The above chart illustrates a typical capital cycle phenomenon, showing how attractive profits tend to attract excess capital and eventually lead to underperformance of the industry, and vice versa.
Example 1: Commodity Supercycle
Commodity Supercycle happened in the period of low interest following the dotcom burst of 2002. It was fuelled by China consumption, whose investment-heavy economy was experiencing double digit GDP growth. By 2010, China was accounted for more than 40% of global demand for several commodities, such as iron ore, coal, zinc and aluminium. This drove the prices far above historical trends, arguably at bubble levels.
Profit of global mininy companies improved with commodity prices. Their return on capital employed rose from around 7.5% to nearly 35% in 2005 and rebounded after financial crisis to around 20%. Analysts were optimistic on continued strong demand from China into distant future as they expected China to overtake US economy eventually. The combination of high commodity prices, strong profitability, and robust projection of future demand led to more investment in global mining production capacity.
In between 2000 and 2011, global mine production (in USD terms) generally rose by 20% per annum, with more than half of the growth coming from iron ore and coal. Mining capital expenditure increased more than fivefold, from USD 30bil to above USD 160bil. As with other industries, there will be a lag from capital expenditure to commissioning of the new capacity. In iron ore mining, it will take 9 years to develop greenfield mines. This led to lumpy addition of new supply capacity.
Attractive profits in mining industries attracted capital investment even from non-traditional producers, including Iran and parts of Africa. Competition intensified, with many newcomers in the form of smaller mining companies entering the market.
Eventually, the supercycle appeared to have turned in 2011, coincident with the slowdown in China GDP growth rate. By April 2015, the price of seaborne iron ore was down by roughly 70% from the peak. Yet, overcapacity is expected as new mines, which were commissioned when prices were high, came on stream. The profitability of global miners fell with commodity prices and their share prices underperformed.
Look for Part 2 in a month’s time for next example on beer industry.
