The Dollar: Now Falling, But For How Long

Judging by recent speeches and comments, the RBA is clearly wondering why the value of the Australian dollar hasn't fallen after that 4.7% dip on our terms of trade in the final quarter of 2011.

From comments from the likes of Governor Glenn Stevens, senior RBA officials have expressed some modest surprise that the value of the dollar has remained strongly above parity with the US currency since late last year.

In fact we can blame demand from foreign central banks and other big investors for the Aussie dollar remaining high in the face of the slip in our terms of trade.

But since the start of March, the currency has started falling, and this week had slipped sharply, despite an improvement in market conditions in the wake of Greece's bailout.

The Australian dollar is losing value at a time when it should be rising.

There's a very real chance it could dip under parity with the US dollar in the near future, and how long it stays there is very much uncertain.

But the days of forecasts for a climb to $US1.20 are over.

The only thing that could stop the weakness gathering strength is a surge in global oil prices from an eruption of Middle East tensions, with Iran the key.

But a sustained dip under parity for the Aussie will ease pressure on much of manufacturing, inbound tourism and the federal budget.

It will come and could be around for a while thanks to the rebound in the US economy and the soaring US gas production, which is changing the global energy picture much faster than any one thought.

In last week's AirWeekly I wrote the rise in the greenback would come slowly, but the impact of the rising ride of US gas production seems to be out in front of where the currency is heading.

After riding out the volatile period from December through January and into February, thanks to those doubts about Greece and the eurozone, the Aussie has lost ground, especially since Greece's future was assured for the time being last week.

The dollar hit a seven week low Thursday at around $US1.0450, and has fallen 4% since early this month when it hit a recent high of just over $US1.0815.

It traded above $US1.05 in New York overnight Thursday.

The fall has come despite the obvious improvement in world markets, the solid rebound in the US markets, the ending of the Greece default fears for now, and a fall in volatility.

And, if anything, the past couple of weeks (apart from Wednesday of last week when markets fell on those fears about Greece), sentiment has been more towards 'risk on' investing, which is normally a good time for the Aussie dollar when it is in greater demand from carry trade investors especially in Europe.

Instead the US dollar is in demand for a variety of reasons led by the turning economy and falling unemployment.

Yields on US 10 year bonds hit 2.29% overnight Wednesday and ended at 2.28%, the highest for seven months.

That's despite the current campaign of the Fed to force down long term rates and hold them there.

US bond yields are rising because the economy is looking better and short-sighted US investors are worried about higher petrol and oil costs boosting inflation. The Fed says that will happen, but will only be temporary.

US mortgage rates have risen sharply as well in the past month, putting in doubt the modest recovery in housing demand in the US.

Gold prices have plunged as well, losing more than 4% or well over $US60 an ounce since the start of this week on the 'good times' are back for the US economy.

Gold bugs seem to be ignoring the story that those inflation fears are returning to haunt markets.

The weakening in the dollar is showing up in the way our stockmarket is performing: it's out of step with much of the rest of the world.

The ASX 200 index is still only 11% above the low it set on September 26 as Europe's sovereign debt crisis re-emerged as a concern.

The Dow average has risen by 24% since October 3, the MSCI world index is up 21.8%, and European and Asian markets are up solidly.

Apple shares are up 10% in March so far alone!

Tokyo is up more than 20% so far this year as the yen continued to fall against the US dollar.

The yen is down 7% over the past six weeks or so after the Bank of Japan added more spending to its easing plan and set an inflation target of 1% for the first time (See Japan story below).

European shares have done as well as our market, up 11% and they have real problems coping with a recession in many countries.

Driving the dollar lower is a worry about the future level of Chinese economic growth and therefore demand for Australian commodities.

At the same time, it is becoming more apparent that global pries for our key exports of coal and iron ore have peaked and are now weakening.

And it's not just softer demand and rising supplies of these commodities that is pressuring prices lower: the surge in US gas production is playing a major part.

Iron ore prices are currently around $US140 to $US143 a tonne, down sharply from the $US183 of a year ago.

Coking coal prices are now around $US206 a tonne, against more than $US280 a tonne a year ago (after the Qld floods and the iron ore problems in WA).

Thermal coal prices have plunged 30% or more to around $US105 a tonne as surplus US coal is dumped on world markets.

Because thermal coal and soft coking coal are fungible to a degree, the fall in thermal coal prices will tug coking coal prices lower in coming months.

That will continue until the supply/demand balance in the US is stabilised, especially in the power industry.

Cold weather next winter could do that, as could a very hot northern summer which chews up coal stocks to meet the demand for air conditioning.

Some analysts are warning the US could start exporting LNG into the Asian market to compete with Australia (they face a shipping cost problem), but the impact on coal prices is far more immediate.

And what's the bottom line for Australia should these weak prices continue?

Well more trade deficits or much smaller surpluses.

Australia exported thermal coal worth just over $A15 billion in calendar 2011 and coking coal exports were valued at more than $A31 billion.

So a 10% drop in prices across the next year would make a substantial dent of around $4.5 billion in our export income.

But that would be mitigated to a degree by the weaker Aussie dollar, especially if it moves decisively under parity with the greenback.

The downward pressure on global coal prices is coming from the rising tide of US gas production which is displacing coal in power generation because gas prices have plunged to their lowest level in a decade or more and will remain there for years to come.

Coal's share of US power generation fell under 40% in December for the first time in nearly three decades.

While Australia frets over coal seam gas and so-called fracking and its alleged dangers, the surge in US gas production is starting to directly damage the Australian economy and our export returns.

Oblivious to the dramatic impact the enormous growth in gas production in America is having on that country, we in Australia are stuck on issues that will be overtaken by events, if we are not careful.

The rise of gas from tight rock or shale, plus a smaller rise in coal seam methane output is making the US more energy independent than it has been for decades.

It is going to be the most dramatic event in US history and some see the US returning to the golden days when energy was plentiful and jobs and growth came easily.

Don't laugh, it is happening right now.

Due to the solid growth in gas output, helped by higher output of renewables and weak demand for products like petrol, the US cut oil imports in 2011 by a million barrels a day: that's $US700 million a week at current prices!

The report showed US oil imports declined to 8.4 million barrels a day by the end of 2011 compared with 11 million barrels a day when Obama took office in January 2009.

And the Energy Information Agency said that net oil imports as a share of total US consumption fell from 57% in 2008 to 45% in 2011, "the lowest level in 16 years".

US gas prices fell to a 10 year low last week and traded around $US3.30 per million British thermal units, down 85% from an all-time high set in 2005.

That is a direct response to the sharp rise in gas production from shale basins in the US (in which BHP Billiton is the biggest investor, and could be a victim because of the $US20 billion invested in the past 18 months).

That in turn is having a dramatic impact on the use of coal in US power stations: it has fallen sharply in the past year and that in turn has started forcing down US spot prices of thermal coal, which in turn is forcing down spot prices in Asia, including the Newcastle market in Australia.

Prices have fallen to 15 month lows in Europe and Asia as US companies start trying to push their unsold stocks into export markets.

Other US companies are cutting production or idling mines to bring costs down.

Prices are now back to before the Queensland floods in January 2011 boosted the price of thermal and coking coal to record levels.

2012 contract prices are settling around $US115 to $US120 a tonne, compared with the record $US130 a tonne a year ago.

Spot prices are down around $US105 a tonne. With the stronger Aussie dollar, the price is under $A100 tonne for spot sales.

Xstrata, BHP, Rio Tinto and Peabody Energy are among the major exporters of thermal coal from Australia. They all face price falls for 2012 to levels sharply down on their peaks for 2011.

The fall helps explain some of the weakness in the share prices of these groups in recent months (along with concerns about the health of the Chinese economy).

Those pressures will continue this year because the amount of gas produced in the US is increasing by the month (as is oil and other liquids, especially from huge fields in North Dakota that are producing more than 500,000 barrels a day, or more oil than OPEC member Ecuador does).

The EIA says US shale gas production is forecast to increase from 5 trillion cubic feet in 2010 (or 23% of total US dry gas production) to 13.6 trillion cubic feet in 2035 (or 49% of total dry gas production).

This surge will change power generation, home and industrial supplies and make more oil available for export from the south and see coal production reduced.

The natural gas share of electric power generation will increase from 24% in 2010 to 27% in 2035, and the renewables share is forecast to go from 10% to 16% over the same period.

"Over the next 25 years, the projected coal share of overall electricity generation falls to 39 percent, well below the 49-percent share seen as recently as 2007, because of slow growth in electricity demand, continued competition from natural gas and renewable plants, and the need to comply with new environmental regulations," the EIA said.

The price pressures on thermal coal prices will be downwards, not upwards, even if China and India boost their imports.

It is far easier for the US to export coal into Asia than it is to ship LNG, which some companies are trying to do to take some of the demand Australia's $180 billion worth of projects are gearing up to meet.

And that price weakness will drag down coking coal costs, especially for so-called soft or PCI (pulverised coal injection), which are a washed (cleaner) form of thermal coal.

And over time that will pull down the price of hard coking coal, the premium product used by steel mills to support their steel making.

Prices in the Asian market, especially in China, Japan and South Korea will come under downward pressure, and so will the value of the Australian dollar and our terms of trade.

For reasons unconnected with the US thermal coal glut, the price of coking coal for the April-June period is reportedly to have fallen in recent contracts.

Japanese steel mills cut the price of coking coal imports from Teck of Canada and Rio Tinto to $US206 dollars a tonne, down around 12% from the price in the January-March quarter and 40% under the record levels of a year ago in the wake of the Queensland floods.

That is going to put further pressure on our terms of trade in coming months and will place renewed pressure for the Aussie dollar to fall sharply.

A sharp fall in the value of the dollar might be enough to offset much of the price weakness, but the question is for how long.

The US gas surge is going to displace more coal from the power industry in America.

And that is going to see coal production cut until supply demand is back in balance.

But for a time that surplus coal will be dumped into markets in Europe and the US, pressuring global prices and Australian export returns.

The slump in global shipping costs, which is helping our exporters remain very profitable for their iron ore and coal exports, is also allowing US producers to make modest profits by dumping their surpluses into markets in Europe in particular.