Why There’s No Such Thing as a Floor Price Just the Market Price.
It’s not just housing spruikers and small-cap tipsters that fall for false optimism. Even senior mining executives and nationally syndicated newspaper columnists fall victim to it.
Yesterday the Age reported:
‘The Fortescue chief executive said he expected the sharp decline in iron ore prices to be followed by a swift rebound, within a couple of months, to $US120 a tonne.’
Today the iron ore price is USD$88.70 a tonne. For the previous two years the markets believed that iron ore had a ‘floor price’. And that floor price was USD$120.
What the mainstream bozos didn’t realise is that there’s no such thing as a floor price. All that exists is the market price…even in a manipulated market.
Even when governments or cartels try to create a false market, it doesn’t necessarily reflect the real market price.
The gold price is a good example. For over 30 years the US tried to peg the gold price at USD$35 an ounce. In fact, that was the official New York price for gold until the early 1970s. But that didn’t stop a free market price for gold developing.
During the 1950s and 1960s, the free market gold price frequently traded higher than the official price. Sometimes trading higher than USD$50 an ounce.
It’s the same on the reverse side. A cartel can try to restrict supply and demand to prop up a price, but eventually the market will win…because a free market is significantly more powerful than any government or private cartel.
As for the iron ore price bouncing to USD$120? Well, it’s possible, but as the chart below shows, the trend isn’t favourable for iron ore bulls:
Click here to enlarge
The price has dropped from USD$140 in May to just USD$88.70 today.
But does the iron ore price really matter? After all, that’s just one part (albeit it a big part) of the Australian economy. But our old pal, Michael Pascoe still reckons Australia is in the sweet spot.
Yesterday Mr Pascoe wrote:
‘Never mind businesses saying times are tough and uncertain, that their confidence is low and the sun won’t come out tomorrow. Instead, pay attention to what businesses are doing with their money: increasing their investment in Australia.
‘The important part of today’s private capital investment figures is what miserable-by-nature chief financial officers are telling the Australian Bureau of Statistics about how much they are sinking into capex this financial year.’
Mr Pascoe explains that the latest figures for 2011-2012 show a 30% increase in capital spending. And the number for the current financial year is 21% higher than last year.
Good times? Maybe. But maybe not.
Remember that capital spending involves spending on big-ticket items…factories, plants, and mining facilities.
These aren’t items a business buys on a whim. They’re typically long-term purchases decided on months in advance. You only have to look at the process a company goes through to decide on whether or not to go-ahead with a mine.
The company doesn’t think about it over a morning coffee and then start digging the same afternoon.
This process takes months…years even. Look at the proposed liquefied natural gas (LNG) plants planned for Gladstone, Queensland. We first started writing about LNG in 2008. Even then it wasn’t a completely new story.
Four years later and there still isn’t a functioning LNG facility in Gladstone. Capital spending decisions take a long time.
So just because a company says it’s planning to spend a billion dollars in the next year, doesn’t mean they made that decision today. Odds are the company made that decision one or two years ago. And that now it’s too late to pull out even if they wanted to – signed contracts, infrastructure built, and so on.
Bottom line, relying on backward looking data that tells you about decisions made by chief financial officers one, two or three years ago, isn’t the best way to predict where the economy is heading next.
This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.