Fund Manager
Craig Porter
Over this quarter, two significant markets shocks have led investors to question the strength of this long bull market. Both the Shanghai market correction and worries surrounding the US sub-prime real estate market have led many to concur that the economy is softening and that it is time to exit the once profitable resource space. Under normal circumstances, we would usually concur. It has long been an adage of Canadian political economy that if the US catches a cold, Canada gets pneumonia. This has held true over the twenty or more years, where demand for resources was primarily driven by economic activity south of the border. Today, resource demand is driven globally and reacts to a wide variety of factors beyond plain supply/demand figures, GDP growth and other conventional economic data. We have long been of the view that the supply constraints and pinch points associated with energy and base metals would prove the key animator of this secular bull market. While Chinese and Indian industrialization are still the source of demand, the supply question is often overlooked and manifests itself in a variety of ways that merit investor attention.
We are of the view that the supply-constraint thesis has much more explanatory power than demand-bias economic indicators. One may well ask why Xstrata has once again gotten into the foray of acquiring nickel producers like Lionore when global GDP is slowing? Why has Lundin Mining offered $863M for Rio Narcea and its nickel production when many analysts predict nickel prices have hit a ceiling? The reasons reside in the realities of producing commodities across all fronts. From sector undercapitalization to geopolitical risk and sheer scarcity, the supply side realities we currently face stand to keep us in this merger and acquisition cycle for some time to come.
Sector Undercapitalization:
Following the oil shocks of the 1970s and the intervention of the US Federal Reserve to end inflation by inducing the recession of 1982, commodities went into a long bear market where little or no investment was made in mining projects, oil and gas refinery or in the precious metals sector. With a relatively benign political environment in the Middle East, the restoration of Iranian production and the rebound in the US dollar over the 1980s, commodities saw little to no investment. Only a brief episode of high oil prices during the first Iraq war in 1990-91 and a wave of consolidation in the oil patch in the early 1990s drew much investor attention. Today this leaves us with infrastructure that is insufficient to meet production requirements and global demand. Many of the mining projects that were tabled in the area of copper, nickel and uranium were shut down and abandoned following weak commodity markets in the 1980s and 90s. The impact of this has been felt in the energy sector, where demand has surged to 86 million barrels a day set against a similar level of production. With minimal global surplus, oil production is operating at the top end of its current capacity. This capacity will not change until refineries are modernized, extraction processes are advanced and until investment and innovation contrive to improve the supply picture.
Geopolitical Uncertainties:
Just as the Yom Kippur War of 1973 and the Iranian Revolution of 1979 sent oil prices skyrocketing, current conflict around the globe in resource rich areas has set the floor on all commodity prices. Since the terrorist attacks of 2001, the current war in Iraq, the threat of UN sanctions on Iran and general instability in the Middle East, oil prices have shown dramatic volatility – moving as much as $10 or $15 a barrel within a week. In Latin America, petrodollars are being converted by Venezuela into the funding of leftist regimes across the continent whose ambition is to nationalize both oil and mining production. What is often referred to as the ‘geopolitical premium’ refers to the wider phenomenon of hostile situations and hostile governments preventing both access to and investments in resource production. This has had the result of bringing investment to Canada where political stability, transparent capital markets and a wealth of energy and mining production possibilities promise to supply the global economy with what it needs.
Cost of Production & Inflationary Pressures:
As the basic inputs of production of finished goods, commodities prices are primary to the inflationary picture. Over the course of this cycle, low labour costs in the industrializing Asian economies provide an offset to the inflationary pressures on commodity prices, however, this only presents part of the picture. Within mining and energy production itself governments, unions, tougher regulations and higher input costs associated with energy and steel have put the costs of new and revamped projects beyond the rationale of sensible investing. Because of the time it takes to bring a mine or an oil and gas well into production and because of rising costs, many of the projects that were brought back a few years ago are now sitting on the sidelines. The message is clear: it costs more and takes more to produce these commodities than it does to sell them.
We have commented previously on differentials between spot prices and multiples and how speculation was a source of commodity inflation. In the present case, lack of supply as a result of sector undercapitalization, geopolitical uncertainty and the high cost of production have all contrived to maintain a floor on commodity prices. Outside of a global recession, which we are not predicting, commodity prices will remain high because of a number of factors that will maintain their scarcity. The current merger and acquisition cycle in Canada is clearly an example as the prudent investors sees that it is better to acquire than to invest because the barriers to production are increasing at a time when barriers to acquisition are diminishing.
Craig Porter - Q1 2007 Commentary
Date Published
Fund Manager
Over this quarter, two significant markets shocks have led investors to question the strength of this long bull market. Both the Shanghai market correction and worries surrounding the US sub-prime real estate market have led many to concur that the economy is softening and that it is time to exit the once profitable resource space. Under normal circumstances, we would usually concur. It has long been an adage of Canadian political economy that if the US catches a cold, Canada gets pneumonia. This has held true over the twenty or more years, where demand for resources was primarily driven by economic activity south of the border. Today, resource demand is driven globally and reacts to a wide variety of factors beyond plain supply/demand figures, GDP growth and other conventional economic data. We have long been of the view that the supply constraints and pinch points associated with energy and base metals would prove the key animator of this secular bull market. While Chinese and Indian industrialization are still the source of demand, the supply question is often overlooked and manifests itself in a variety of ways that merit investor attention.
We are of the view that the supply-constraint thesis has much more explanatory power than demand-bias economic indicators. One may well ask why Xstrata has once again gotten into the foray of acquiring nickel producers like Lionore when global GDP is slowing? Why has Lundin Mining offered $863M for Rio Narcea and its nickel production when many analysts predict nickel prices have hit a ceiling? The reasons reside in the realities of producing commodities across all fronts. From sector undercapitalization to geopolitical risk and sheer scarcity, the supply side realities we currently face stand to keep us in this merger and acquisition cycle for some time to come.
Sector Undercapitalization:
Following the oil shocks of the 1970s and the intervention of the US Federal Reserve to end inflation by inducing the recession of 1982, commodities went into a long bear market where little or no investment was made in mining projects, oil and gas refinery or in the precious metals sector. With a relatively benign political environment in the Middle East, the restoration of Iranian production and the rebound in the US dollar over the 1980s, commodities saw little to no investment. Only a brief episode of high oil prices during the first Iraq war in 1990-91 and a wave of consolidation in the oil patch in the early 1990s drew much investor attention. Today this leaves us with infrastructure that is insufficient to meet production requirements and global demand. Many of the mining projects that were tabled in the area of copper, nickel and uranium were shut down and abandoned following weak commodity markets in the 1980s and 90s. The impact of this has been felt in the energy sector, where demand has surged to 86 million barrels a day set against a similar level of production. With minimal global surplus, oil production is operating at the top end of its current capacity. This capacity will not change until refineries are modernized, extraction processes are advanced and until investment and innovation contrive to improve the supply picture.
Geopolitical Uncertainties:
Just as the Yom Kippur War of 1973 and the Iranian Revolution of 1979 sent oil prices skyrocketing, current conflict around the globe in resource rich areas has set the floor on all commodity prices. Since the terrorist attacks of 2001, the current war in Iraq, the threat of UN sanctions on Iran and general instability in the Middle East, oil prices have shown dramatic volatility – moving as much as $10 or $15 a barrel within a week. In Latin America, petrodollars are being converted by Venezuela into the funding of leftist regimes across the continent whose ambition is to nationalize both oil and mining production. What is often referred to as the ‘geopolitical premium’ refers to the wider phenomenon of hostile situations and hostile governments preventing both access to and investments in resource production. This has had the result of bringing investment to Canada where political stability, transparent capital markets and a wealth of energy and mining production possibilities promise to supply the global economy with what it needs.
Cost of Production & Inflationary Pressures:
As the basic inputs of production of finished goods, commodities prices are primary to the inflationary picture. Over the course of this cycle, low labour costs in the industrializing Asian economies provide an offset to the inflationary pressures on commodity prices, however, this only presents part of the picture. Within mining and energy production itself governments, unions, tougher regulations and higher input costs associated with energy and steel have put the costs of new and revamped projects beyond the rationale of sensible investing. Because of the time it takes to bring a mine or an oil and gas well into production and because of rising costs, many of the projects that were brought back a few years ago are now sitting on the sidelines. The message is clear: it costs more and takes more to produce these commodities than it does to sell them.
We have commented previously on differentials between spot prices and multiples and how speculation was a source of commodity inflation. In the present case, lack of supply as a result of sector undercapitalization, geopolitical uncertainty and the high cost of production have all contrived to maintain a floor on commodity prices. Outside of a global recession, which we are not predicting, commodity prices will remain high because of a number of factors that will maintain their scarcity. The current merger and acquisition cycle in Canada is clearly an example as the prudent investors sees that it is better to acquire than to invest because the barriers to production are increasing at a time when barriers to acquisition are diminishing.