Category Archives: Mining

why commodities companies overinvest, turning boom to bust

November 21, 2013 By in economics, Energy, Industry Analysis, Mining, semiconductor manufacturing, Strategy, Technology Tags: , , , , , , , , , Leave a comment

This is a continuation of my post from yesterday.

It may be that, as Chris Hackett suggests in a comment to yesterday’s post, that everyone has his head in the sand, not only commodities company CEOs and boards.  Maybe it’s some deep-seated psychological need to have the good times continue, or maybe a denial of the finitude of man, or…  Yes, commodities companies aren’t the only ones who extrapolate chiefly from the recent past in forecasting the future.  Nevertheless, I can think of three reasons why commodities companies feel most comfortable reinvesting cyclical cash windfalls back into new capacity in their primary business–even though that action itself inevitably triggers a cyclical downturn.

1.. It may be the best they can do.

Looking back at yesterday’s post, I think I was a little unfair in saying that there firms never think of diversifying.  During the first oil crisis in the early 1970s, all the big oils did diversify.  Gulf Oil bought the Barnum and Bailey circus (great job, Gulf; no wonder you got taken over); Mobil bought Montgomery Ward and Container Corp of America (both disasters); Exxon started a venture capital arm, which produced nothing of note.

Peter Lynch, of Fidelity fame, called this kind of move “diworsification.”  Ugly word, but an accurate observation.  Look at HPQ or Microsoft as other serial diworsifiers.

Of course, this is not really the best a company can do, either.  The firm could pay a special dividend to shareholders, but this sensible action rarely occurs to CEOs.  Reinvesting in a business they has some expertise in always seems to be the safest bet.

2.  Holding on to cash may be personally risky to a CEO, for two reasons:

–a cash hoard may make the company a takeover target.  Great for shareholders, not so much for the ego of a person who’s a demi-god to employees, but just a broken down old guy (albeit a rich one) if he loses his position.

–a sensible strategy would be to amass cash with the intention of buying assets on the cheap from semi-bankrupt competitors a couple of years after the cycle turns.  Suppose the cycle lasts longer than the CEO expects, however.  His profits are less than competitors; his company’s stock underperforms.  Maybe he’s ousted before he can act and his successor reaps the glory of making canny acquisitions.

Arguably you have more job security by staying with the herd.

3.  I can believe that adding capacity at or near the top of the cycle can make a perverse kind of sense under three (or maybe four) conditions.  They are the assumptions that:

–all attempts to diversify into other businesses will end in disaster,

–the company’s industry is in secular expansion, so that new capacity will be very valuable in the next upcycle,

–the company will be the first to add significant capacity, and will therefore have a year or two of supernormal profits from the new plant.   That will ease the pain of the downturn and put the firm in a stronger market position in the next upturn.

–(the, maybe, fourth)  even if a firm can’t be alone as the first to add new capacity, it should expand anyway.  This extra industry capacity will at least foil rivals’ plans to cash in big with their expansions.  Yes, the downturn will come earlier than otherwise, but the present market structure will be preserved.  A bit Machiavellian, and maybe giving undue credit to guys who think buying the circus is a great idea.  But it’s possible.

My bottom line:  long-cycle commodities, epitomized by base metals mining, are a true boom and bust industry.  As such, they’re a value investor’s dream come true.  For the rest of us, if we want to play we have to be in the uncomfortable position of buying when the stocks are very beaten down and it seems all hope is lost.  If you’re not accustomed to thinking this way, picking the right point to buy will be very difficult.  In any event, that point is not today.

the decline phase of the base metals cycle–where we are now

November 20, 2013 By in Energy, Industry Analysis, Mining Tags: , , , , , , 1 Comment

I started my career as a securities analyst as a generalist.  I covered companies in the oil and gas, utilities, and electronics industries as I learned the trade.  After I’d been working for a few months, our oil analyst was headhunted away and–poof!–I was the new oil analyst.  That reoriented my progress for several years much more toward natural resource companies.

One of the more peculiar ones I encountered as I expanded my coverage was Moore McCormack.  A conglomerate, Moore McCormack was originally a shipping firm but had expanded into iron ore and coal mining, cement, and oil and gas drilling.

On the theory that most things happen for a reason–no matter how hard it may be to see the rationale from the outside–I asked the CFO how the company had evolved in such a singular way (I was thinking “into such a ragbag of sub-scale commodities businesses” but phrased my question differently).  He told me that Moore McCormack deliberately specialized in holding long-lived assets that required large amounts of up-front capital investment and where the firm was essentially a price taker.  In other words, it specialized in commodity mining and shipping.

Why do this?  …because, he said (incorrectly, as it turned out), the key to success in these business lines was how the capital investment is financed.  And Moore McCormack was an expert in financing.

The company dissolved during the Second Oil Crisis of 1978 and the ensuing recession.  It couldn’t survive the sharp shrinkage of cash flow in all of its business lines caused by the ending of an almost decade-long commodities boom and the economic downturn that accompanied/intensified it.

How did this happen?

The base metals industry–shipping, too–is extremely cyclical.  But each cycle lasts a decade or so, much longer than an ordinary business cycle.  A boom begins when garden-variety economic growth expands to the point where demand for metals exceeds available supply.  Fabricators need more copper for construction or  iron ore for steel car bodies than existing mines can handle.  Or, say, the developed world is using more petroleum than the existing fleet of tankers can carry.

Because it may take five years to open a new mine, or a similar span of time to get a new cargo ship from the yards (a year+ to build, a four-year waiting list), the only way a user can get the commodity inputs he needs is to bid them away from everyone else.  So prices go through the roof.

But commodity producers in general, and base metals firms and shippers in particular, are like lemmings.  Everyone is making money hand over fist; everyone plows the cash into expanding capacity like there’s no tomorrow.  No one puts much cash away for a rainy day; no one diversifies sensibly.

Then–several years, maybe half a decade, into the boom–the first new capacity begins to enter the market.  Prices begin to flatten.  Then a cascade of new output comes online–much more than anyone can possibly use.  Commodity producers frantically put as much of their expansion on hold as they can.  But it’s too late.  Prices sag.  Cash flow shrinks drastically.  And the industry waits for world demand to grow big enough to create demand for all the new capacity there is.  The bust lasts maybe another five years.  And then the cycle begins again.

For base metals, we’re in the decline phase now.  I don’t have any idea how long the current period of weakness will last.  But I don’t think the turnaround is any time soon.

To me, the interesting question is why managements of companies in long-cycle industries exhibit the same imprudent behavior cycle after cycle.  Don’t they know their own industries?  Don’t they remember what happened last time around?  If they do, they somehow convince themselves that this time will be different.

More on this tomorrow.

A side note:  Moore McCormack thought it was diversified, even though it recognized that all its divisions had the same economic characteristics.  Sort of like thinking a balanced meal consists of several different flavors of ice cream.

where’s the bottom for the gold price?

July 8, 2013 By in cash flow/share vs. earnings/share, Current Market Thoughts, Gold, Industry Analysis, Mining, Stock ideas Tags: , , , , , , 4 Comments

falling gold

The gold price has fallen steadily from a high of just under $1800 an ounce last October to the current spot price of $1231 this morning.

How low can the gold price go from here?

supply/demand…

In the simplest terms, prices fall when producers supply more to the market than buyers want at a given price.  The price drops to the point where buyers are willing to absorb the excess supply.  Typically, producers read the market signal and begin to cut back on the amount they put on the market.  When cutbacks are large enough, the price stabilizes.

For most things, adjustment happens quickly.  For gold   …not so much.

…for gold

Gold is mined in remote, inhospitable places by hardy workers who operate expensive and highly specialized machinery that needs considerable maintenance.  Once a mine shuts down, chances are it won’t reopen.  It’s hard to reassemble the needed mining crews…and it’s expensive to bring the plant and equipment back up to snuff.  So mining companies try to avoid shutdown at all costs.

Part their planning tends to make over/undersupply worse rather than better.

As the gold price rises, mines continue to process the same amount of ore, but switch to lower-grade areas.  This means they produce less gold, increasing the supply squeeze.  Conversely, when prices being to fall–the situation we’re in now–mines routinely shift to processing higher-grade deposits.  The idea is to keep their revenue steady–and therefore the mining crew together and the mine profitable.  But putting more gold on the market tends to depress prices further.

waiting for the weak to falter

Experienced mining firms also know how any market downturn will play out, even if no one voluntarily withdraws supply from the market.  At some point, the gold price will drop below the cash outlays of the highest-cost mines.  When red ink causes enough of these to cease production, supply will shrink, restoring equilibrium.

So…

…the gold price bottom question boils down to what cash costs for gold miners are and at what price do high-cost gold mines begin to die.

the Thompson-Reuters report

On April 4th, Thompson Reuters issued its 2013 Gold Survey.

TR says current average cash costs for the gold mining industry are $738 an ounce.

Average cash costs in 2009 were well under $500 an ounce, suggesting that that price level is highly defensible.   The addition of high-cost South African supply (averaging over $1,000 an ounce) and cost increases in Australia (much of it currency-induced, I think) are responsible for most of the rise since.

my take

Relative to nine months ago, gold looks cheap.  But supply probably isn’t going to be withdrawn from the market until the gold price falls below $1,000.  And rock-bottom (sorry) is probably $600 or so.

That’s a long way down.

To my mind, no one other than dyed-in-the-wool gold bugs will be interested in gold today.

Dr. Copper is speaking–but what is he saying?

May 7, 2013 By in Mining, Portfolio management, Recent Market Action, Stock ideas, Strategy Tags: , , , , , , , , , Leave a comment

Albert Edwards

Albert Edwards of Société Générale is one of the longest-tenured strategists of global securities markets around.  He’s very smart.  He foresaw the problems that would result in the peripheral EU countries from the very beginning.  He predicted long ago the current condition of globally low interest rates and slow growth, which he dubbed the “ice age.”  It took a more uplifting spin by marketing juggernaut Pimco, which called the situation the “new normal,” before the idea gained wide acceptance.

In some sense, Mr. Edwards’ predictions are  …well, predictable.  He’s almost always bearish.

Dr. Copper

He’s currently listening to “Dr. Copper,”  whose price has been falling since the beginning of the year.  Mr. Edwards likens today’s situation to that in 2007, when a swoon in the red metal (it ultimately lost 2/3 of its value) presaged recession.

Why is copper so important?  Its use is highly economically sensitive.  It’s tubing and wiring in building construction; it’s the guts of an electric power generator; and a new car can contain up to a hundred pounds of it.

Recession in the back half of 2013 wouldn’t be pleasant.  Monetary spigots around the world are already wide open.  Fiscal loosening takes a long time to have an effect–and, ex the EU, dysfunctional legislatures are unlikely to agree on anything positive in any event.  So for the first time since WW II, we’d just have to take our lumps.

is this right?

I’m not sure that Mr. Edwards is correct, though, about what’s causing the copper price to fall this time.  A tripling in the price of copper since 2006 has caused new mine projects to start up  and existing mine production to rise steadily.  I haven’t been able to find good statistics for recycled copper, another important source of supply, but I’m confident that it’s up as well.  As a result, a market that was chronically short of supply has recently turned into one where supply is now slightly ahead of demand.  Hence the price fall.  Unlike 2007, my view is that Dr. Copper is swhispering that supplies will be plentiful from now on, not that demand is drying up.

Europe is cheap

By the way, Albert Edwards has another big insight.  This one is bullish.  So, coming from a bear, it’s well worth listening to.

He thinks European stocks are startlingly cheap.  Copper is telling him that world economies are going to hell in a handbasket over the next eighteen months, so the timing isn’t quite right today.  But if–like me–you think he’s getting the wrong message from Cu, they’re worth taking a look at now.

commodities cycles

April 18, 2013 By in Capital-intensive firms, Current Market Thoughts, Gold, Industry Analysis, Mining, Trading Tags: , , , , , , , , , 2 Comments

commodity rhythms

agricultural

The co-owner of one of the smaller investment companies I’ve worked for was a farmer.  He made me realize that there are no long cycles for most agricultural commodities.  If prices for a particular crop are high, farmers will plant more–usually a lot more–the following season.  That virtually guarantees that prices will either level out, or more likely fall.  The opposite happens–supply falls, and prices subsequently go up–if prices are currently low.

Considering that many crops have two or three growing seasons in a year, price adjustment comes swiftly.

metals

Metals mining, especially base metals mining, is just the opposite.  Mines tend to be gigantic projects, costing billions of dollars and designed to last 20 years or more.  Most of that money is spent up front:  for the mine itself, for all the drilling machines and other earth moving equipment, for the ore processing plants, for the roads or rails to tap into a country’s established transport infrastructure, and maybe even for new sources of electric power.

Because the optimal project size is “humongous,” mines tend to spew out very large amounts of output when they open.

Because–unless you’re very unlucky–the running costs are low relative to the initial investment, projects seldom shut down once they’re up and running.  They normally don’t even consider doing so unless the output price falls below out-of-pocket extraction costs.  And even then a mine may not shut down.  Miners always identify pockets of especially rich ore that they set aside for a rainy day.  So the first response to weak pricing it to turn to these high-grade areas in order to keep going–and spewing even more price-depressing output on the market.

In addition, some emerging countries run their mines to create employment and get foreign exchange.  Because whether they make money or not is a secondary concern, such mines almost never shut down.

The result of all this is a supply/demand dynamic somewhat like the farm one I sketched out above.  When times are good and metals prices are high, miners generally spend their cash developing new mines.  This creates periodic overcapacity when supply outstrips global industrial demand as all the new mines open at once.  But, unlike the case with soybeans or corn, excess capacity doesn’t disappear come winter.  Instead, it can stay for a decade.  What cures the oversupply is the eventual expansion of the world economy to the point where it can use all the raw materials being produced.

an example

I was a starting-out analyst when a supply-demand imbalance sent base metals prices skyrocketing in 1980.  I remember copper briefly hitting around $1.40 a pound and bringing previously loss-making capacity back onstream.  The price almost immediately fell back.  It took nine years for demand to expand to the point where it absorbed all available supply–and for the price to regain that 1980 high ground.

Another wave of new capacity pushed the price back down in the mid-1990s, where it stayed again until sharply climbing demand from China absorbed all the new output.  The price began to rise again in 2003.

For most metals, this pattern of feast and famine is common.  It’s not alone.  Chemicals and shipbuilding are the same way.  The common threads are:  commodity industry; long-lived assets with most of the capital in up front; capacity additions coming in large chunks.

Try to find a copper chart that goes back to the 1980s.  It isn’t that easy–suggesting to me that commodities traders aren’t as up on their history as they should be.

investment significance

I think that for base metals, and maybe for gold as well, we’re deep in the end-game transition from fat years to lean.  It has less to do with the state of demand in China than the state of supply among mining companies.  If I’m correct, time–and the accompanying gradual world economic expansion–is the only cure.