2015 was another tough year for commodities with a sharp slowdown seen in demand from China. Combined with ongoing supply growth—the result of a 30-year high in capital investment over 2009-13—this has led to all non-precious commodity prices falling materially, and the global mining sector equities underperforming for an unprecedented fifth consecutive year, making it the worst period since at least 1966.

Looking forward into 2016, it is hard to see what might pull the sector out of its tailspin. A demand shock seems unlikely given the state of China’s economy. Aside from the structural transition away from fixed asset investment (FAI) intensive growth in China, we worry about deteriorating demographics in China and a multi-year slowdown in property investment. We note that floor space per capita in China is already the highest in any emerging market and among the top 10 of all countries globally. Residential investment in China as a percentage of gross domestic product is unsustainably high.

There are no clear signs of supply deficits emerging until 2018 (iron ore) or later (copper, coal and aluminium). It implies pricing at or around marginal cost levels for the time being. Costs themselves are under negative pressure. Meanwhile, returns on equity are sub-cost of equity following unprecedented capex and depreciation levels, and net debt as a proportion of enterprise value is at an all-time high.

The likelihood of meaningful stimuli in China, oriented towards commodity intensive sectors sufficient to offset the other factors affecting the sector also looks low. The risk to the outlook remains to the downside, with fixed asset investment and the property sector the most significant risk factors. Elsewhere, the next two most important regions for commodity demand—Asia ex-China and Europe—may account for some improvement in consumption but it is unlikely to be shocking even as we note a pickup in global purchasing managers indices recently.

Margins of the commodity-grade steel producers in China have been at the lowest level since 2011 for a few months now. However, there has been little in the way of production cuts so far (not even the temporary closures that accompany low profitability let alone permanent closures of capacity). On the other hand, the property sector in China, which absorbs 48% of its steel production, faces a prolonged slowdown.

Capacity curtailment is a key pillar for the recovery thesis for aluminium. Amid the capacity overhang, capacity restarts (particularly in China) with even lower costs are undermining and delaying the potential recovery. Chalco had announced the shut down of its 540 kilo tonnes per annum Liancheng smelter, but it has been restarted after the provincial government lowered the power tariff for the plant. This is a double-whammy for aluminium price recovery, where capacity restart will keep the market oversupplied while lower costs will push the cost curve further down.

Copper prices have been weak in 2015 amidst macro uncertainty and weakness in demand, especially from China, while supply disruptions have increased in the last couple of months. Glencore’s recent announcement that it will cut back copper and zinc supply could be instrumental in improving the supply-demand balance. This is in addition to an annual decline for mined concentrate supply from China. Demand indicators are also starting to look up, with copper concentrate imports picking up and grid spending in China accelerating. We expect the latest stimulus measures in China (especially for autos) to drive zinc end demand in the next 6-12 months.

Meanwhile in India, the recent decline in global commodity prices has raised the prospect of renewed leverage stress on Indian metal companies. A significant part of the wider Indian metals universe has been on the edge of credit distress and likely to be pressured by the weakness in commodity prices. We believe the wider metals universe may see a number of companies struggling to meet credit obligations. The recent imposition of safeguard duties on hot rolled steel hasn’t helped much with domestic pricing pressure continuing. Recent currency depreciation in steel exporting countries and a further drop in Chinese hot-rolled coil prices have offset the benefits from the introduction of safeguard duties. Indian imports continue unabated and have rather shifted to value-added categories, further impacting steel pricing scenario.

More importantly, domestic demand remains tepid even as there is a wide-spread hope of a recovery in 2016.

Overall, commodities face a bumpy road ahead as China goes through a challenging economic transition amid slower growth, high corporate leverage and widespread overcapacity.

The focus areas will be on promoting industry consolidation and reduction of overcapacity and development of green industry, with stricter emission controls. Copper and zinc are the relative bright spots in the commodities space. In India, hopes are pinned on a demand recovery in 2016, which seems to be the only silver lining for the space for now.

Chirag Shah is director of research, Barclays Capital.

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