Inside investment: Commodities – filtering signal from noise

A group of investors in the Boston area gather weekly to meet company managements and to discuss commodity markets. It is a knowledgeable and convivial assemblage that combines a soupçon of witty banter with serious discussion. It can also be a lion’s den, where weak promotional assertions are treated with undisguised scorn. (It must be said, however, that the lion in this particular den is generally more like the late, lamented Cecil than those ravenous beasts among whom the Prophet Daniel was cast.)

I attend these breakfast meetings frequently and learn a lot. Lately, the mood of this gathering has been lacking its past ebullience. The collapse in metals and hydrocarbon prices has provided an increasingly lugubrious backdrop. It is as if the floor-to-ceiling windows of the private dining room where we meet looked out not on the pleasant prospect of a boathouse beside the idyllic Charles River but on the dark, roiling waters of the Styx, where the boatman Charon awaits to bear investors across the water toward the open jaws of the three-headed hellhound Cerberus on the other bank.

This gives the gaiety and banter of the group a slightly forced and hollow quality.

Darkest before dawn

Since it is always darkest before the dawn, however, an investor must ask himself if the dawn is about to break. To answer this question, I turned to Edward Guay of Wintonbury Risk Management, who pointed out that indices for iron ore (currently $52.93/ton), copper (currently $2.36/lb), and gold (currently $1,174/oz), when compared with the CPI-U since 1959, and rebased on the 1982 average gold price, indicate that gold and copper are still overvalued while iron ore is undervalued. But this is, of course, only the starting point for analysis.

Whether the current prices of these metals are high or low in some abstract sense, they are not high enough for miners and processors to embark on substantial new projects. (Over time, barring new discoveries, grades decline and mining becomes more expensive.) Today, no one is willing to invest new money unless sunk costs are substantial; the calculation is one of marginal cost. This being the case, production, ceteris paribus, will decline until prices rise, in the long term.

Over the next few years, however, the outlook is uncertain and dependent on world economic growth and the drawdown and build-up of inventories.

According to the International Copper Study Group, world inventories of refined copper are about 200,000 tons, which is high compared to recent history. Guay explains this high level by the curious fact that much of the copper in China is being used as collateral for loans rather than being held for near-term production. (One is reminded of Sweden’s Riksbank, Europe’s first central bank, which in the 17th century issued notes backed by copper plates.) This creates a risky inventory overhang.

Iron ore port inventories in China, the main consumer, are about average at 80 million tons. Inventories of neither copper nor iron ore would create a problem were there to be an acceleration in world growth, but the IMF, which has consistently shown an optimistic bias, is only expecting growth of 3.1% this year and 3.6% next. It seems, moreover, that the range of possibilities around this number is skewed: more things could go wrong than right.

Gold is hard to analyze as it is little used in industrial production. Mine production is inelastic at 3,000 tons/year, but demand varies considerably over time. The Chinese central bank has been increasing its gold reserves, and some other countries, notably Russia, are doing the same. Nonetheless, total gold demand dropped 12% year-over-year in the second quarter of 2015 – for the first six months demand dropped 6.6%. Jewellery demand fell from 595 tons in Q2 2014 to 514 tons in Q2 2015, investment demand from 200 tons to 179, and institutional demand, including all central banks reporting, also fell, from 157 to 137 tons, according to the World Gold Council.

The two most important factors in considering gold are the growth and composition of central bank reserves and consumer confidence, the latter of which affects demand for jewellery. I don’t see why consumer confidence in China and India, the main jewellery markets, should not be at normal levels next year, but who can tell.

Institutional interest in physical gold derives conversely from central banks’ desire to hold dollars in reserve. The two main foreign holders of US treasuries are China ($1.3 trillion) and Japan ($1.2 trillion). China’s gold is about 1.8% of reserves; that is the wildcard. Going to 10%, or even 5%, would be hugely disruptive in the illiquid physical gold market.

Since I likened today’s resource investor to Daniel in the lions’ den, I shall in fairness close with a reference to Daniel’s New Testament homologue John, who says in his Revelation that he saw the souls of the dead hiding under the altar crying: “How much longer must we wait?” (Rev. 6:9). If some of them are investors in industrial commodities, it may be quite a while.