a reply to a reader comment

I spent a lot of time over the weekend thinking about how to reply to a comment from an astute regular reader about my post on Friday.

Here it is (edited slightly):

Thanks for your comment, Chris.

I agree completely with most of what you say. I think the US stayed with easy money for far too long.  As you point out, we’ll find out how damaging the speculative excess this has spawned has been as rates begin to rise. At the same time, the internet has changed the dynamics of ownership of physical assets. The aging of the population plus the unwillingness/inability of homeowners to use the equity in their houses to fund current spending will also be drags on consumption in the US. And, despite our warts, we’ve come out of the big recession in better shape than the rest of the developed world. So we now face a complex, slow-growth world with lots of challenges for stock and bond markets.

As to mining commodities, though, I continue to think that they exist in their own boom-bust worlds whose main feature is that participants will add capacity, even though history has shown that this will destroy pricing, so long as they have positive cash flow and can get bank loans. Oil and gas are a little more complicated, but let’s ignore that. The ensuing slumps can last a decade or more. It’s the odd nature of these industries that they produce more when prices decline rather than less. I regard the current weakness in the prices of mining commodities as resulting from industry weirdness rather than a recession-induced falloff in demand.

Of course, this is an optimistic viewpoint and I’m an optimist, so I could easily be wrong.

Does it make a difference whether oil and iron ore price declines are harbingers of general economic weakness or are just playing out a new day in their Groundhog Day existences?

I think it does.

If I’m correct, then mining weakness–and the “lost decade” it seems to predict for countries radically dependent on mineral production, although important, is one of many entries to the list of transformational issues facing today’s world. That list includes:

–Millennials vs. Baby Boomers
–China’s emergence as the world’s biggest economy
–the disruptive power of the internet
–political reaction to the failure of the governments of the US, EU and Japan to enact appropriate fiscal policy, defending entrenched special interests (many of them on the wrong side of change) instead.

In the world I envision for 2016, stocks will go basically sideways.  It will be hard to make money by owning them, but with careful selection it’s possible.

If, on the other hand, if you’re right that mining commodity price weakness foreshadows global economic contraction that just hasn’t hit mainstream indicators yet, then my take is much too positive. Cash will be the best place to be.

natural resource production companies: accounting quirks to watch for


Mining is mostly about how a company develops resources that have already been discovered, sometimes very long ago.

1.  Metals orebodies can vary considerably from one part ot the next in the proportion of valuable minerals they hold.  Standard practice is to mine the highest-grade ore when prices are low, and the lowest-grade when prices are high.

Not a lot of operating leverage this way.  But the idea is to enable the mine to stay open even during the inevitable cyclical downturns.  Doing the opposite, which will likely boost the stock price in good times, can lead to disaster during the bad.  There’s no easy way for an outsider to tell, except by the reputation of company management.  In the case of gold, we may find out who’s been prudent and who’s been reckless when the 2013 financials are published.

2.  Same thing with site preparation.  Standard, and prudent, practice is to routinely spend money on things like removing overburden (layers of dirt covering the ore) in places where the company is not mining today, but plans to in the near future.  This activity can be quite expensive.  But it’s necessary.  On the other hand, a firm can make short-term profits look considerably better by not doing so.

oil and gas

Oil and gas is much more involved with finding new deposits, and how to account for those costs, than metals mining.

1.  Companies have two ways to account for the costs of buying mineral rights and doing exploratory drilling.  They are:

–successful efforts, where, as the name suggests, only successful fields are put on the balance sheet and gradually written of as oil and gas is produced.  The costs of unproductive areas are written off as expense as soon as they’re incurred.

–full cost, where all exploration costs, both for productive and non-productive projects, are capitalized and written off against production.

Successful efforts is more conservative, but normally results in lower earnings.

2.  Accumulated costs are written off pro rata as each unit of oil or gas is produced.  The amount expensed against the revenue from each unit is its proportionate share of the total cost of finding and developing all oil and gas (it’s a little more complicated than this, but this is basically what you need to know).  That proportion, in turn, is calculated based on periodic estimates by petroleum geologists’ of the total size of reserves.

Big oil companies use their own geologists; smaller ones hire outside consultants.  The important point is that this estimate–and therefore the amount of cost written off per unit produced–can vary a lot, depending on the particular consultant hired.  It may also depend on the tone, conservative or aggressive, company management sets.

Just as important, as I mentioned yesterday, oil and gas price changes can alter the size of total reserves.  The cost of recovery doesn’t change, but the amounts of hydrocarbons that can be brought to the surface at a profit can be.  Lower selling prices can raise the per unit amount expensed;  higher selling prices can lower the unit amount.  Potentially, lots of operating leverage–that’s completely out of management’s control.

3.  A minor clarification of #2:  subject to some limits, the company decides how to group reserves and associated costs into different “cost pools” for figuring out depreciation and depletion.  Artful grouping of these pools can help disguise an extended run of bad drilling luck.  Not usually a worry, except with small firms with limited history.

4.  As with any other capital construction project, when oil and gas companies explore and develop with borrowed money, they can capitalize (that is, put on the balance sheet rather than expense immediately) the interest expense on that borrowing.  The interest expanse becomes part of the general costs that are written off against oil and gas production.  For smaller companies with an ambitious drilling program, this can sometimes create the peculiar (and potentially disastrous) result that it shows positive earnings while it is suffering cash outflows.  This is because interest is being paid to creditors but these payments basically don’t show up on the income statement.  Check the cash flow statement!!




natural resource production companies: proved reserves

Early in my career I interviewed for a job with a company that had brought in a new chief investment officer to revamp its research department–a job I (luckily, as it turns out) didn’t get.  In the interview, the CIO said he thought that any competent analyst could figure out most industrial or service companies, but that there were three areas that demanded special expertise, They were:  financials, technology and natural resources.

Personally, I’d take technology off the list, leaving financials and natural  resource companies as the real specialist endeavors.  I’ve coped with financials by either avoiding them entirely, buying plain vanilla commercial banks in emerging markets, or by mirroring the index (so they neither help nor hurt performance).  As it turns out, I spent about eight years concentrating on natural resource companies at the start of my career (true, during the last century).  Rightly or wrongly, I feel comfortable with them.

Two thing make natural resource production companies unusual:

–their revenues depend on the price of the mineral commodities they mine, which can be very volatile, and

–their stock market value most often depends on the amount and value of their proved reserves, something that only appears tangentially in the firms’ financial statements.  Companies routinely disclose at least some information about their reserves, but it’s in supplemental disclosure that you have to find elsewhere in the annual.

proved reserves

Proved reserves are deposits of minerals that can be recovered:

–at a profit,

–with today’s technology, and

–at currently prevailing prices.

Almost always, natural resource companies have more stuff in the ground than they report as proved reserves.  Two possible reasons:  the minerals genuinely aren’t recoverable at a profit, given today’s technology and pricing; or (commonly with small companies) the firm hasn’t wanted to spend the money to get hard geological evidence of the extent of their holdings.

why this is important

1.  When prices go up, two good things typically happen to natural resource companies:  the value of each unit of reserves rises and the volume of reserves rises as well.  The opposite happens when prices fall.

Most people don’t realize the volume part.  That will be particularly important this year when gold mining companies report their reserves.

2.  When technology changes–as is currently the case with the development of horizontal drilling and hydraulic fracturing in  shale–acreage that previously seemed worthless may suddenly become a big source of profits.

In the case of natural gas in the US, this is a two-edged sword.  The amount of new gas production that fracking has spawned is so great that it has lowered the domestic gas selling price.  This means that some high-cost operations that were previously economically viable are no longer so–thereby moving those reserves out of the proved category for the companies affected.  For particularly maladroit drillers, where the value of the reserves found is barely higher than their finding costs (i.e., where the stock market appeal is purely the bet that prices will rise steadily), fracking can be a death knell.

More tomorrow.



commodities cycles

commodity rhythms


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 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.