There’s an interesting similarity between crude oil and iron ore on the world markets at the moment. In fact, if we take out the point that Opec is a cartel (which isn’t important to this point) we’ve actually got very much the same underlying economics in both markets. And the economics of this is clearer in iron ore than it is in crude oil but it does lead to very much the same price prediction for both commodities: prices are going to keep going down in 2015.

The basic insight (not that it’s a difficult insight to gain) is that both commodities are currently in over-production. Well, over-production doesn’t really exist, as prices move to balance supply and demand. But more is being produced than there is demand for at the prices of 6 months ago: thus the price today is lower than the price of 6 months ago. Our interesting question is whether this is going to continue next year?

The answer there seems to be that yes, it probably will. Because even at current prices there’s still more production than there is demand for it. Meaning that some producers will need to leave the market, curtailing supply, before prices rise again. It is, of course, possible that lower prices will stoke demand but the demand led price cycle for iron ore is long and it’s probably, with crude oil, longer than the influence of low prices on supply.

Here’s a nice piece about iron ore that illustrates the point:

At the $8 billion Roy Hill mine Rinehart is building in the Pilbara region, where her father made the first discoveries in the 1950s, ore must sell for about $56 a metric ton at Chinese ports to avoid losses, and costs are even lower for Australian output from Rio Tinto Group and BHP Billiton Ltd., UBS Group AG data show. Even with prices down 65 percent from a record in 2011, top buyer China pays $67 for the steel-making ore today.

And:

Ore with 62 percent content delivered to Qingdao, China, plunged 50 percent this year to $66.84 on Dec. 23, the lowest in more than five years, according to Metal Bulletin Ltd., and the raw material was at $66.94 on Dec. 24. Even as prices drop, high-cost output may be slow to shutter. Some mines in China will attempt to “hang on” above $60 to $70, Bank of America BAC +0.72% Merrill Lynch said, to preserve jobs. A drop below $60 next year is needed to accelerate cuts, Citigroup C +0.55% Inc. says.

Mines just aren’t something you close down because they are unprofitable on an overall basis. There’s billions upon billions tied up in capital investments there, making true profitability not the measure against which you make production decisions. Instead, you keep producing as long as you’re covering your operating costs. Because that means that you’re still at least with a positive cash flow to make some contribution to those past sunk costs.

So, a mine might well keep operating at much lower prices than would tempt someone to open a new mine. This means that price swings can be quite violent in the industry (I’ve seen, handled even, metals that have had 1000% price increases in one year and 90% price collapses in others). The corollary of this is that prices need to go down well below full production cost, below even operating only cost, in order to shake the high cost producers out of the market.

This is also true of the crude oil market. Developing an oil field is a hugely expensive and capital intensive process. Actually pumping up the oil once you’ve done that not so much. And just as with the iron ore mines the different suppliers of oil have different all in costs and also different operating costs. Saudi Arabia could, in some fields, see the oil price at $10 a barrel and still have a positive cash flow. That’s simply not going to be true of the tar sands up in Canada. And that sort of price would certainly stop people drilling new shale wells: but it might well not stop them collecting the oil from the ones they’ve already drilled.

So, in this sense the two markets are very similar, in their underlying economics. Current supply is above current demand, thus price falls. But to curb supply (for demand will react more slowly than supply) some of the higher cost producers need to exit the market. And they’re not going to do that one the basis of all in costs, but on the basis of operating only costs, ignoring their sunk costs. Thus the price will need to go well below market clearing price in order to shake out those high cost producers.