The rise and rise in the price of Australia’s major commodity exports – coal and iron ore – has been one of the astounding features of this year. This note explores to extent to which this gain in prices was fundamentally justified, and whether these solid price gains can continue. It also re-explores valuations in the Australian resources sector.
Commodity price gains are not just speculative
As seen in the chart below, the rebound in Coal and iron ore prices this year has been explosive. Since late 2015, the iron ore prices have increased by almost 80%, while thermal and coking coal prices have increased by around 110% and 200% respectively over the same period. These rapid moves, however, are not out of line with the volatile swings in these markets over recent years. Indeed, history shows that just as commodity prices can power to the upside quite quickly, subsequent price slumps can be just as rapid.
That said, as noted in the Reserve Bank of Australia’s November Statement on Monetary Policy, there are some fundamental factors underpinning recent price gains.
For starters, Chinese demand for steel has rebounded somewhat this year, reflecting policies that encouraged even further real estate investment (i.e. high rise apartment building), more infrastructure projects, and production of motor vehicles and capital equipment. The associated increase in manufacturing activity has also lifted electricity-related demand for coal.
What’s more, high cost Chinese producers of coal and iron ore have been exiting the market in a lagged response to low prices last year and Government efforts to reign in excess capacity, especially among the least efficient and most highly-polluting producers. Reduced local supply and increased demand has in turn increased Chinese import demand for raw materials, which has pushed up global coal and iron ore prices. The fact that major global coal producers such as Australia and Indonesia have had their own (albeit temporary) supply disruptions in recent months, and US coal exports have also contracted in face of earlier coal price weakness, have added to recent coal price pressures. 
Ongoing commodity price gains dependent on Chinese policy
Although the rise in commodity prices so far this year has been impressive, at least a partial price correction is probable by early next year. In Australia and Indonesia, an end to coal supply disruptions is likely in coming months, and even some high cost Chinese producers may be tempted to re-enter the market in light of recent higher prices. As the RBA notes, moreover, local Chinese government authorities have started to tighten up on real estate policies in response to the recent upsurge in speculative property price pressure.
The RBA argues “it is likely that continued efforts to restrict price growth will eventually result in slower residential investment and dampen demand for related industrial products and commodities.”That said, China’s actions this year have again demonstrated its willingness to pump prime the economy – even in sectors afflicted by over capacity – should it feel the need to support economic growth. With Chinese exports now quite weak (reflecting soft global demand and reduced Chinese price competitiveness), further ongoing stimulus to support the local industrial sector can’t be ruled out, even if it means further increases in overcapacity and Chinese debt.
Resources sector earnings have improved but valuations remain high
Reflecting the lift in commodity prices this year – together with extensive cost cutting by miners – earnings expectations for companies in the SPDR S&P/ASX 200 Resources (AX:OZR) have started to turn up in recent months. Indeed, between March and October, forward earnings for the sector lifted by 57%. If earnings expectations for FY’18 and FY’19 hold at current levels, forward earnings would rise a further 10% between now and mid-2017, and 17% over the following 12 months to mid-2018. 
The challenge for the resources sector, however, is that even if forward earnings did rise in line with current market expectations, much of the good news already appears priced in still quite high price-to-forward earnings valuations. As at end-October, for example, the S&P/ASX Resources sector was trading at a price-to-forward earnings ratio of 18.9, which is admittedly down from a recent end-month peak of 24.9 in April, but still well above its long-run average of 13.6. If current earnings growth expectations are realised, and prices moved sideways, the forward PE ratio would be trading at a still above-average 14.6 by mid-2018. In short, the market now appears to be counting on further upgrades to the resources sector earnings outlook.
It has been already quite high valuations that have led me to adopt a cautious investment attitude with respect to the sector so far this year.