Commodity contagion shows why history may be doomed to repeat itself

Das Capital: Every $1 change in the iron ore price cuts Australia’s tax revenues by $200m

Glencore's headquarters in Baar, Switzerland (Getty)

In late September there was talk of Glencore, the troubled commodity trader, being the 2015 Lehman and the epicentre of a global resources crisis. Interestingly, Glencore’s share price ended a volatile week largely unchanged and subsequently rose, albeit it is down more than 60 per cent over the past year.

But the problems in commodity markets are important and will affect the broader economy through a number of channels.

The first channel of contagion is income. The revenues of individual businesses will fall sharply. This will flow through into employees and suppliers – and affect governments too through lower tax revenues.

Saudi Arabia is highly dependent on oil, which contributes 45 per cent of GDP and 80 per cent of government revenues. A 10 per cent fall in the oil prices equates to a fall in revenues of more than $25bn (£16bn).

Meanwhile every $1 per tonne change in iron ore prices reduces Australia’s national income by around $500m. It also reduces the country’s tax revenues by around $200m.

The second channel of contagion is investment. Planned spending is being cut back as projects are deferred, mothballed or abandoned. Low oil prices have reduced investment in energy exploration, development and production by almost $1trn.

Similar retrenchment is occurring in other sectors. The lower spending levels will adversely affect activity and growth.

Over-investment during the boom creates legacy issues. There is now overcapacity in many commodities. The overhang will maintain the downward pressure on prices, delaying the equilibration of supply and demand.

The third channel is financial markets. A standing joke in the US shale gas industry was that it was driven less by real engineering (fracking technology) than financial engineering (the cheap capital available from the high-yield bond markets as investors reached for higher returns). Lending to the energy sector alone totals $2.5trn.

Between 2004 and 2014, emerging market corporate debt rose from $4trn to $18trn, much of the increase taking place since 2008.

A significant portion of the rise – especially in China, Russia, Brazil, Mexico and Chile – was related to the commodity sector. The default risk on this debt is increasing.

A toxic combination of declining commodity revenues and high debt levels is evident. Much of this debt is in dollars. Lower foreign currency revenues driven by lower commodity prices, a rising dollar, increasing US interest rates and higher credit spreads has the potential to become a big source of instability.

Pressure to maintain revenues or cashflow – for example, to meet debt commitments – has forced companies to maintain or even increase production, exacerbating oversupply and helping to perpetuate low prices.

In the US natural gas sector, these pressures are likely to increase – not abate. In the first half of 2015, around 30 per cent of the cashflow for the industry was from hedges using derivatives entered into at higher than current oil and gas prices. As these hedges expire, cashflow will fall.

At current prices, many projects will not cover their cost of capital and will destroy economic value. That also destroys the value of equity, making it difficult for companies to raise new capital to reduce debt. In industries such as shale gas and oil – which were cashflow-negative even at high oil prices because of the need to invest to maintain production – reduction in the supply of capital affects the ability of companies to operate. It will also create continued deflationary pressures, heightening broader economic problems.

Some commodity groups have significant derivative exposures. One area of concern with Glencore is its large derivatives portfolio, in addition to around $30bn of debt.

Activity may be designed to mitigate business exposure or be speculative in nature. Commodity traders also act as quasi banks, facilitating derivative activity by clients. These exposures link the commodity businesses into the wider financial market. While much of the trading is secured by collateral, the risk of large movements in values triggering big cash calls on trading companies has the potential to be highly destabilising.

The near-failure of the insurance giant AIG in 2008 is an example of this danger. The risks and linkages identified are similar to those that existed in 2007 before the financial crisis. Despite concerted efforts by regulators to improve transparency, the interconnections in the commodities markets appear to be poorly understood.

None of this is, of course, new. As the economist John Kenneth Galbraith once stated: financial markets suffer from a fatal and persistent brevity of memory.

Satyajit Das is a former banker and author whose latest book ‘A Banquet of Consequence’ will be released in February 2016