Category Archives: Mining

natural resources and economic growth

January 20, 2015 By in Energy, Gold, Industry Analysis, Long-term themes, Mining, Shaping a portfolio for 2015, Strategy Tags: , , , , , , 1 Comment

I ended up with my first stock market job, more or less by accident–and without any finance experience or training–in the late summer of 1978.  A few months later, the firm’s oil analyst was headhunted away and I took his place.  Within a couple of years (an MBA from NYU at night along the way) I had picked up a bunch of metals mining companies, too, and was in charge of the firm’s natural resources research.

The oil industry was (and still is) really non-intuitive–more about my early adventures tomorrow.  Today I want to write about the mining industry, which is a little more straightforward.

natural resources in the 1970s

I started out by reading the annual reports and 10-Ks of the major base metals mining companies for the prior five or six years.  What stood out clearly was that all the firms held very strongly a series of common beliefs, namely:

1.  that global economic growth would continue to be strong for as far into the future as one could imagine,

2.  that the availability of all sorts of base metals–lead for batteries, copper for wiring and tubing, iron ore for steel, and so on–was a necessary condition for this growth

3.  that, therefore, demand for base metals would grow at least in lockstep with GDP increases.

Implicitly, the companies also assumed that:

4. that oversupply was highly unlikely,

5.  that substitution among raw materials–like aluminum or PVC for copper–wouldn’t be an issue, and

6. that, because of 4. and 5., the selling price of output from future orebody discovery/development would never be a concern.

CEOs’ conviction was buttressed by reams of computer paper containing economists’ regression analyses “proving” that all this stuff was true.

a massive investment cycle…

Naturally, the companies, not risk-shy by nature, went all in across the board on new base metals mine development.

As I was reading these documents in 1979-80, the first (of many) massive new low-cost orebodies were coming into production.  This wave turned out to have been enough to keep most base metals in oversupply–and a lot of mines unprofitable–for the following twenty-five years!!!  Miners were also in the midst of a massive switch to exploring for gold, where high value deposits could be developed quickly and at low-cost–causing, in turn, a twenty year glut of the yellow metal.

…that didn’t work out

The mining CEOs turned out to be wrong in a number of ways:

–like any capital-intensive commodity business where the minimum plant size is huge, industry profits for base metals are determined by long cycles of under-capacity followed by massive investment in new mines that causes long periods of over-capacity

–although it wasn’t apparent in the 1970s, substitution of cheaper materials has been a chronic problem for base metals.  Take copper.  There’s aluminum for heat dissipation and wiring, PVC for plumbing, and glass/airwaves for audiovisual transmission.

–Peter Drucker was writing about knowledge workers as early as 1959.  Nevertheless, the mining companies and their economists weren’t able to imagine a world where GDP growth might not require immense amounts of extra physical materials.

I’ve been looking for a sound byte-y way to put this all into perspective.  The best I can do is a gross oversimplification:

–real GDP in the US has expanded by 245% since 1980.  Oil usage is up by about 10% over that period; steel usage is down slightly.  The supposed dependence of GDP growth on increased use of natural resouces simply isn’t true.

Why am I writing about this today?

…it’s because I continue to read and hear financial “experts” say that weak oil and metals prices imply declining world economic activity.  To me this argument makes no sense.

 

 

 

crude oil (ii): what’s happening now

January 8, 2015 By in Energy, Mining, shale oil, shale oil and gas Tags: , , , , , , , 1 Comment

lower oil price+=less new drilling

Sharply lower oil prices have two main effects on the planning of new drilling by oil exploration companies:

–the more obvious is that they are only getting about half as much for the oil they are selling today than from output they sold half a year ago.  If production is constant, their cash flow has been cut in half

–the second is that projects on the drawing board and highly profitable at $100 a barrel may not be moneymakers at $50.

For both these reasons, less cash flow and fewer winning projects, exploration firms are cutting their capital spending budgets for 2015.

also…

–when prices are rising, oil explorer/developers tend to build up large inventories of supplies for “just in case.”  Instead of having, say, a three-month supply of the steel drill pipe that lines the walls of the wells, companies may want six months’ worth.  Now that drilling may only be half the level originally anticipated, a wildcatter could be saddled with what is now a year’s worth of pipe, or 4x what he could carry in normal times.  And he’s looking to save cash.

One of the company’s first calls is to suppliers.  It will want to cancel any outstanding orders–and to see if the supplier will take back some of what the firm already has in inventory.

It’s no surprise, then, that US Steel just announced layoffs at a big steel pipe-making plant.

–In good times, banks are happy to lend.  Wildcatters–natural optimists and not very risk averse–are eager to borrow.

I remember talking in early 1982 with the CFO of a mid-sized oil explorer that a short time later went bankrupt.  He said that over the preceding few years he routinely went to the local bank for drilling loans, which were always promptly approved.  He assumed the bank had done all the analysis needed to determine that the project was sound;  the chief loan officer assumed that because the CFO had an MBA he had done the work.  In reality, no one had.  Whoops.

During the same period, a small Oklahoma bank called Penn Square (located in one tiny office in a strip mall) originated tons of drilling loans, supposedly vetted by expert loan officers and collateralized by oil and gas assets, and sold them on to other Midwestern banks eager to participate in the late-1970s drilling boom.  Turns out no screening was done   …and documents securing the collateral were never signed.

In today’s world, a lot of drilling finance has come through junk bond issuance rather than bank loans.  That may be a plus for the exploration companies, if lenders have done their usual poor job of protecting their own interests through debt covenants.

At any rate, I think the bad debt story for drilling companies has just begun to unfold.

a price turnaround?

At some point–which I don’t think is anywhere close to today–at least a few savvy producers will begin to withhold production from the market.  This will come as/when they think oil is too cheap and likely to rebound in price within a relatively short period of time.

We’ve also already seen American car buyers adjust to lower gasoline prices by starting to favor gas guzzling cars and trucks again.

However, like any other commodity, the bottom for oil will come when the cash flow of the highest-cost firms turns negative and they cease production.   My not-very-well-informed guess is that this is between $40 and $50 a barrel.

 

 

why the oil price will continue to be weak

October 22, 2014 By in Energy, Industry Analysis, Mining, oil and natural gas, Recent Market Action, shale oil and gas, Strategy Tags: , , , , , Leave a comment

supply and demand

In the short term (read:  for now and for some vague time into the future), demand for oil is pretty constant, no matter what the price (i.e., demand is inelastic).   People need to fuel their cars and heat their homes.  Industry needs to generate electric power and keep factories humming.

The supply of oil is similarly inelastic, for two reasons:

–major oilfields are mammoth, expensive, multi-year capital projects.  Engineers get underground oil flowing toward wells at what they calculate to be the optimal rate to drain the entire deposit.  Changing that rate once the oil is moving can mess things up so that lots of oil gets left behind–meaning having to do expensive and time-consuming extra drilling to recover it.

–a macroeconomic look at OPEC’s oil-producing countries, especially in the Middle East, is a real eye-opener.  These nations typically have large young populations and more or less no economic activity other than oil.  In my cartoon-like view, they have tons of high school graduates entering the workforce each year and nothing to offer them but make-work “jobs” funded by oil money.  Keeping the political status quo ultimately requires that the oil keep flowing.  According to the Wall Street Journal, the budget breakeven oil price for Iran, for instance, is $140 a barrel and Saudi Arabia’s is $93.  (This isn’t an immediate do-or-die thing, though.  Countries can use savings, borrow or sell assets to bridge a budget gap for a while.)

recent history

Over the past decade or more, supply and demand have been close to being in balance, with China’s strong economic growth giving prices an upward bias.

China is now trying to halt the proliferation of low value-added, energy-wasting industry, so this source of extra demand is fading.  More important, the advent of oil extraction from shale in the US has raised world oil supplies by about 6%, or 5 million barrels a day over the past five years.

Given that demand is relatively constant, the only way to get buyers for this extra oil is to cut prices.  This is what’s happening now.

revisiting the 1980s

There’s lots of ugly history of colonial exploitation of Middle Eastern oil producers in the 1970s and before.  Let’s skip over that, in this post at least.

During the 1970s, OPEC pushed the price of a barrel of oil from under $2 to around $25.  By the start of the 1980s, the association was clearly divided in to two camps.  One wanted to maintain the highest possible current price (which had risen to around $35 for the easiest oil to refine).  The other, led by Saudi Arabia, the largest OPEC producer, feared users would find substitutes for oil, diminishing the long-term value of their vast untapped reserves.  It wanted prices at, say, $15 – $20 a barrel.

Saudi Arabia decided to force its will on the other camp by unilaterally raising production to stabilize prices.  However, a long and deep global recession soon began (partly caused by higher oil prices, mostly by the Fed’s decision to raise interest rates sharply to choke off runaway inflation in the US).

Saudi Arabia then reversed course and began to cut production, again to defend its preferred price level.  Other OPEC nations agreed to reduce production as well, but by and large never did.  Prices eventually bottomed at about $8 a barrel.

The point, though, is that the Saudi attempt to act as the “swing” producer by raising and lowering its output in order to stabilize prices, didn’t work out.  All that happened was that Saudis absorbed a huge amount of the pain of the price decline, allowing its OPEC rivals to prosper, in a relative sense at least.

today

I think Saudi Arabia learned from its experience in the early 1980s that unilaterally reducing production doesn’t work.  Besides, unlike in the early 1980s, it needs its current coil income to balance its budget.

Shale oil production will continue to grow, if nothing else simply from projects begun a few years ago.

As a result, I think the oil price will drift lower, either until a healthier world economy increases demand, or until lower prices force high-cost oil producers to shut down.  We’re a long way from the latter happening.

Bad for oil producers–in fact, energy producers of any stripe, great for everyone else.

oil? ebola? the dollar?–why stock prices have been falling

October 14, 2014 By in Consumer Staples, Current Market Thoughts, economics, emerging markets, Energy, EU financial crisis, Industry Analysis, Mining, oil and natural gas, Securities regulation, shale oil and gas Tags: , , , , , , , , , 4 Comments

In many ways, stock market commentators have an unenviable task.  At any given moment they have to come up with new and interesting reasons why stocks are rising or falling.   The media gurus’ difficulties are compounded by the fact that most are story presenters who have little understanding of investing and are therefore reliant on sources whose statements are many times influenced by their own private agendas.

After peaking in mid-September, US stocks have fallen by about 7% through yesterday/  This has erased most of their year-to-date price gains, although with dividends factored in the S&P is still up about 4% since New Year’s Day.

Among the current “explanations’ for the fall are:

–a falling oil price.  I don’t think this makes sense.  It would be one thing if world GDP were turning negative and demand were sagging as a result.  The current issue, however, is oversupply, being caused by the rise of shale oil/gas production in the US.

Yes, 10% of the S&P 500 consists of oil-related stocks, many of which are hurt by lower prices.  But, to simplify a bit, the other 90% of the index is a beneficiary.  Lower prices are bad for oil-producing nations in the Middle East, for Russia and for the rest of OPEC.  But they’re great for consumers.

Another point:  today’s production contracts with national oil companies provide that virtually all revenue from oil price increases above a certain level goes to the host country, not to the international oil firm that is developing the petroleum deposits.  Although this has been true for decades, my sense is that many investors still don’t get this.  The dynamic is much more consumers gain/emerging countries lose than the consensus thinks.

–ebola.  More about this tomorrow.  Ebola is scary.  The only model we have for what happens to stocks once investors become aware of pandemic possibilities is SARS.  On the other hand, Doctors Without Borders has been handling ebola patients for many years without a single infection of their own.  In my view, stocks would be way lower than they are today if investors viewed ebola a real threat.

–the dollar.  This is an issue, although almost no one is talking about it. The US dollar has risen against the euro by almost 10% since early May.  In back-of-the-envelope terms, 25% of the earnings of the S&P 500 is sourced in euro.  A 10% fall in the dollar value of the euro means that overall S&P earnings–without factoring in current Euroland economic weakness–will be 2.5% lower than previously thought.  Discounting this outcome would explain about half the recent market decline.

my take:

–technicals.  At the peak a few weeks ago, stocks had already discounted all the S&P earnings growth that’s likely for 2014.  In addition, the market had already also factored into prices, let’s say, a third of the expected earnings growth for the index next year. This is normal market behavior, granted, though, that we haven’t seen “normal” for the better part of a decade.

By September, potential short-term buyers couldn’t justify paying higher prices for stocks.  In addition, euro weakness + a lot of other miscellaneous stuff had put 2015 profits under threat.

We’re now in the process of determining how low prices have to go to bring buyers back.

Looking at past levels where lots of buying and selling has taken place ends up being a surprisingly effective tool for figuring out where buying will emerge again.  Don’t ask me why.  If this rule of thumb holds true, as I read the charts the key levels are 1840-80 (i.e., where we are as I’m writing this) and 1800.

North Dakota, fracking and flaring

July 8, 2014 By in Energy, Industry Analysis, Mining, shale oil and gas Tags: , , , Leave a comment

My internet is working again!!!

 

Oil production in North Dakota, driven by hydraulic fracturing in the Bakken shale, has risen from 400,000 barrels a day to over a million over the past three years.  This has elevated the state to second place in oil output, trailing only Texas–and the coastal waters surrounding the US.  At today’s rate, North Dakota accounts for 15% of total national output of crude.

No wonder North Dakota has sailed through the recession without many bumps or bruises.

Part of this expansion has been enabled by the wasteful practice of allowing drillers to “flare,” or burn, associated natural gas at the wellhead.  Last week, the North Dakota legislature took a baby step toward controlling this activity.

what flaring is

Many underground hydrocarbon deposits contain both oil and natural gas.  So output that reaches the surface is a mixture of the two.  Even in a remote area where there are no pipelines, crude can be saved in holding tanks and periodically trucked away.  Not so natural gas, which requires either a pipeline or  complex (and expensive) cryogenic system to get it to market.  This lack of transportability is the main reason natural gas often sells at a steep discount to crude oil based on heating value.  It also makes the gas a liability.

A generation ago, the most common way of dealing with natural gas that came to the surface with crude oil was to divert it to a safe distance from the well and set it on fire.  In today’s world, the accepted practice is to require the driller to pump it back underground.  That way it can be recovered and sold once there’s a transport mechanism in place.

Not so in North Dakota, though, where about 30% of the natural gas brought to the surface is wasted and burned.  Statewide, that’s about $50 million worth a month–four times that in energy value using its crude oil equivalent.  The 30% compares with 5% of gas flared from wells in Texas.

Environmentalists have been squawking about flaring for some time.  Landowners, too, who see potential royalty payments going up in smoke.

So last week, the ND legislature acted.  It is forbidding new wells to flare natural gas–meaning they must have a way to pump gas back underground–but does very little to stop the practice in already-producing wells.

The obvious consequence of this action is to raise the cost of future drilling in North Dakota.  This will gradually lower the profit growth of companies drilling there.  My guess, however, is that it will do little to slow the growth of production, since the new legislation just removes “Free lunch” from the bar.