By Eric Angeli
Long time readers and seasoned investors in the natural resource arena are well aware of the cyclical ups and downs that come hand in hand with commodity production. In many ways it represents the truest form of the free markets that remain in the investment world. So for those of you who nodded off during Econ 101, here is a quick rundown of what I mean.
With few exceptions, the majority of worldwide production of raw materials is generated by companies who have the singular goal of maximizing profits with every decision they make. In contrast, a state-owned enterprise would seek to maximize revenue for their citizenry, with profit often being a secondary goal, if a goal at all.
[Sidebar – the primary difference is that when there is a mining project or an oil well that is no longer economic, a for-profit company will eventually cease production and redirect capital to where management believes they can see a better return on their investment. A state-owned enterprise may not have any choice but to continue producing at a loss because their social programs and domestic spending relies on the revenues from that production.]
Assuming that free-markets will always be more efficient than state-regulated markets, when a commodity price makes a move higher there are now new sources of supply that suddenly become economic. The efficiency of the private market causes producers to bring new production online because everyone wants to get a slice of that upward commodity price action. Assuming the demand remains constant (or at least doesn’t outpace supply growth) we will quickly see a market that is oversupplied.
This has been borne out time and time again in the commodity sector and as Rick Rule loves to say “the cure for low commodity prices IS low commodity prices!”
Whenever there is an oversupply of goods or services, prices will drop and those who can produce cheapest are crowned winners. To the victor go the spoils as they are able to capture additional market share from the high-cost producers who are forced to shut down production. This self-correcting mechanism of free markets will invariably lead to lower supplies. Further, assuming demand remains constant, an undersupplied market will eventually cause prices to spike higher, which starts the cycle anew.
The cycle is wonderfully portrayed in the chart U.S. Global Investors put together showing the annual performance of the 14 most important commodities traded worldwide. This illustration effectively demonstrates this natural market phenomenon and how it affects the rise and fall of commodity prices from one year to next.
Predictably, those that were the top performing materials one year are often times the worst performing the following year. Vice versa, the commodity that saw the greatest retracement in its price the preceding years usually had a sharp spike in price the following years.
Some commodities have production logistics which are more responsive to price moves; oil is a good example of this. An oil well that is drilled today can be producing cash flow in a matter of weeks and can be shut down just as quickly. In contrast, it takes years for mines to be constructed and commence production and shutting them down can be just as challenging as starting them up.
Investment opportunities arise when we identify the arbitrage between the slowly responding production side of the commodity sector and the rapid changes in the underlying spot prices of that commodity.
The story is not yet written as to how 2015 will close but it is worth noting that every commodity on this chart has so far seen a year-over-year drop in price.
I will leave it to readers to determine which of the above commodities will be the first to see a break out in price. Each one has its own unique nuances concerning supply/demand and while there has clearly been a global slowdown in commodity consumption growth, history tells us that markets tend to overshoot the mean in both directions (which is represented by σ in the table above). Global economies have grown accustomed to high levels of raw material production capacity and the companies that have the largest and most efficient operations will be the ones who emerge from the ashes as victors.
Markets like this may only come around once in a decade. These are the days where a patient investor can start to feel comfortable about buying tangible value for their hard dollars. To find out which commodities and stocks I am positioning my clients into right now, please contact me at 760-444-5254 or email me at EAngeli@sprottglobal.com.
Because when the scared money runs away, the contrarian can come out to play.
Join the conversation or track mentions of your favourite stocks daily at CEO Chat, the investment conference in your pocket.
This information is for information purposes only and is not intended to be an offer or solicitation for the sale of any financial product or service or a recommendation or determination by Sprott Global Resource Investments Ltd. that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the objectives of the investor, financial situation, investment horizon, and their particular needs. This information is not intended to provide financial, tax, legal, accounting or other professional advice since such advice always requires consideration of individual circumstances. The products discussed herein are not insured by the FDIC or any other governmental agency, are subject to risks, including a possible loss of the principal amount invested.
Generally, natural resources investments are more volatile on a daily basis and have higher headline risk than other sectors as they tend to be more sensitive to economic data, political and regulatory events as well as underlying commodity prices. Natural resource investments are influenced by the price of underlying commodities like oil, gas, metals, coal, etc.; several of which trade on various exchanges and have price fluctuations based on short-term dynamics partly driven by demand/supply and nowadays also by investment flows. Natural resource investments tend to react more sensitively to global events and economic data than other sectors, whether it is a natural disaster like an earthquake, political upheaval in the Middle East or release of employment data in the U.S. Low priced securities can be very risky and may result in the loss of part or all of your investment. Because of significant volatility, large dealer spreads and very limited market liquidity, typically you will not be able to sell a low priced security immediately back to the dealer at the same price it sold the stock to you. In some cases, the stock may fall quickly in value. Investing in foreign markets may entail greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. You should carefully consider whether trading in low priced and international securities is suitable for you in light of your circumstances and financial resources. Past performance is no guarantee of future returns. Sprott Global, entities that it controls, family, friends, employees, associates, and others may hold positions in the securities it recommends to clients, and may sell the same at any time.