Words of wisdom from a GURU
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Economic Theory Meets the Real World
By Lawrence Roulston Printer Friendly Version
March 29, 2007
www.resourceopportunities.com
While some economists are warning of a bubble about to burst, investors are making big profits in the greatest commodity bull market the world has ever seen.
The following is extracted from the February 2007- 2 Issue
There is an enormous divergence of opinion in the investment world regarding the outlook for base metals. Some economists describe the market as a speculative bubble on the verge of bursting. Others see the present price levels as being the result of the fundamental forces of supply and demand. The latter group describes the outlook for base metals as a super-cycle or a secular bull market with multi-year longevity.
In the face of such uncertainty, many investors are staying out of the metal markets, and thereby missing one of the most extraordinary investment opportunities in years.
Anybody trying to understand the metals markets based on historic patterns would likely conclude that this is just one more cycle, like so many that have come before, and therefore it must eventually reverse. That it will eventually reverse is an inescapable conclusion. ‘Eventually’ is the key word. For the reasons that I will discuss below, ‘eventually’ in this case is long enough for investors to make enormous profits and still have time to comfortably cash in your profits before a reversal.
Base metal prices have reached levels beyond the estimates of even the most optimistic of bulls. Economists are trying to understand the markets in terms of historic trends. Yet, the present markets are where they are because of forces unlike any that the world has ever seen before.
Understanding what is happening in the base metal markets will require broadening one’s perspective of economics beyond the study of historic patterns.
A decade-long bull market in commodities in the 1960s-70s was driven by the emergence of Japan as a modern industrial power. At present, a similar process is happening throughout Asia. An important difference this time around is that 20-times as many people are involved, creating an even stronger and longer-lived bull market.
I have commented many times over the years on various aspects of the metal markets. This is an attempt to reconcile the divergent outlooks in a way that provides a framework for investing in the mining industry.
The most strident of the base metal bears is Frank Veneroso. A couple of his articles are available on Kitco and he has also spoken at several investment conferences. Mr. Veneroso is a well-respected economist and his views are not to be taken lightly.
Mr. Veneroso’s point is that there has been a flood of speculative money into the commodity markets. He concludes “This consequent increase in the amplitude and duration of this commodity bull cycle will inevitably encourage supplies and ration demands. This process is now throwing markets into surpluses which will eventually weigh on prices.”
There is no question that a massive amount of speculative money has flooded into the commodity markets. That huge influx of capital has clearly had an impact on the markets. But, an influx of money into derivatives in the commodities market does not necessarily distort the market on a long-term basis.
In the late 1990s, Mr. Veneroso correctly drew the attention of the investment world to the massive derivatives position overhanging the gold market. He concluded that the mountain of paper – or the house of cards, as he described it then – could not be sustained. His analysis pointed to a gold price that would reach a level in the multi-thousand dollar range in the near term.
Mr. Veneroso’s observation with regard to the size of the gold derivatives market was valid, and the gold price did indeed move higher. Nevertheless, the dramatic outcome predicted at that time has yet to be realized, seven years later.
is a market open to manipulation in that nearly all of the gold ever mined is still available to be traded. Vast holdings of gold bullion provide backing for positions in the gold market in a way that allows speculators to form a meaningful long or short position.
The base metal markets are very different. In copper, for example, metal equivalent to one day of consumption would fill four trains, each of 100 cars and measuring one mile long. The concept of a secret inventory of copper of a size that would have a meaningful impact on the market is not credible.
I simply cannot agree with Mr. Veneroso's conclusion that speculators in the base metals markets have created a lasting distortion on the price levels. Certainly, speculators played a role in copper touching $4.04 briefly last year. For a period of time, the speculative forces almost certainly exerted upward pressure on the copper price.
Recent activity in the copper market makes it evident that the present level of $2.80 is well supported by a balance of physical demand and mined supply.
The nickel price, at over $19.91, is unsustainable and it will undoubtedly back off from that speculative excess in the same way that the copper price ultimately reached an equilibrium level supported by supply/demand fundamentals.
I do not doubt Mr. Veneroso’s figure that commodity derivatives exceed $1.5 trillion. However, I see no evidence whatsoever to suggest that the speculative position in the base metals markets is pushing the market to either the long side or the short side on a net basis over a prolonged period time.
Simply put, a pound of copper is mined and then sold to a manufacturer to become part of the wire in a car or a pipe in an apartment building. The fact that investors in New York, Singapore or Dubai trade an abstract derivative based on that pound of copper among themselves can not and does not change the fundamental supply and demand equation. In the absence of physical copper being taken out of the market, or added back in to the market, speculators can do no more than create short-term swings in the markets.
Whether metal prices are high because of fundamentals (or as Mr. Veneroso contends, because of speculators) it is worth looking at the second part of his conclusion: that high prices “will inevitably encourage supplies and ration demands”.
On a basic level, that is unassailable economic theory. The great unknown is when those forces will kick in. ‘Eventually’ in this instance means several years or more.
He states “the process is now throwing markets into surpluses”. It is not clear where those surpluses are. Remember, Mr. Veneroso's analysis encompasses commodities in general. The oil market, by far the largest component of the commodity markets, has certainly seen production increases, allowing the price to moderate. He also discusses the aluminum market in some detail, a market which is considerably different than the other base metals. (In essence, aluminum is more like iron ore or coal, where the economics are dictated primarily by material handling costs. Production of copper, nickel, zinc, lead, tungsten, tin and the other minor base metals involve a much greater element of exploration and development cost and time, which put a constraint on supply.)
Financial commentators have made much in recent weeks of a surplus of metal in the copper market. As I discussed in the last issue, the worldwide copper inventory represents 4.5 days of consumption. That is a tiny fraction of normal inventories prior to this bull market. Not surprisingly, the highest level of negative sentiment in the popular press corresponded exactly with the bottom of the market. Those who invested counter to the popular opinion saw copper move up from a low of $2.42 in mid-February to $2.80 today.
On a superficial level, copper inventories have increased substantially in percentage terms, growing from near zero a short time ago. Nickel inventories are effectively nil, resulting in a price that is closing in on 10-times the level at the start of this decade. The story is similar for many of the other base metals.
It is very clear that demand for metals has been rising. Never in the history of humankind has the world experienced such a strong level of worldwide economic growth as at present. Manufacturers are bidding against one another to buy every pound of metal that is being produced. Even in the face of record prices, demand for metals has not lessened and there is no indication that demand will lessen any time soon.
I heard one person, who I once thought to be highly intelligent, state publicly that the bull market in base metals was not real because there had been no real increase in metal consumption. Hello! Every pound of metal being produced is being consumed. There are no more pounds available to be consumed.
Lets look at what’s happening on the supply side of the metal markets.
Accountants and economists will tell you that mining companies are investing unprecedented amounts to increase production. Digging a little deeper into those numbers makes it clear that the vast majority of investment in the mining industry has been devoted to buying existing production. Investment in new production has barely been adequate to replace old mines that are being depleted. Industry production has risen only modestly, even after six years of rising metal prices. Mine development projects now underway or on the books will hardly offset mines that will soon run out of ore.
Economic models and historic trends are not able to account for geological reality. The mining industry at this time simply does not have a lot of big, high-grade deposits awaiting development.
Over a period of several decades starting in the 1950s, geologists scoured the surface of the earth. The largest, and the highest grade, and the most accessible of the metal deposits that were found in the course of that multi-decade search have been developed. Many of those deposits are now mined out and others are on their last legs.
After decades of cherry picking, the best of the low-hanging fruit is gone. In the 1970s and 1980s, for example, one of the greatest copper districts ever found – the Chilean copper belt – was developed. Many of the largest and the highest grade deposits ever found were developed one after the other. Not surprisingly, the cost of producing copper trended downward for more than two decades.
It is plain wrong to simply project that historic pattern of declining production costs into the future. There is no Chilean copper belt – or anything like it – awaiting development. The next generation of copper mines will be built around deposits that are described by some as “a pile of dirt”.
The mining industry and analysts are just beginning to get their minds around the idea that future mines will be lower grade, they will be more remote, they will be deeper and they will generally be smaller than what everybody has become used to. Furthermore, they will be built with higher priced steel and operate with higher priced energy.
And, in case anybody hasn’t noticed, a growing portion of the world is distinctly unattractive for making multi-billion dollar investments to develop mines. Add to all that the growing challenge in terms of cost and time delays to secure permits as environmental standards grow ever more rigorous (as they should) and special interest groups become ever more strident at imposing their views onto local communities.
The discovery rate of new deposits over the past couple of decades has not come anywhere near the success rate achieved in earlier decades. Record exploration spending over the past half decade has turned up hardly any new discoveries. Most of the success has come in rejuvenating projects that were rejected in earlier years.
In the absence of better alternatives, the mining industry is paying big prices to buy existing production. It is a simple reality that there is nothing available in the world that is anywhere near as good as what was found and developed in earlier years.
Economic theory does not take into account the long lead time to find, prove up, evaluate, permit, finance and develop new mines. Historians will record that the economists got it right and the bull market in the early part of the millennium, like all commodity cycles, eventually came to an end. That is like when a geologist calls something “recent” when it happened millions of years ago. Time is relative. The cycle will end. But, not for a long time.
To recap, in simple terms: Demand for metals is strong and will continue to grow. The supply of metal is constrained by the availability of suitable deposits that can be developed and by the long lead time to develop new mines.
Eventually, enough new mines will be developed to catch up to the growing demand for metals. At best, that will take several years.
During that time, companies that find and develop metal deposits will continue to pay off for investors. In the last month alone, two of the companies that we follow in Resource Opportunities have received takeover offers, generating big payoffs for shareholders and further enhancing our track record of picking successful exploration and development companies.
Good luck, bt.