Many investors understand the importance of “barriers to entry” to an industry. If an industry is difficult, time-consuming or prohibitively expensive to enter, then-incumbent industry players will be protected from competition. This is an attractive characteristic for the shareholders of said incumbents and usually results in the industry generating above-average industry returns.
Fewer investors consider the notion of “barriers to exit” with respect to industry. And even fewer, the consequences of such barriers. Many commodity producers are currently facing barriers to reduce production capacity; and this in turn, is exacerbating enormous oversupplies in many commodity sectors resulting in further price declines.
The concept of barriers to exit can be somewhat counterintuitive. After all, if I own a mining project, surely I can simply tell all my employees to pack up and go home, thereby exiting the sector. But it’s not quite that simple. As Macquarie highlighted back in November last year, there are at least 10 factors that can hinder the reduction of capacity within commodity sectors – many of which can be conceptually extended to other sectors as well.
- The need to service debt – The commodity-producing industries are full of companies who spent big to expand capacity in the demand boom, only for realised commodity prices to be well below expectations when this new supply was delivered. This leads to a debt problem, and shutting capacity denies the revenues needed to service this debt. As they have always tended to do in this type of environment, companies treat capital investment as “sunk” and seek to generate revenues exceeding operating expenditures alone.
- The ability to cut costs – Helped by currency and energy cost tailwinds, producers continue to surprise in their performance in stripping costs out their business. And while there are still gains being made in this area, there is a natural reticence to admit defeat – even if commodity prices are falling faster. This is when the static nature of cost curves becomes a problem, as any given company will think “if I can just cut costs 5% more I’ll be below Company X and they will have to cut”. However, Company X is doing exactly the same thing, and cost curves keep grinding lower.
- Producer optimism – Until recently, many producers were still in the denial phase, thinking both demand conditions and price would recover and it was all about battling through the tough phase. However, the potential duration of this downcycle is now well understood, and thus this exit barrier should be heading lower.
- Game theory – ‘If I take supply offline it only helps my competitors and I’m lower in cost than them in any case’. Some would call this stubborn; others would call it good business practice. It does, however, lead to more widespread pain and a lack of capacity closures. The producer meetings held in China are an attempt to get industry consensus and a ‘pain-sharing’ agreement – these are a classic test of game theory as there is always some temptation to try and gain market share during this period.
- The social impact of closures – Many companies quite rightly consider the wider consequences of any closures (plus remediation costs involved) and decide the easier solution is to keep operations going and buy some time.
- The influence of government ownership – Governments, either local or central, often view major assets under their ownership as more than a simple economic investment. And thus, when considering the welfare required from any capacity closures, will avoid making such decisions (many would argue governments struggle to even take easy decisions in many countries). In terms of taking loss-making capacity offline, we trust the private sector to do so first, listed companies will reluctantly do so eventually, while State Owned Enterprises go under the assumption cuts will simply never be made.
- Seeking out subsidies – Part of the help governments can provide is through subsidies, either direct or indirect. At the current time we have seen various examples, including under collection of tax, making a contribution towards liabilities, giving incentives and lowering power tariffs. The latter has been widespread in the aluminium industry, both in China and the US.
- Exporting the problem – As we have seen from steel and aluminium in China, production tends to keep going as long as there is a buyer somewhere. And if that buyer is abroad, so be it. This transitions local oversupply into a global problem.
- Selling into stockpiles – If the export market is one terminal market, then stockpiles are another. This can be as simple as delivering to the London Metals Exchange, or trying to encourage someone else (such as the Chinese State Reserve) to purchase excess inventory. While this may optically solve the inventory problem, without production cuts the very same thing will be needed again in the future
- Low interest rates – Or to put it another way, the availability of cheap money. In this cycle, we have not let conventional economics work – we simply have not seen enough hard decisions made by company boards or bankruptcies of uneconomic capacity. Part of the problem is the low prevailing interest rates, which have thus far eased the refinancing cycle. However, with US rates starting to rise, this period of abundant and cheap money may well have come to an end.
These factors described above have dramatically hindered the rate of supply cuts that declining commodity prices over recent years should have encouraged. And this, in turn, has meant commodity prices have continued to fall, as shown below. Many of these barriers to exit continue to persist. In our view, therefore, the pain still to come in these sectors can be measured in years, not months.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.