which recovers first, crude oil or base metals?

I’m in the oil first camp.  (My private opinion is that it could take a decade or more for base metal prices to perk up.  Whether that turns out to be true or not is less important to a long-only investor like me than the idea that recovery is not soon.)

How so?

history

Leading with (the opposite of what you’re supposed to do) my weakest reason, look at the last cycle of gigantic investment in expanding natural resources production capacity.  Oil and metals prices both peaked in 1980-81  …and then plunged.  Oil stabilized and began to move up again in 1986; for metals recovery was over a decade later.

closing the supply/demand gap

There’s only a gap of a couple of percentage points between the amount of oil the world is demanding and the amount producers are willing to supply.  Growth in the car industry in China, the replacement of scooters and motorcycles with cars in other high-population countries like India and the strong increase in gasoline consumption in the US now that prices are lower all argue that the shortfall between demand and supply is, little by little, being erased.

On the other hand, the extent of base metals overcapacity is less easy to put your finger on, but is, nevertheless, massive.  Demand is also more cyclical–therefore less dependably growing, as well, but that’s less important than that mining capacity is added in gigantic chunks.

the nature of the enterprise

The up-front cost of a base metals mining project is very high.  There’s the mine itself, the huge machines that rip the ore out of the earth and the sometimes elaborate plants that crush or grind or otherwise separate it from the ordinary dirt.  Then there’s the transport link with the outside world.  All of this infrastructure can lie fallow for long periods without impairing the mine’s ability to be restarted–even expanded from its prior size–very quickly.

For oil, in contrast, finding new fields is a much more important issue.  Drilling new wells in an existing field is, too, in many cases.  As time has passed, the focus of the big oil majors has increasingly been on mega-projects that make them look much more like base metals miners than they did when I was covering the oil industry as a securities analyst in the late 1970s – early 1980s.

Hydraulic fracturing, however, has changed the industry for good.  This technology has made huge numbers of projects economically viable that have limited output that goes on for relatively short periods.  This converts 21st century oil exploration, in the US at least, into a sharp-pencil engineering business that even small firms can excel at.  Granted, the fact that production can turn on very rapidly when prices are high enough puts a cap on how far they can rise.  But the fact that several millions of barrels of daily output can be turned off equally quickly argues that the response time of the oil industry to a supply/demand imbalance will be much quicker than has been the case in the past.

 

natural resources and economic growth

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.