Commodities Priced for the Future?

The recent drop in commodities prices is a warning that despite all the hype about consumption growth commodity prices are cyclical. At this stage it is just a warning, but increased exploration and development expenditure will result in production catching up with demand (as a rule Malthus is wrong).

The growth in industrial production and demand for construction materials which started to rise suddenly from the early 2000’s and rose far more quickly than supply could respond to resulted in very substantial increases in commodity prices. For decades resource companies under invested in exploration and development and had diminished pipelines of new projects constraining supply to meet the growing demand. Management teams and expertise required to bring projects on had also been laid fallow.

These price rises have resulted in massive increases in profitability for resource companies and in turn massive increases in exploration and development budgets over the last 10 years. For instance in 2000, BHP’s earnings were $1.7 billion and their capital expenditure was approximately the same.

Compare that with profits of just under $13 billion and capital expenditure of nearly $11 billion in 2010. Supply will inevitably increase as new billion dollar plus projects come into production. Next year alone, BHP will invest $15 billion and RIO some $11 billion to fuel future production.

It is difficult to predict when exactly supply will catch up with demand but at current commodity prices the margin over cost of production is so large that there is significant downside in prices when this does occur (or rather when it becomes apparent).

For large resource stocks prices are generally a far bigger driver of profitability than volumes. Stock levels (the number of days of stock held for the annualised consumption) reached extremely low levels in the period 2005-08 but have been trending upwards for some time.

We are comfortable with the notion that volumes of iron ore, copper, coal etc will continue to rise but commodity prices are in our view unlikely to be maintained indefinitely.

One can argue that demand will remain strong in emerging economies and economic growth is returning to the US and in a more modest way to Europe. This is a plausible argument but commodity demand can keep on growing long after the prices have peaked.

Another aspect is the explosion of speculative activity. The financial crisis has dented confidence in financial assets and increased the demand for physical assets including commodities as evidenced by the large open positions on commodity exchanges.

For those of a cynical nature the partial sale of the giant commodities trader Glencore (the Summo sized baby of legendary trader Marc Rich) could be an indicator that we are well into the second half of the game.

Hugh MacNally, May 2011