Feb 12 2008 1:17PM
The Realities of this Secular Bull Market in Commodities
The following is the text of a presentation given by Lawrence Roulston at the Vancouver Resource Investment Conference on Monday, January 21, 2008
Today was a bad day in the equity markets around the world. To a large extent, the sell offs are a result of the uncertainty with regard to the outlook for the U.S. economy, and the belief that a slowdown in the U.S. would impact the rest of the world.
We should remember that the most successful investors are those who take a long term perspective. If you have a firm understanding of the big picture in a long term context, you can use the short term moves in the markets to advantage.
There is so much information available today that it has become extraordinarily difficult to read everything on any given topic, much less digest the significance of the constant flow of news.
Another problem is that instant information leads to short-sighted views of the world. Sometimes that makes it difficult to maintain a clear view of the long term picture.
There are a lot of opinions coming from the experts about what is happening in the economy and those opinions cover a range from doom and gloom to optimism.
I wish I had some fancy theory or computer model – the modern day equivalent of the crystal ball – that would give me a feeling of comfort that I had all the right answers. All I can offer are some observations.
When you understand the significance of those observations, you will see that it points to one of the best investment opportunities available anywhere. As a result of the information explosion, people don’t have the time to evaluate news, and many people react to headlines, to superficial analyses.
Another problem is that so many people get caught up in the day to day stuff, that they miss the big picture. If you react to what is happening on a day to day level, it can destroy you – financially and emotionally.
The most successful investors are those who understand the big picture, who have a clear vision of the long term and invest according to that long term vision.
I would like to state emphatically that what we are experiencing now is definitely not a cycle of boom and bust like we have seen before in the mining industry. This is a secular bull market. The mining industry is going through fundamental changes that will sustain a bull market for many more years. That applies to precious metals and to base metals.
Let’s look at gold. Everybody here has heard a lot about the outlook for gold. I would concur that gold is headed higher. The credit crisis is one more example of the fragile nature of paper investments and of currencies. More and more investors are adding gold to their investment portfolios.
The price of gold is reflecting the declining value of the U.S. dollar. Last week’s announcement that the American government is directing another $145 billion to prop up the economy is another endorsement of gold. That bail out just means that the government will have to print that much more money. Gold is also gaining in real value as demand from investors continues to build over time.
I would urge a little caution about the pace of the rise in the bullion price and also suggest that you remain aware of the tendency of the gold market to suddenly snap back after a big gain… as we recently witnessed. The story for silver is similar to gold. There is much less consensus with regard to base metals. In fact, there is a great deal of confusion, a lot of misinformation.
The big question on everybody’s minds at this moment is: Where are we in the commodity cycle?
Everybody connected to the mining industry thinks of the industry as always going in cycles of boom and bust. We have now had seven years of boom. For that reason, some people are saying that we have reached the end of this cycle.
The issue that is most on the minds of every investor at this moment is the state of the U. S economy. The fear is that the economy will go into recession and that will slow down the whole world, resulting in metal prices plummeting.
We have all heard the word recession so often that people believe it is real. The popular press repeatedly reports that someone or other has warned that the economy might go into recession. As a result of that media blitz, 60% of Americans think that their country is presently in a recession.
The reality is that the American economy is still growing. No doubt, growth is slower than everybody would like - 2% a year rather than 3% are 4%, like people became accustomed to.
But, economic activity in the United States is still expanding and is forecast to continue to expand. The economic forecasters best suited to make predictions continue to project positive growth. Slower, but nonetheless positive growth. One example is the Organization for Economic Cooperation and Development. Their comprehensive projection, published in December, shows U.S. growth this year at 2.0%, down from 2.2% last year.
I know, there is an argument that says that the figures are being fudged, and there really isn’t growth.
In terms of metal prices, it doesn’t really matter whether the U.S. economy expands by a couple of percent or declines by a couple of percent. The rest of the world is continuing to grow. In fact, much of the rest of the world is booming, and is forecast to continue to boom.
The OECD report forecasts that growth in China will slow to only 10.8%, slightly less than last year. China is now the fourth largest economy in the world.
Some analysts are still naïve enough to believe that the strength in the Chinese economy is based simply on making stuff to export to the United States. Therefore, the projected slowdown in the United States would cause the Chinese economy to crash.
Anybody who has spent any time in China will realize how ludicrous that belief really is. The professional forecasters have factored in the slowdown in the American economy and still project the Chinese economy to grow at 10.8% this year. China is by far the world’s largest consumer of metals.
In a single decade, China has gone from obscurity to become the fourth largest economy in the world. India and most of Southeast Asia are also booming. Three billion people are modernizing at the same time. It will not stop any time soon.
There has never been anything like this in history. There is no precedent for the economic forecasters. No pattern to plug into a computer model.
Yesterday, Frank Holmes gave a very revealing presentation in which he showed figures for the amount being spent on infrastructure around the world. There are hundreds of billions of dollars being spent on infrastructure. China and India are at the forefront. The rest of Asia is also spending. Oil exporting countries, awash in cash, are building roads and ports and new cities. Russia and parts of Latin America are booming. (See the presentation: Infrastructure: A Global Opportunity at www.usfunds.com )
So far, we have just seen the first wave – the build up of infrastructure. That process is continuing, perhaps even accelerating. Added on top of the infrastructure wave is the beginning of a second wave – hundreds of millions of wealthy consumers who are just beginning the life-long process of accumulating material possessions.
Demand for metals is rising steadily as more and more of the world enters the modern era. The rise in metal demand is likely to accelerate as growth in infrastructure continues and at the same time the number of consumers in the world is soaring.
Rising demand for metals over the past few years has pushed the metal prices higher by multiples ranging from three times to more than 10 times their levels at the start of this decade.
Economic theory would hold that higher metal prices would lead to reduced demand. The reality is that every pound of metal that the mining industry can deliver is being consumed.
Now, let’s look at what is happening on the supply side of the mining industry. Economic theory holds that higher prices will lead to investment by the industry and that will increase production. In previous cycles, that is exactly what happened.
Reality shows that economic theory is half right in this cycle. Mining companies have invested enormous amounts – tens of billions of dollars. Yet, production has barely increased.
Looking closely at what has actually happened in the industry, it is clear why production is flat. Almost all of the new investment has been directed to buying existing production.
Companies have grown their production capacity by buying other companies. Noranda was bought by Falconbridge, which was then bought by Xstrata. Inco was bought by CVRD. Alcan was bought by Rio Tinto. BHP is now trying to buy Rio Tinto. CVRD is now trying to buy Xstrata. And on and on throughout the mining industry.
Those corporate takeovers don’t create even a single new pound of production capacity. Investment in new mines has barely offset depletion – that is, older mines are running out of ore and are being shut down.
Let’s look at copper as an example. In 2000, the mining industry produced 15 million tonnes of copper metal. Last year, the industry produced 16 million tonnes of copper. While world economic activity was growing at 4-5% a year, production capacity grew by barely 1% a year. It is not surprising that the price of copper increased more than five-fold.
Part of the reason that the mining industry chose to buy existing mines rather than developing new ones is that they had little choice. During the down part of the metal cycle, there was little effort devoted to exploration and development. When prices began to move up, there was little in the development pipeline. In order to grow production, mining companies had to buy other mining companies.
For decades, geologists have been scouring every part of the earth’s surface. The big, high-grade metal deposits that were sticking out of the ground were found, and over the years were developed, and in many cases have now been mined out. For example, in the 1980’s, the Chilean copper belt was developed. The largest and some of highest grade copper deposits in the world were developed one after another. Not surprisingly, the copper price fell. In 2000, it reached $0.60 a pound, the lowest price, in real terms, ever.
Today, there is no Chilean copper belt waiting to be developed, or a comparable belt for the other metals. The deposits now under consideration are lower grade, more remote, deeper and in general more difficult than mines that operated in the past. There is also a great deal more political uncertainty, putting many areas of the world off limits.
Several years into this cycle, there are projects ready to go into development. Yet, the industry is still not doing much to develop new mines. The reason is that there is still an unrealistic view of the future.
The bankers and bean counters and analysts have adopted an entirely unrealistic view of the future of the metal industry. That view has stopped most projects from going ahead.
For example, in forecasting prices, analysts take the average metal prices over the past couple of decades and project that average a couple of decades into the future.
There are a couple of fundamental fallacies in that approach. First, the figures are all measured in simple U.S. dollar terms. Yet, the value of the dollar has greatly depreciated over the past couple of decades. It is down roughly 40% against the Euro in the past five years, for example. Even if an average price from the 1980s and 1990s made sense, which it does not, at the very least, it would have to be adjusted for the declining value of dollar.
As I noted a moment ago, the low hanging fruit has been picked by the mining industry. The easy to develop and the cheap to operate deposits are gone. The financial world must come to grips with the concept that cost, and therefore metal prices, have shifted upwards in a fundamental and long term way.
In evaluating development projects, revenue is based on long term average metal prices projected 20 years into the future. Yet, capital and operating cost estimates take into account today’s prices. There is a fundamental mismatch between costs and revenue and that is extremely detrimental to the viability of projects.
Are all of those analysts really so far off base? The short answer is yes.
Here is one example. Over the past few years, the mining industry has sold metal forward. That is, they have shorted their own products – in a way that has cost shareholders billions and billions of dollars of lost profits.
If those analysts can’t get the price forecasts right for the next 6 or 12 months, how can we rely on them to forecast for 20 years into the future.Another example: Canada’s nickel industry was sold off a couple of years back based on projections of nickel at $8.00 a pound. The Swiss company Xstrata and the Brazilian company CVRD are still laughing at the Bay Street bozos who evaluated those deals for the Canadian companies.
Soon after the sales were completed, nickel was as high as $24 a pound. The buyers of those companies were selling that Canadian nickel for three times what they had just paid for it. Even at the present $12, the foreign buyers are enjoying an enormous windfall profit.
The objective of all this economic analysis is simply to get a sense of whether demand for metals will continue to increase at a faster pace than the supply of metals. That is clearly the case. I’m not suggesting for a moment that metal prices will go higher from the present levels. I just don’t know.
But, what I can tell you with certainty is that metal prices will remain well above long term trends for many, many years, or more likely, forever. Certainly long enough for investors to make huge gains off the small companies that hold the deposits that represent the future of the mining industry.
Furthermore, the mining industry has a critical need for new metal deposits that can be developed into mines. Just to maintain the present production levels, the mining industry needs new mines each and every year. The junior companies that are finding and developing those deposits represent outstanding investment opportunities.
At some time, there will have to be a realization that the long term forecasts for metal prices don’t make any sense.
The first thing that will happen is that companies with existing production will get an immediate re-rating.
Secondly, development projects will be re-evaluated. Companies that hold large, advanced stage metal deposits could see their values multiply.
In time, the gains should be reflected throughout the exploration and development sector for companies that have credible management teams and realistic prospects of finding and developing new metal deposits.
This period of uncertainty represents a buying opportunity in a long term bull market for metals.
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