By Andrew Woods | Source: BAE, AWC, WI, AWEX, RBA, ICS
Commodity markets rise and fall, sometimes precipitously, and the wool market is no exception. The recent rises in fine wool prices are a good example of price volatility reappearing after an extended period of low volatility, depressed premiums. A natural fear is that prices will retrace these sharp rises, returning to the levels of recent times. This article takes a look at price movements in wool price down cycles during the past forty years, as a guide to the price risk in the market.
Price cycles take time to play out, both when rising and when falling. Figure shows the median change in price from nine selected price peaks from 1973 onwards for the average merino micron price, in nominal US dollar terms. It shows the median change from the peak price by month for 24 months from the top on the market. In addition the worst or most severe downturn is shown as well as the best or most mild downturn.
The median downturn falls away from the peak price reasonably steadily for 15 months or so, ending up 30% below the peak price. The best cycle hardly suffered a fall in price at all, finally slumping by 10% or so about 18 months after the peak. At the other extreme the worst cycle ended up 50% down some 15 months after the peak and 60% 18 months after the peak.
Figure 2 repeats the same analysis, in Australian dollar terms. It is a similar story in terms of timing and the extent of price falls. The best performing cycle falls by 10% within 9 months of the peak. Note how the worst down cycle falls by 20% immediately in the month following the peak (this was in 1973). The peak price in this instance was present for only a short time in the market.
Arguably the first 20% drop in the worst cycle is artificial as it is referring to a brief price level in the market which would not be reflected in forwards and would be averaged out by exporters. Figure 3 shows the worst down cycle with the drop in the first month of the cycle following the peak removed. The adjusted worst down cycle becomes similar to the median down cycle.
The key weakness with this type of analysis is that we do not know the market has peaked until we see it in the rear view mirror. However it does enable some back of the envelope calculations as to what is an acceptable level of discount to accept when considering forward prices in a strong market as we have at present.
For example it says that looking forward 3 months or so after the peak, a discount of 5-10% is probably the worst that can be expected. For the current 19 MPG around 1900 cents, which may or may not be near the peak price, this translates to a forward price between 1700 and 1800 cents. Looking forward 9 months a fall of 20% would be the worst case which from a 1900 cents price level translates into 1520 cents, with the best scenario a discount of 10% or 1700 cents. The risk increases out to around 18 months from the peak, where the price falls steady.
Forward prices in the wool market are, as a rule, discounted. In a strong market they are discounted further. Apart from not knowing when the market has peaked until after the event, the other question is what level of discount in the forward markets is acceptable? The historic analysis of down cycles provides an objective estimate of the best and worst price falls that can be expected, which can be used to judge forward prices on offer.
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