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Is the Good Times over for Commodities?

Tuesday, September 12, 2006

Firstly, there was this CSLA report urging caution on commodities.

Here is a snippet posted on Bloomberg.

  • Sept. 12 (Bloomberg) -- Investors should be wary of commodity-related shares because a slowdown in U.S. economic growth may dent demand for crude oil and metals, according to Christopher Wood, CLSA Ltd.'s global equities strategist.

    Fund managers should instead be favoring stocks that will benefit from the end of interest-rate increases in the U.S., such as Hong Kong developers, Wood, 49, told reporters yesterday on the sidelines of a CLSA investor conference in Hong Kong.

    ``As more evidence of a U.S. slowdown materializes, commodity prices will come under pressure,'' the Jakarta-based strategist said. ``That makes me cautious on commodity stocks in the near term.'' Wood was ranked the second-best Asian strategist in Institutional Investor's 2006 survey.

    The International Monetary Fund estimates the U.S. economy, the world's largest, will grow 3.4 percent this year, slower than 2005's 3.5 percent. The slowdown comes after 17 interest-rate increases in the past two years by the U.S. Federal Reserve to curtail inflation.

    BHP Billiton and Nippon Mining Holdings Inc. led a slump in commodities stocks in Asia today. Nippon Mining, Japan's biggest copper producer, fell 4 percent to 819 yen. BHP, the world's largest mining company, tumbled 3.9 percent to A$25.10.

    A measure of energy-related stocks including PetroChina Co. is the worst performing of 10 industry groups in the past month on the Morgan Stanley Capital International Asia Pacific Index. The energy index has slumped 8 percent in that time, as oil lost 12 percent. The broader MSCI index dropped 0.7 percent in the past month.

    Good Call

    Crude oil in New York fell for a sixth day, its longest losing streak in almost three years, on signs fuel demand growth will slow with the global economy. Prices have fallen 16 percent from a record $78.40 a barrel on July 14 as evidence mounts that the U.S. economy is slowing and Middle East violence is easing. Oil was recently at $65.75 a barrel in after-hours trading.

    ``Oil's been rallying all year on geopolitical reasons, not macro economy,'' said Wood. U.S. economic growth of below 2 percent annually might drag oil prices to $50 a barrel, he said.

    The strategist was a journalist with the Far Eastern Economic Review and the Economist before joining investment banking in July 1994. He moved to CLSA in February 2002.

    Wood in May forecast Asian stocks would extend their declines from a record close on May 8. MSCI's Asia Pacific measure has fallen 1.5 percent since the end of that month and is down 12 percent from its high.

    Currency Peg

    An index of raw materials producers such as BHP Billiton on the MSCI benchmark has declined 2.2 percent in the past month, making it the region's second-worst performing industry group.

    An index of six metals including copper on the London Metal Exchange dropped 4.6 percent yesterday, as signs of weakening global economic growth prompted investors to sell commodities.

    ``Commodity stocks have pretty well had their run,'' said Donald Gimbel, who helps oversee $2 billion including BHP shares at Carret & Co. in New York. Commodity ``prices may continue to rise but at a much lower rate. I think it really is time to look at other parts of the economy'' to invest in.

    Hong Kong developers will benefit as the Fed's rate increases draws to a close, Wood said, without naming any specific companies. The Hong Kong Monetary Authority last month held its key lending rate steady, echoing a Fed decision to leave U.S. borrowing costs unchanged.

    Hong Kong's monetary policy typically follows the Fed because the local currency is tied to the U.S. dollar.

    The latest move by the Fed's policy makers may help revive Hong Kong's real-estate market, which cooled as borrowing costs climbed. The value of property sales in July tumbled 42 percent from a year earlier, the biggest percentage drop in six months, according to government figures.

    ``An environment of falling rates will support property stocks in Hong Kong,'' Wood said. ``I would be wanting to move more money from commodities to interest-rate sensitive'' shares.

Well, the guys at FSO, they have a show every weekend and here is a snippet of the transcript posted on their website.

  • The Commodity Boom Is Not Over

    JOHN: Well, Jim, people are chattering away out there, talking about the rise in oil prices, the rise in gold prices, the rise in commodities, the bubble we have going here. So if we do have a bubble. Is the bubble going to burst? Or is this simply – to coin a phrase – in the markets a midcycle adjustment?

    JIM: You know I strongly disagree that we’re in a commodity bubble because one of the things that are very characteristic of a bubble is you see excess surplus or supply come into the market as a result of prices that we’ve never seen before. I mean just take a look at what happened to stocks, technology companies and internet companies. We had just this plethora of IPOs and people going public trying to raise money in the tech bubble, and we saw a surplus of just about everything – in telecom broadband. Just surpluses of everything that you can think of. When it comes to commodities right now, we do not have an abundance of surpluses that we can say this is very bubble-like – that we have more than we need, or because the inventory levels –just like housing are at such levels that there’s such a big supply of housing on the market – or big supply of commodities on the market you know this whole thing’s going to burst. We just don’t have that. So I would disagree rather strongly with the concept that this is a commodity bubble. I’m more in the Jim Rogers camp, the Marc Faber camp, who think that this is a long term cycle, that these things tend to last around 18-20 years – a couple of decades in length and there’s a reason for that and we’re going to get to that in just a moment, but you know, I disagree with the bubble assumption. [1:08:37]

    JOHN: But Jim, there are critics of the bubble. You keep hearing this all the time. For example, why should oil prices go up? I mean there’s no increased usage here, so obviously this is something on the part of price-gouging on the part of the oil companies.

    JIM: You know, if you look at, for example, demand for commodities, especially in the Western world. You’re right, John, it’s only up about 1%, not rather strongly. And I think this was one of the arguments, for example, Bill O’Reilly was making against the oil companies. He would say, “Gosh, you know, demand for oil in the United States has been flat, it hasn’t been up, how come prices are up?” And he’s absolutely correct when he says that. If you just look at consumption of commodities from the point of view of the demand side – whether it’s copper, lead, zinc, energy – it’s up marginally in the Western part of the world. It’s up a little over 1%. And quite honestly, the greatest increase in demand for commodities is coming from Asia, especially China and India. They are really accounting for the greatest marginal increase in demand for commodity products.

    But that is only looking at one side of the equation. The problem this time is on the supply side. Ok, we’ve got the demand side, which has been moderate in Western countries, stronger in Asian countries especially China and India, but you know the demand side has been rather moderate. So you can make the argument: gosh, demand is not that high in those parts of the world, and if the economy is going to slow down as the experts are predicting, well therefore the demand will slowdown along with it, and this whole thing is going to come crashing down. But if you look and take that argument, and most of the arguments I’ve taken a look at, that’s what they’re saying, you’ve got to look on the supply side. And the real problem with any bear market as we had in commodities that lasted more than two decades, what happens in a bear market? Companies go out of business because they can’t compete because the price of what they sell goes down, they can’t make a profit, the weaker companies go out of business, the stronger companies consolidate, the industry contracts. Eventually nobody invests in new plant and equipment, nobody invests in going out and looking for oil, nobody invests in going out and looking for mines. I mean, what mining company was spending a ton of money in the late 90s trying to find new supply? In fact, it wasn’t until recently – 2004 and 2005 – that an increase in mining expenditures and exploration actually took place. So, looking at the demand side is only half the equation. [1:11:25]

    JOHN: So Jim, if we go back and look at things we’ve talked about here on the program before – go back to 1985, world demand for oil was 60 million barrels, the world supply was about 70 million barrels, so we had a surplus of 10. That no longer exists, and in oil and other areas what we could be looking at is maybe the surplus for the commodities are just simply gone. They don’t exist.

    JIM: Yes, I mean you don’t have a surplus of a lot of commodities. It takes time, for example, you’ve recently heard about the new oil discoveries in the Gulf. Just as if you go back to the oil discoveries in the North Slopes of Alaska, and the North Sea at the end of the 60s, it was a full decade before that oil could come online and supply. It’s going to take a while for any new discoveries to come online. It takes a long time today – 7 to 10 years – to bring a mine into production. You don’t just go out and poke a hole in the ground, discover new oil and it’s on the market on Monday. And it’s the same thing with mining.

    And the other thing is one of the things we’ve also been talking about on the program, there is a lot of skepticism in the mining industry and the natural resource industry. There’s a lot of guys that are running mining companies today that have spent the bulk of their careers in a bear market. And when you go through a bear market that lasts for two decades, it’s kind of like somebody that went through the Great Depression. That has an impact on you in terms of how you’re going to spend money. These guys are not cutting loose with the checkbooks in the same way that they might have done let’s say towards the tail end of the bull market in the late 70s. [1:13:21]

    JOHN: We talk a lot about mining and exploration and a lot of the companies out there are increasing their exploration budgets, but you seem to have a different take on that.

    JIM: You’ve got to remember what has happened to the mining industry and the energy industry. Yes, energy exploration has increased in dollar terms; yes, mining exploration has increased in dollar terms. But last year alone, if we take a look at a year over year period price inflation in the mining industry is up over 35%. I can’t read a quarterly report by a mining company talking about what their cost structure – you know, the cost of steel has gone up, the cost of labor has gone up, the cost of acquiring earth moving equipment has gone up, the cost of acquiring trained geologists and skilled personnel has gone up, benefit costs have gone up, energy costs have gone up. And so yes, the price of gold has gone from 250 to over $600 but margins have not gone up in the same measure, and the reason is cost structures have also gone up.

    So it’s a little misleading if you say, “well, gosh there’s an x amount of dollar increase, that means sure we should see a lot more supply.” Remember, a lot of those dollar increases are simply going to keep pace: it costs more money to get a trained geologist today, it costs more money to get a permit today; it costs more money to get a drilling rig. I mean just take a look at some of the day rates for drilling rigs even in the oil industry. You have drill ships in the Gulf of Mexico that are getting over half a million dollars a day today, versus ¼ million dollars a day two or three years ago. [1:15:07]

    JOHN: If we look overall, both the mining and the oil companies seem to be spending more money, so at least you would think on the surface that we would be seeing more supply out there.

    JIM: Yes, there’s more money spending, but you know what, John, one of the things, and this is as everybody knows I’m a big believer in peak oil, in fact at our client meeting that comes up at the end of September, I’m presenting the culmination of almost 3 years worth of research and over 70 books in my conclusion. I’m a big believer in peak oil. And one thing we’ve seen is the discovery rate of new exploration has been very disappointing by any historical standards or even past standards, let’s say in the last decades. So the correlation between increased spending for exploration and future output gains or results is considerably weaker this time. You’ve also got the same thing outside of companies like Aurelian that made a major find in Ecuador, there just haven’t been a lot of elephants. Yes, we’ve just got news this week, for example, that Chevron and Devon and Statoil have made a major discovery in the Gulf of Mexico, or that perhaps Mexico has made a discovery. But John, it may be 10 years before we get the full benefits of all of that coming online. So you’ve got to take the time factor between discovery.

    There’s always this inclination in my mind that people make, and I think this is how the media tends to distort this: “Wow, this is a big discovery” or “I can’t believe the size of the Aurelian discovery in Ecuador, so all this gold is going to come online.” It may be a major new mine, it may be a major new oil discovery but from the time of discovery, the lag period could be 7 to 10 years. In the meantime, demand continues to grow each year.

    And the other thing that you have to look at is depletion. If you have a mine, you may mine that mine and over a 10 year period you’ve gone through your high grade, you’re going to lower grades, it’s getting more costly, and the amount of ore that’s left to process may be diminishing. You also have the same thing with oil fields that you pump out at a very high rate when you first bring it online, and then eventually you start getting into a decline rate as depletion starts to set in. So that’s another thing you have to factor in. [1:17:46]

    JOHN: Yes, let’s tag in on something you and Dave talked about earlier that right now it’s actually cheaper to go out and buy somebody today than it is to do your own work.

    JIM: You know if you take a look at what happened in the last bear market, we got these big behemoths in the mining industry. You know, it’s hard to believe that for example, over half of the world’s copper is produced by a handful of companies – about 7 or 8 companies. Just take a look at the gold mining industry, the behemoths – the Newmonts, the Barricks, and the Anglos, some of these companies. You know, it is very hard to replace that, and you’ve got this mind set with a lot of these guys who have come through this bear market who say, “you know what, do I want to really sit there and expand capacity.” What they’re doing, John, and you’re seeing this over and over again, and I think you’re going to see this accelerate, is what a lot of the mining executives, even the oil guys are thinking, it’s far easier to expand their capacity via mergers and acquisitions than by developing new mines. Because let’s face it, if you’re going to go out and discover new oil, you’re going to go out and discover new copper, lead, zinc, mine a new gold mine, a new silver mine. You’re going to have to go out there, and you’re going to have to stake a claim, you’re going to have to drill it, you may get dry holes when it comes to oil or natural gas, you may get dry holes when it comes to discovering gold and silver. And even if you do find it you’re going to have to spend a couple of years drilling it out, you’re going to have to go to feasibility, you’re going to have to get environmental permits, and then who knows, you may get ready to bring it online, and then Greenpeace or some environmental group shows up and says, “nope, we’re going to stop this.” And so you’re fighting the environmentalists. And so there’s also a risk there.

    You have no assurance today that even if you find something that you can bring it online. There’s a lot of risk. So a lot of these guys are basically saying, “you know what? It is far easier to focus more on buying somebody else.” And this is also a function as you see the industry become more concentrated as it has – whether you’re looking at the oil industry or the mining industries – companies just become more focused on projects that produce relatively quick returns to their shareholders. They get more cautious about these risky adventures of going out and trying to find a new project or a new prospect. And so how can you get immediate benefit? Well, here’s a junior mining that’s selling at a discount below market value, let’s buy it. Or here is an oil company that has good natural gas reserves, let’s buy it. Or here’s a copper company, or a lead and zinc company, let’s go out and buy that. So that’s what we’re seeing in the news, and that’s what these guys are thinking because that’s really the way the industry functions.

http://www.financialsense.com/fsn/BP/2006/0909.html

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