Destocking and restocking effect on commodity price
When commodity price starts falling and downtrend continues then if you are anywhere in the value chain — a commodity producer, a distributor, a processor or even commodity user there was absolutely no incentive for you to hold inventory because prices kept falling. In such situation destocking takes place. The demand for the commodity gets masked and stakeholders in the supply chain think that demand has come down too steeply but reality is that demand is still there but stakeholders in value chain are selling their stocks and are not buying to replace the stock anymore. This is called destocking.
As a result of destocking the producers in the upstream of the supply chain gets the gloomy forecast of the demand and hence cuts down the production, cancels leasing facilities, lays off surplus workers. The stock in the pipeline is meeting the requirement of the processors and consumers. This destocking becomes so overwhelmingly emphasized by everyone in the supply chain that everyone keeps destocking with least emphasis on replacement and at the end of supply chain the processor keeps inventory for only one week or even less than a week. Nobody is stocking, everyone is in the process of destocking. The gloom is predicted everywhere. The producers who had built excess capacity during boom are saddled with underutilization of capacity, debt to service, their assets become nonperforming. The currency of commodity exporting countries which were rising in boom days are now depreciating, the exporters are not getting bank financing rather banks are on their neck for recoveries and threatening to declare them defaulters.
When the price of the commodity bottoms out there is incentive for smart stakeholders in the supply chain to build the stock. The investors in the commodity who are building the stocks are said to be Restocking. They are not buying for supplying downstream but restocking because they see value in the commodity. They slowly start building the stock and this demand for restocking sends the amplified signal up the supply chain. The producers are not able to fully meet this demand because they have already cut down the production facilities during falling demand and gloomy forecast.
Demand forecast updating is done individually by all members of a supply chain. Each member updates its own demand forecast based on orders received from its “downstream” customer. The more members in the chain, the less these forecast updates reflect actual end-customer demand.
Order batching occurs when each member takes order quantities it receives from its downstream customer and rounds up or down to suit production constraints such as equipment setup times or truckload quantities. The more members who conduct such rounding of order quantities, the more distortion occur of the original quantities that were demanded.
Price fluctuations due to inflationary factors, quantity discounts, or sales tend to encourage customers to buy larger quantities than they require. This behavior tends to add variability to quantities ordered and uncertainty to forecasts.
Rationing and gaming takes place. Rationing and gaming is when a seller attempts to limit order quantities by delivering only a percentage of the order placed by the buyer. The buyer, knowing that the seller is delivering only a fraction of the order placed attempts to “game” the system by making an upward adjustment to the order quantity. Rationing and gaming create distortions in the ordering information that is being received by the supply chain. Now there is more emphasis on restocking. Each member in the supply chain is not buying only to replace the demand that it is getting from downstream but is buying more to restock. Many times restocking rally in commodity is perceived to be real rally in otherwise long term bear market. This restocking rally may last for quite some time.
Now the questions are being asked whether the recovery in China’s commodity markets is for real and prices are booming along with demand for raw materials. But so far that activity is based on restocking in anticipation of a pickup in demand from the real economy, leaving the possibility that the boom could fizzle.
Over the last few months, the Federal Reserve has signalled that they are not going to raise rates as much as earlier expected. The downfall in commodity producing currency stopped. Another reason why commodity prices were continuously falling was that there was unwinding of a very big cycle which was that commodity producing countries were seeing greater prices for their exports. Because of that, their balance of payment surpluses was strong. Their currencies were appreciating and that was pushing up the cost curve and pushing up the prices even more. The unwinding had started and some currencies of commodity exporting countries like the Australian Dollar, the Brazilian Real, and the South African Rand had been almost in a free fall. Because of that comment, these commodity producing currencies have actually rebounded and this means that we have actually seen at least for the next 12 months or so a bottom in most commodity prices.
Now the second thing that has happened is that China has restarted infrastructure investments. Now, there is a lot of debate about this, about how sustainable it is? Is the stimulus over or is it ahead of us? The Chinese activities are suggesting that the demand is starting to pick up. The approvals are in place and the activity levels are now going to start.
So these are two very disruptive changes that have happened in the world view and because of this, there is a restock cycle. So now what starts to happen is that everyone in value chain, needs more inventory and this is a very classic supply chain bullwhip effect. The end demand may move in a very small fashion but it is perceived by supply chain participants as that end demand would be very robust and that is what we are seeing for commodities.
So it is very hard to say how long these kinds of spikes will sustain but what is very clear is that at least for the next 9 to 12 months the restocking rally can last and the reason why these rallies last so long is that the supply chains take a long time to respond.
The banks in most of the countries are very reluctant to give working capital to commodity companies because of the long duration stress that they have already seen. Commodity companies themselves are quite reluctant to start their production aggressively because they have been under severe stress. They do not want to start unless they have good clarity on how long this sudden spurt in demand lasts and because of that the commodity rally, that has started may actually last fairly long. It is still too risky because this is a restocking rally in what is actually a long-term downtrend.