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January 21, 2015 10:19 am

Emiko Terazono

Reasons why producers fail to respond to market falls

he commodities cycle is all about supply and demand responding to prices.

To put it very simply, as prices rise companies invest and supply increases. Prices then fall, which leads to production cuts, and eventuallydemand increases, pushing up the market and the cycle starts all over again.

That is, at least, the theory. In practice the price signal usually takes time to take effect, especially in amarket downturn. Although there are signs of oil producers responding to price declines, in some othercommodities, such as metals, coal and sugar, the reaction has not been immediate.

Why do producers fail to respond to a falling market? Here are our “five Cs” — a list of some of the factorswhich prevent the prices of commodities from regulating supply.

Contracts

Many producers are bound by “take or pay” agreements, or contracts that bind them to the use of particularmodes of transport or logistical infrastructure, such as a coal railway or an export terminal.

These contracts mean that the producers still have to pay for the usage even if they do not honour the contract, or pay a penalty rate. Thismakes stopping production less attractive.

Cash flow

The investment for production is a sunk cost and is possibly funded by debt. Producers need to keep on generating cash flow to pay offloans or interest and keep the operation running and will do so until production results in negative cash flow. This scenario is now playingout in the US junk bond market, with nearly a fifth of low-rated energy debt currently trading at distressed levels.

Capacity utilisation

Producers of commodities such as iron ore have tried to reduce costs by raising capacity utilisation. When everyone in the market doesthis, prices will continue to fall and it becomes a “last man standing” competition. In iron ore, for example, the result has been a near 50per cent drop in the price of the commodity since the start of 2014.

Currency

Most commodities are traded in US dollars. The flip side of a strong dollar usually means weaker commodity currencies, which means

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Commodities explained: The price-supply disconnect

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1/21/2015 Commodities explained: The price-supply disconnect - FT.com

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Oil, United States of America, Agricultural Commodities, Industrial metalsRELATED TOPICS

producers can get more bang for their buck in local currency terms even if the commodity price comes under pressure.

Depreciating commodity currencies also lower the local cost base such as wages, helping margins at producers, which receive theirrevenues in dollars.

Costs

Lower fuel prices benefit the commodities sector, by helping reduce production costs. Crude oil producers, miners and farmers all benefitfrom lower fuel prices and energy costs. Fuel accounts for about 10 per cent of overall costs for miners, while for farmers, lower energycosts mean lower inputs such as fertiliser.

This article is part of an online series on commodities made easy

Further reading:

Rio raises iron ore shipments to 300m tonnes

Low oil prices do not ensure shale output cuts

Also read:

Commodities explained: Contango

Commodities explained: Qingdao

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