In the world of the rational economist, the law of supply and demand – the idea that the availability of, and desire for, a particular resource will have a material effect on its price – is as fundamental as the law of gravity is in the physical realm. What follows should help explain why the rational economist may prefer to keep well away from the commodities sector.
The chart below, which comes courtesy of analysts at Goldman Sachs, plots the price of copper over the last three decades versus the marginal cost of its production. More precisely, the latter line shows what is known in commodities circles as the ‘90th percentile of costs’ – in effect, the costs that are seen as integral to production as opposed to the 10% that can be stripped away comparatively easily.
Source: Wood Mackenzie, Company data, Goldman Sachs Global Investment Research – February 2016
Rightly or wrongly, this figure has become a key focus for people when they analyse commodities as it is widely believed the price of a metal or other resource will ‘bounce’ off the 90th percentile of costs. After all, as the price of a commodity dips below that line, businesses start making losses, they stop production and the law of supply and demand does its thing. That is only rational, right?
Well, it might be if commodity companies – whether they are conscious of it or not – were not in thrall to the story of the bear and the hunters. You know the one – two hunters are being chased by a huge bear. One stops to change into his trainers. The other laughs and tells him he has no chance of outrunning the bear. “I don’t need to outrun the bear,” comes the reply. “I only need to outrun you.”
The snag is – as we discussed in the context of the platinum industry in Good call – shutting down production is instinctively a last resort for commodities companies. Instead, they tend to try and reduce their costs by increasing supply but the more businesses there are trying to ‘outrun the bear’, so to speak, the more likely things are to end messily.
The interesting thing about the above chart is that, after a pretty much continuous slide over the last five years or so, the price of copper is now broadly back to the cost of production – a situation we have not seen since the early 2000s. Over that period, for various reasons – most notably China – all that space between the two lines on the chart was essentially profit for copper producers.
The prices of other commodities do of course spike up from time to time but – reassuringly for the rational economist – the law of supply and demand sees them heading back down again pretty quickly. Certainly the price line rarely resembles the one in the above chart but, as it happens, the copper producers are now taking some comfort from the point the price of copper has reached.
The feeling seems to be that this is where everything begins to turn around – that the price of copper must now start heading back up because it has touched the cost of production. Can you feel a ‘but’ coming? Because, looking at the chart, you can see that in the previous down-cycle, which broadly started in the mid-1980s, the copper price essentially peaked where it is today.
When it did so, it was quite some way above the cost of production and then the same thing happened that we have seen over the last five years – a drop down to the cost of production before a bounce. But – there it was – while that might indeed look quite comforting for copper miners at first glance, this bounce was short-lived.
Everyone in the sector started to run faster to bring costs down – over the next 15 years, they actually fell some 60% – but, each time the costs went down, the price of copper followed. This happened again and again in what was effectively a 15-year period of deflation and thus the copper price hitting the marginal cost of production was very much not the start of great times for the industry.
Indeed, with the benefit of 20/20 hindsight, we know it really only marked a point about one-third of the way through a very difficult time for copper mining. There is no denying that, as costs continued to come down, businesses became more efficient but there was no rally in the price of copper because there was too much supply and not enough demand.
If you were looking to be more optimistic about the sector’s prospects, you might argue the price of copper has been falling for some five years and yet only now has it reached the cost of production. Here on The Value Perspective, however, we would argue this is not a reason to become too excited because supply and demand trends in commodities are extraordinarily long-term in nature.
The last time supply and demand got so out of kilter, prices rose for about a decade and, now they are heading in the opposite direction, there is no reason to think this all comes back into balance any time soon. In the copper industry, supply apparently begets more supply, costs come down and the price follows the costs – until some catalyst eventually causes it to do otherwise.
Last time around, China helped prices head back upwards and, one day, India may well do the same. As for other catalysts, well, here on The Value Perspective, we certainly do not expect the industry to sort itself out any time soon as the incentives for it to do so do not really exist.
Sure, in theory, copper should be as much subject to the law of supply and demand as any other commodity – but then, as baseball legend and people’s philosopher Yogi Berra once observed: “In theory there is no difference between theory and practice. In practice, there is.”