt. Ltd, maker of television sets and washing machines, said input costs have increased 4-5% since May and that if the trend continues, the company could reconsider the pricing of its products. She added that this, however, wouldn’t happen anytime soon because demand is still low.

Most companies and analysts say the impact of the rising prices of commodities will be felt only after a couple of quarters.

“Earnings impact comes with a lag effect," said Hitesh Agrawal, head of research at Angel Broking Ltd. “Commodity prices started falling since July 2008 and their positive effect was only felt in the quarter ended June 2009."

The reason for this lies in the nature of contracts between companies and their raw material suppliers. In some cases, this could be as long as a year. This means that even if prices change during the 12 months, raw material vendors will continue to supply the commodity at the contracted rate.

Thus, even if prices continue to firm up in the forthcoming months, the impact will be felt only after the current quarter, said Soli Mullan, senior general manager at Godrej and Boyce Manufacturing Co. Ltd, which makes storage and security products.

Another fallout of the rise in commodity prices could be a rise in inflation. The Reserve Bank of India raised its projection for inflation in 2009-10 from 4% to 5% in its quarterly review of monetary policy in July. According to the central bank, there are indications of inflation firming up by the end of the year “due to the waning base effect of last year, increase in commodity prices, delayed progress of monsoon potentially driving up food prices, expansionary fiscal policy and accommodative monetary policy".

The central bank also said that inflation expectations have not been declining in step with the WPI (Wholesale Price Index) inflation in the face of CPI (Consumer Price Index) inflation remaining firm.

Despite the decline in WPI for about two months now, retail inflation or that measured by CPI continues to remain high.

Graphics by Ahmed Raza Khan / Mint and Photograph by Santosh Verma / Bloomberg