Supply Inelasticity Meets Rising Demand StockInterview Chats with Technical Chartist: David Fuller
Adjusted for inflation, the historic CRB chart shows there may be more to the commodities bull market than many believe.
StockInterview talked with David Fuller, a career analyst, writer, lecturer and investor. He is one of the world's most highly regarded independent market commentators, frequently appearing on CNBC or quoted by The Wall Street Journal and other major business-orientated media. David Fuller is a director of Stockcube Research Ltd, where he is Global Strategist and writer of Fullermoney, his unique and highly regarded international investment newsletter. Visit his website: http://www.fullermoney.com/
StockInterview: Many people are wondering: Is the commodity bull market intact?
David Fuller: Absolutely, beyond a shadow of a doubt. This is a commodity super cycle, and it will be the biggest commodity super cycle in history to date. This could go on for several more decades – thirty to forty years.
StockInterview: The longest timeframe we’ve been told about is through the year 2020.
David Fuller: Commodity cycles can often last longer than that. I have generally stated a ‘generational long process.’ I think this will go on for much longer than would be logical with a commodity super cycle.
StockInterview: And why would that be?
David Fuller: There is one main over-riding reason why this is so different from what we saw in the 1970s. I lived through that as a financial analyst so that is still a vivid memory of mine. Then, we had inflation fears. We did have some strong global growth. But the main problem was that we had the political decision to cap production from OPEC. This sparked a lot of interest in commodities, and that was quite a powerful cycle. That’s the one people use as a benchmark. This time it is different because the demand is vastly greater.
StockInterview: But critics would argue Western countries are more energy efficient.
David Fuller: Yes, they are. But, look at all the additional gadgets we have that use energy. We use it more efficiently, but we don’t use less of it. We still use an enormous amount of it. The key change – far more important than what I just mentioned – is the conversion of all these previously undeveloped economies. Some, which had been formerly moribund economic systems, have been converted to capitalism. We have China embracing capitalism. We have India embracing capitalism. That’s brought 2.2 billion people into play as very ambitious earners, who aspire to middle class status. If we take Asia , there are 3.5 billion people who aspire to the same middle class lifestyle many of us in the West take for granted. If we look further beyond Asia , this same phenomenon is evident with many other developing countries. We see it in parts of the Middle East with the Dubai city-state as an example.
StockInterview: Is this, then, a worldwide phenomenon or restricted to Asia and a few other areas?
David Fuller: Look at Central and South America . Again, we’ve seen a stronger move to the capitalistic economic model, although there are inevitably backlashes there. My guess is those will be temporary. Even if I’m wrong on that point, these economies are major exporters of commodities. Their GDPs are going through the roof relative to what they had previously seen. And that is increasing demand for resources within those countries as infrastructure building takes place. There are 5.5 billion people in the underdeveloped, or developing, world, who are living in countries that are now seeing GDP growth expand quite rapidly.
StockInterview: What do you see as the main reason for this?
David Fuller: This process is greatly aided by globalization, which has encouraged the adoption of capitalist economic systems. Part of globalization is the export of technology, which also helps these countries to grow at a far more rapid rate than we have seen in previous decades. This is putting an unbelievable demand on industrial sources, which I think we’ve only just begun to see. Previously, there would be a surge in demand which would last a few years and then drop off very rapidly.
StockInterview: Won’t China slow down at some point?
David Fuller: I see articles than tend to be China-centric and mostly bearish. How many times have I heard someone forecasting a China hard landing in the last three or four years? Of course, it hasn’t happened. At some stage, they’ll inevitably get a recession, as all countries do. We should not be thinking in China-centric terms.
StockInterview: Why not?
David Fuller: China is important in leading this process among developing nations, but there all the others. It’s far easier to not list the countries now growing very rapidly, far easier to mention the exceptions: Cuba , Cambodia , Burma and North Korea .
StockInterview: Is it all coming from demand?
David Fuller: When we look at the supply side, the supply has been very tightly, partly because of the previous 21-year bear market for resources. That meant obsolescence, a loss of manpower. People got older, retired and moved into other professions. There have been major impediments in increasing supply. Supply is increasing and will continue to increase. But, we’re now reaching the stage where it isn’t so easy to find replacement natural resources, aside from the costs which are considerable. If we take oil as an example, the 35 billion barrels of oil we are currently consuming each year, the ability of the world to find replacement oil on that scale is questionable. Certainly we won’t find it from conventional oil.
StockInterview: Do you see steepened curves as commodity-rich countries will change the economics in those countries?
David Fuller: You could really say there is an inverse ratio between the price of the metal and the freedom of western companies to actually extract that metal and market it. It’s the same we see with oil. If oil is $20/barrel – Russia , Venezuela – they’re very happy to have Western oil companies come in and produce the stuff. When it gets to $60, $70, nearly $80/barrel, then they’re saying, ‘Wait a minute. Let’s rewrite the contracts, or even nationalize. The important Fullermoney investment theme, for the past four years is: Supply Inelasticity Meets Rising Demand.
Adjusted for inflation, it appears the price of gold has a long way to go before it surpasses the previous peak price.
StockInterview: And that leads to higher prices?
David Fuller: It’s very difficult to increase the supply of these resources sufficiently to meet rising demand. It does mean higher prices, but we must never overlook the fact that markets are inherently volatile. So, I’m not talking about exponential trends. When we get a steepening rate of ascent, this becomes unsustainable and leads to a fairly significant correction. It will be a very powerful, but erratic, bull market just like any other bull market. To define that more precisely, it will be punctuated over different time spans, as we’ve already seen, with medium-term corrections. I would define a medium-term correction as a reaction that lasts for at least a few months. They sometimes last for a year or two, but very seldom more than three years. Then, the primary bull market reasserts itself once again. We have seen a series of medium-term corrections in the resources sector, most of these starting around the April-May period. Now, they’re picking up again, with the exception of oil. But, that’s not going to be long, I feel, before we see that picking up again.
StockInterview: But uranium has not corrected at all?
David Fuller: It doesn’t have a futures market. That’s the big factor. The price is certainly rising, but with a futures market, you get the big leverage coming in. You get hedge funds rushing in and plenty of other speculators. You get them buying, and they’re short-term players. The absence of a futures market and the constraints on owning uranium metal really restrict that. As we’ve said all along, it’s been a Fullermoney premise that uranium was the best of the energy bull stories by far. That’s an obvious point, particularly with all the concern over carbon emissions.
Ongoing uranium bull market price chart
StockInterview: How do you see uranium now that its price has soared so high in such a short number of years?
David Fuller: In terms of long-term demand, it can only rise and rise enormously. I don’t see any other solution to the energy problem, let alone the clean energy problem, other than nuclear. Any elasticity meets rising demand. There is very little incentive for any major mining company to increase the production of uranium because they would be locked-in, depending on the contract. Some perhaps at $20, or possibly even worse. Anybody who really knows understands the resource in the ground is infinitely more valuable. Is China going to quibble over the cost of uranium? Are the French? I doubt it very much. This has been, still is, and will remain by far, in my view, the most bullish of the energy stories.
1. Mining shares in our universe trade at 18-year valuation lows. Investors’ apparent preoccupation with a US-led global slowdown means there appear to be good buying opportunities in our universe. If supply remains constrained and demand is better than market expectations, we believe it is only a matter of time before investors realise that 2007 is likely to be significantly better than 2006 in terms of metal prices and earnings.
2. Many investors believe commodities are in a bubble. How many times do we hear that the rally in commodities is a bubble that draws parallels with ‘tulip mania’ or the ‘tech bubble’ of 2000? We understand investors’ concerns given that many commodity prices are at all-time highs and their charts look ‘interesting’. This goes a long way to explain why the shares in our universe continue to de-rate—investors appear to expect a major correction soon. The reality is, however, that while speculators have played a part in driving up prices, the lack of supply and strong demand have pushed copper, nickel, zinc and aluminium into substantial deficits for 2006. Going into 2007, the big four metals (aluminium, copper, nickel and zinc) are likely to be in deficit again, even in a benign growth environment.
3. Infrastructure in emerging economies is more important than US housing starts. Investors’ apparent preoccupation with US economic data and their slowing momentum is providing good buying opportunities in the sector. Our analysis illustrates that the infrastructure programme build globally is more important than consumer-driven swings. In China, the country is spending more money on underground and overland rail networks in the next five years than the rest of the world has spent in the last 20 years. Russia has just announced a major investment spending programme to reinvigorate its electricity industry. Even in Europe the necessary buildout of electricity generation is likely to require an additional 1 million tonnes of copper over the next ten years. Finally, India’s infrastructure is just beginning. We predict it will add 1% to global metals demand every year for the next five years.
4. Supply, supply, supply Copper supply disruptions from strikes and lower-than-expected mine output should remain a key theme in 2007. We believe there is potential for the copper market to experience supply disruptions of up to 642,000 tonnes next year. The growing deficit in copper concentrate means smelters are likely to take downtime in the near term, which could lead to further tightness in an environment of low inventories. New capacity remains constrained and we expect delays in projects reaching full capacity. Added to this, companies have in recent years not been incentivised to build new mines or smelters and instead appear to prefer to use their growing cash piles on special dividends and share buybacks. This all adds up to a supply story for 2007 that will underpin metal prices and profits.
5. Copper could spike to US$12,000/t in 2007. In recent weeks, tin, lead, zinc and nickel have broken out to new highs. Only copper and aluminium remain the laggards. Copper is holding firm and any signs of a breakout to new highs would likely send a message to investors that they may have become too bearish on the 2007 outlook. Copper is key because it represents 32–51% of the Big 3 earnings. Investors do not appear positioned for positive demand shocks and seem to be factoring in a worst-case scenario for demand in 2007 given their pre-occupation with the US economy.
6. China restocking could return and surprise our demand forecasts. The key question is when will China return to the copper markets and restock its inventory? So far this year the copper statistics from China have been confusing and bolstered the bears’ belief that China is slowing. The Chinese State Reserve Bureau is believed to have released up to 200,000 tonnes of refined copper into the market, leaving it, we believe, with limited strategic stocks. In addition, copper scrap availability has increased by as much as 200,000 tonnes. Both effects have led to a 20% drop in Chinese semi copper imports, which implies that Chinese copper growth is slowing. With limited stockpiles, the risk is now that China returns to the market and restocks. This could have the effect of increasing Chinese copper demand growth from 4% in 2006 to 8% in 2007.
7. M&A is likely to hot up in 2007. Pressure is likely to build on our corporates to take part in value-creating M&A deals. If metal prices do stay strong, companies will come under pressure to take part in the consolidation of the industry. So far, 2006 has been a disappointing year for M&A among the big 3 mining companies. In a Brave New World (11 January 2006), we had predicted 2006 would be a busy year for M&A. While the Canadian sector has enjoyed a brisk year, the big 3 mining stocks haven chosen to sit it out. In our view, there is still significant undiscovered value in many potential targets. Higher long-term commodity assumptions that reflect the higher cost structure of building new mines and smelters are sending a message to companies that the first option for growth appears to be M&A.
8. Potential emergence of financial buyers and Chinese consortia. If the mining companies in our universe do not leverage up their balance sheets, they may find someone will do it for them. We are surprised that private equity has not been active in base metals and believe that coal would be a likely candidate for their attention. Perhaps their need for ‘safe less cyclical businesses’ has stopped them so far. Nevertheless the ability to sell forward production and the growing realisation that our universe is enjoying what seem to be sustainably high margins could change this lingering perception. As China has adopted an aggressive downstream growth strategy in aluminium, cobalt, zinc, steel and copper, it has increasingly grown dependent on imported feed. The country’s lack of self sufficiency in these commodities could be rectified by acquiring foreign producers. The recent shortage in cobalt concentrate and the impact it is having on producers in China who are struggling to feed their furnaces is a good example of China’s growing dependency on imports.
9. The ‘snowball effect’ means the industry may not be able to catch up with the annual leaps in consumption from emerging economies. Four years into the commodity bull market, the industry is simply not responding fast enough to build new capacity. Each year of delaying new projects is a year that the emerging economies continue to grow and increase the gap between new demand and new supply. In short, this cycle could extend for at least another 3–4 years.
10. With limited gearing and strong cash flows, share buybacks and special dividends will continue to increase because mining companies are reluctant to build new mines. We think miners will come under increasing pressure to leverage up. Our analysis in Figure 4 shows that at 50% gearing it would be earnings accretive for the sector by 21%.
BALTIMORE, MD -- (MARKET WIRE) -- November 08, 2006 -- Zinc prices have increased 187.6% in the past twelve months. But because of severe supply constraints and skyrocketing demand, one analyst is still calling zinc "The Most Undervalued Metal on the Market Today."
Zinc prices hit an all-time high today of $2.0713 per pound, representing an impressive 292.1% increase since mid July 2005. Luke Burgess, managing editor of GoldWorld.com, compares zinc's remarkable 16-month move to the price changes of other major metals over the same time period:
There's simply no comparison. But the obvious question is, have investors missed the big moves? According to Burgess, "No way. The strong fundamentals that have driven zinc this far are still in place."
Burgess recently published a report on the galvanizing metal titled "The Most Undervalued Metal on the Market Today". In it he claims, "I expect zinc to be selling over $2.50 a pound in 2007. After that, sky's the limit. With the right conditions I believe we could be looking at $5 or $6 zinc within a few short years."
What would account for such a move?
Burgess claims it's a simple matter of supply and demand. He says, "Production and warehouse stock levels are plummeting while demand is relentlessly marching higher."
Between 1960 and 1990, global zinc consumption grew at an average annual rate of about 2%. But since 1993, annual worldwide demand has been growing by roughly 3.2%. And by all accounts this is just the beginning. The International Lead and Zinc Study Group (ILZSG) says global demand for refined zinc will increase 3.9% over last year's demand to 11.06 million tons in 2006.
And what about production?
"Because of decades of low prices, there's has been little serious investment in zinc mining," Burgess says in his report. "This has led to a peak in zinc's global production."
Current global zinc demand is outstripping mine production. We've been able to make do with warehouse supplies and recycled material. But that's a problem, too.
"In April 2004, London Metal Exchange zinc warehouse stocks topped off at about 784,000 tons," Burgess says in his report. "Today, only two and a half years later, these stocks have plummeted a whopping 86.5% to about 105,000 tons. In the past 12 months alone these warehouse stocks have fallen 78.1%."
In fact, the LME supplies have gotten so low now that there's only enough stockpiled to satisfy the world's total demand for four days!
So what does that mean for investors?
Simple: There's a boatload of money to be made by investing in zinc exploration and production companies.
Burgess says he personally likes "the upside of junior explorers right now, especially those trading on the TSX Venture Exchange." He recommends "looking for junior mining firms with savvy management, a proven track record and a decent land package in a geopolitically safe country." He continues in his latest report, "These firms should also have mid- to advanced-stage properties. Historic production and drill results are always a plus."
In "The Most Undervalued Metal on the Market Today," Burgess explains in detail why he believes we'll see such a climb in zinc prices and gives advice on how to look for potential investments.
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