The resources boom is over — or so they say.
If you saw the headlines in the paper this week, you might never buy another resource share ever again. But hold on there.
Both the oil and gold price headed higher this week. Can we take anything away from that? Well, hold that thought for a moment.
If there’s one area where the bulls and the bears are starting to diverge in a big way, it’s on the commodity bull market. The bearish argument says new supply, a Chinese hard landing and a deflationary economy will knock commodity prices over and hold them down. So you should get out while you can.
The bullish argument says the rising middle class in Asia and Africa will put a rocket under demand for the next decade or more. And with central banks printing money faster than Prince Harry can knock back the vodka’s, this will devalue currencies against hard assets. In that case, load up on resources stocks now.
So which is it?
When the Commodity Bull Runs Different Races
It’s fair to say that when investors talk about the commodity bull market, they’re usually talking shorthand. After all, which commodity? In Australia’s case, the commodity bull market usually means iron ore and coal.
You can understand why, when you consider that these two commodities make up a huge share of Australian exports and the effect they’ve had on the terms of trade.
But the natural resource market is a little bit bigger than those two, and a bit bigger than Australia as well.
To remind ourselves of the broad shift in the commodity asset class over the last ten years, we sat down with our CRB Commodity Yearbook this week and thumbed through from Aluminum to Zinc.
If there was one commodity that stuck out in terms of rising production, it was iron ore.
Worldwide, it’s almost triple what it was 2002. We couldn’t see any other commodity with such a huge shift in output.
Even the infamous gold bull market has seen production trending down in the last ten years in big producers like Australia, South Africa and the United States. The only major country to show a significant increase is China — and it doesn’t export any of it.
One lesson of the last bull commodity market in the 1970′s is that different commodities will peak at different times. Iron ore looks like the first to peak this time around and coal is probably not far behind.
As resource expert Rick Rule likes to remind us, ‘markets work’. Price signals bring on more production until demand is met or higher costs cause it to subdue.
In the 20th century, the three big commodity bull markets ran on average for about 17 years. If you take the start of the current global bull market as 2000, we’re a good way in. It’s natural the huge price run-ups we’ve seen will level off in at least some sectors of the natural resource market.
But there’s more to Australia’s natural resources than just iron ore and coal.
Even so, you’d expect Australia’s terms of trade to normalize in the near future as those two huge markets revert closer to the mean. The good thing is opportunities should be available elsewhere…including overseas.
There’s Still Opportunity in Resources
It’s important to remember that the same price action doesn’t happen in every commodity at the same time. Each natural resource has its own supply and demand dynamic. Commodities may correlate in a broad way as an asset class, but each commodity will still form its own trend.
The hard part is separating the price signals between the underlying supply and demand from the shaky global economy, because the fundamental problems in financial markets have not been addressed.
We’ve heard it described as two huge weather patterns (the financial crisis, the natural resource bull market) clashing against each other. The result is volatility.
Oil demonstrates this perfectly. In 2008, it nearly hit USD$150 a barrel. In January 2009, it was under USD$40. This week it nearly touched USD$100 again.
Now oil may spike up or down depending on different events. But as oil explorers go into deeper water or use more difficult onshore extraction methods, its costs are going higher.
Some estimates say it costs about $75-80 a barrel for projects like off-shore Brazil or Africa. The trend in the production cost is up. The easy oil is gone. The low in 2009 was a chance to take advantage of distressed sellers.
But almost every commodity took a nosedive in 2008. When the market breaks like that, resource companies shelve marginal projects and try to save cash…to make sure they have enough money to survive until the market returns to normal.
No Capital, No Business
Four years later, most Aussie resource companies did survive.
But, in the face of the relentless global financial crisis, the resource industry is shelving projects and cutting costs again. And like 2008, low-margin, high cost and capital starved companies could go out of business.
Only companies with lots of money at hand, good cash flow, and low operating costs will make it.
The result will likely mean a crimp in supply, and some markets could even develop shortages. That will draw new companies into the market, and encourage cash-rich resource companies to crank up their exploration and mining projects again.
The continued volatility in financial markets will keep presenting opportunities like the break in oil. But how do you know where to look?
Well, Rick Rule’s approach to investing in natural resource markets is to look for industries with poor capital investment and poor supply.
If commodity prices stay depressed or fall further, the industry outlook will be bleak. This will be the best time to buy.
And as Dan Denning pointed out this week to subscribers of Australian Wealth Gameplan, it’s at the bottom of the cycle that you have the chance to buy assets for a song.
The bull market in iron ore and coal may be over but that doesn’t mean resource investing is going down with it.
Callum Newman
Editor, Money Weekend
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