Ambrose Evans-Pritchard: Commodity crash tests faith in supercycle

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, December 10, 2008

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/370266...

Rio Tinto gambled its future by contracting debt on a grand scale to fund its heady expansion near the top of the commodity bubble.

The bill has now fallen due. Tom Albanese, the chief executive, is cutting 14,000 jobs and slashing investment by $5bn over the next year in a frantic effort to lower debt. " He cited the "unprecedented rapidity and severity of the global economic downturn."

The last straw may have been a push by China to cut iron ore contracts for 2009 by 82pc, although almost every part of Rio's portfolio has been savaged by the metals crash. The trio of copper, lead, and zinc have now fallen by over 60 percent since peaking in the summer. They have dropped further -- and faster -- than they did during the Great Depression from 1929 to 1933.

It has been an article of faith in the markets that the commodity bust would be over quickly, followed by a V-shaped recovery as the Malthusian dearth of oil, metals, and food, reasserts itself -- and as the industrial revolutions of China and India trump falling demand in the Old World.

But the "Supercycle" thesis itself is now being called into question. The World Bank's global outlook this week suggested that credit excess had pushed commodity prices far above their sustainable level in this cycle. "Over the longer run, the price of extracted commodities should fall," it said.

The commodity booms of the industrial age have mostly lasted a decade and seen a rise in real prices of 60pc. This time the gains reached 109 percent at the peak. "The magnitude of commodity price increases in the current boom is without precedent," it said.

Moreover, China appears to have hit a brick wall since the Olympics. Officials have begun to talk of 5pc growth next year, which is below the level needed absorb the flood of urban migrants. The manufacturing sector is highly-geared to demand in America and Europe. Far from escaping, China is now suffering the brunt of global trade contraction.

There is no such thing as consensus in the commodity world, but most experts still think that the economic arrival of two billion people in Asia is a "game-changer" that will underpin prices for years to come. Oilfields are running down in the North Sea, Mexico, and Western Siberia. New sources -- off-shore Brazil and Angola, Russia's 'High North' in the Arctic, Canada's oil sands -- are hard to extract. Plans are being shelved because the capital markets are frozen.

A study by the US National Academy of Sciences found that 26pc of the copper that ever existed in the earth's crust has already lost through grinding or buried in landfills. The picture is bleaker for platinum. There is not enough to supply the world's motor industry with catalytic convertors for a decade.

Francisco Blanch, head of commodities research at Merrill Lynch, says the supercycle is alive and well, though oil prices could fall to $25 a barrel as the global economic storms inflicts its damage.

"It is going to be very difficult for a few months but we expect prices to bottom out in the first half of the year. The issue on everybody's mind is whether this is a recession or a depression. We don't think governments are going to allow debt deflation to occur because it would be too awful . There is too much debt out there. So the answer is going to involve inflation," he said.

Recovery may come too late to spare Rio Tinto the consequences of its debt-funded expansion blitz, capped by the takeover of Canada's Alcan for $38 billion in 2007. Mr Albanese has admitted that Rio will have to divest "significant assets not previously highlighted for sale", which means forced sale in a illiquid market.

The company will have to auction its "crown jewels" to raise money, says Shaun Giacomo, from SG Asset Management. Mining credit is now prohibitively expensive. It is far from clear whether Rio can raise money on tolerable terms given its BBB+ credit rating, barely above junk.

Mr Albanese aims to cut its $39 billion debt by $10 billion next year. "Our imperative is to pay down debt," he said.

It is a race against time. Some $19 billion of debt from the Alcan deal -- currently at 30 to 35 basis points over Libor -- matures over the next two years. The interest spread will be massively highly in this climate, if lenders can be found at all.

"Rio has blown it," said Stephen Pope, chief equity strategist at Cantor Fitzgerald.

"They are the most indebted of the big miners and it is now going to be a very tall order to refinance. It was all so easy during the boom when you could raise as much debt as you wanted, but that party is over. Goodness knows why they didn't take the money when BHP Billiton offered to buy them out for $66bn," he said.

For BHP Billiton it was the a very lucky escape. The Australian rival can now bide its time and pick off Rio's prized mines and reserves around the world. Who knows, it may even swallow the whole company after all, at a fraction of the price.

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