Supply the key commodity driver as demand takes a back seat

LAUNCESTON, Australia: The big change in many commodity markets this past year was that demand is no longer king, with supply becoming the key driver, a dynamic that's likely to persist in 2015.
While this trend has been identified, it has not been well understood, with much market commentary still focused on the state of demand as the key determinant of commodity prices.
This has been especially the case with China, where concern over the slowing pace of economic growth has been used as an explanation for weaker commodity prices.
The problem is that this analysis doesn't stack up against commodity volumes being bought by China, the world's largest consumer of natural resources.
In the first 11 months, China's imports of crude oil rose 9 percent from corresponding year-ago levels, iron ore arrivals jumped 13.4 percent, unwrought copper 8.3 percent, unwrought aluminum and products 13.6 percent and soybeans 12.3 percent.
The only major commodity where the weak demand as a result of the softer economy argument actually holds is coal, where imports fell 9.4 percent in the first 11 months.
Of course, there are several factors at work across the commodity complex, with China's stockpiling of crude and copper helping boost imports, while coal has been hurt by increased efforts to reduce emissions in the world's largest polluter.
But in some ways these factors serve to distract from the fact that supply, whether it be growth or contraction, is the headline act in commodity markets.

IRON ORE THE TEMPLATE
The best example is iron ore where spot Asian prices have plunged 49 percent this year to a 5 1/2-year low.
This has been driven by higher supply, mainly from Australia, where the top two producers, Rio Tinto and BHP Billiton, have flooded the market with their low-cost output.
The companies have argued vociferously that they are still profitable at the current low prices, they expected prices to drop and they believe they will win the long-term game as higher-cost producers are forced to exit the market.
They may still be proven correct, but I'd wager that prices have fallen far further than even their most pessimistic forecasts, supply hasn't left the market as quickly as they thought and their profits will come under pressure from weak prices that are likely to persist for years to come.
It's the same miscalculation that cost coal producers dearly, with thermal coal at Australia's Newcastle port down 27 percent so far this year and heading for a fourth consecutive annual decline.
The problem is not so much that demand has failed to meet expectations, it's that the amount of supply built was far in excess of even the most heroic demand forecasts.
This has already been seen in coal and iron ore.
Next cab off that rank is liquefied natural gas, where the seven under-construction projects in Australia and two in the United States are likely to shift another market that had been in deficit to structural oversupply.
In crude, rising US shale oil supply has been cited as the factor driving prices lower, but there has also been increasing output from Iraq and to some extent from a relaxation of Western sanctions on Iran.
The Saudi decision to defend market share, which I projected in a Sept. 30 column prior to Saudi Aramco's move to cut official selling prices, shows that for the moment surplus supply is driving the market to the extent that the world's biggest exporter has to stand aside.

COMMODITY DEFICITS
While many commodities are now in structural oversupply, there are some that are in deficit or may move that way.
Indonesia's ban on exports of unprocessed mineral ores saw nickel prices surge earlier in 2014, but the market has since realised that supplies are not as tight as feared.
However, Indonesia's bauxite export ban has tightened that market, and the huge Chinese stockpile of the ore used to make alumina is eroding.
This makes bauxite a good bet, and this will likely have flow-on effects to alumina and to the final stage product, aluminum, which is likely to move into a deficit outside of China, which will still have a domestic surplus.
Copper has also been sold down this year, again on the soft economic growth story and expectations of rising supply.
Both these dynamics may shift in 2015, with increased copper demand from power grid and infrastructure spending in China and disappointment on the supply side.
While supply will continue to drive many commodity markets, this doesn't mean that demand can be safely ignored.
The most likely scenario for commodity demand is for a global picture of modest increases, however this could be altered if the Chinese authorities decide to boost spending to prop up growth.
This is by no means a given, but each soft reading for key economic indicators increases the likelihood of stimulus.
Overall, many commodity producers are still trying to come to terms with their ill-considered expansions.
History does repeat itself, and as usual a demand-driven commodity boom, this time led by China, has resulted in over-investment in supply.
While volumes will remain strong, prices will remain weak and cost-cutting will stay the order of the day.

— Clyde Russell is a Reuters columnist.
The views expressed are his own.