Tuesday, November 11, 2014

Good Theory Of The "Commodity Supercycle"

Great post by Young Money, a significant refutation of the "commodity supercycle" delusion:

The price of aluminum has fallen significantly over the past century, but copper, lead, zinc, and nickel have shown little real change over time. Despite that, they've been quite volatile: metals price cycles tend to be the same length as overall economic cycle, and sometimes they're even shorter.

The mix of volatility and mean reversion means that the typical metal trades in a wide range. For instance, copper has normally traded between $1 and $3.50 in today's prices. On a few occasions, metals have overshot or undershot their range as a group. During the Great Depression, prices plunged far below the low end of their range. The same thing happened in the late 1990s, when many metals approached their Depression-era prices. By contrast, in 2006-07 prices broke above the range's high end.

So commodity prices started the 2000s near record low levels, and less than a decade later they were making record highs. Prima facie this looks like evidence of a supercycle, but that kind of price gain had actually never happened before. It was an unprecedented move rather than a manifestation of a price cycle that commodities repeatedly, inevitably go through. Moreover, there are specific identifiable reasons for both the record lows and record highs, so we don't need to invent the idea of a supercycle to explain the move.

In the 1990s, there was a series of emerging markets debt crises, the most prominent of which were the Tequila Crisis, the Asian Financial Crisis, and Russia's 1998 default and devaluation. The common features of these crises were that they 1) fostered a need for foreign currency, since the crises were generally the result of external debts and 2) crushed the local currency, making commodity production much cheaper. Essentially, the crises provided both a carrot (lower production costs) and a stick (the need for hard currency) for flooding the commodities markets.

During the same period Russia was recovering from the Soviet Union's breakup, and its legal regime was weak and unstable. Most of the people who seized control of newly-privatized companies in 1990s Russia did so through dubious means, and they realized that in the same climate their companies could just as easily be seized from them. This lack of ownership security gave them an incentive to maximize short-term profits. For mining and oil companies, that meant producing as much as they could as quickly as they could. Russia is a major commodity producer, so this dynamic led it to dump large amounts of commodities on the world market throughout the '90s and particularly after 1998.

By 1999, metals were near Great Depression levels. There was a bounce in 2000, but prices fell again in 2001 and 2002 and retested the lows. Yet five years later, many were at record highs. The obvious cause of this price rise is China's (mal)investment spree and the associated demand for commodities. But financial speculation also played a role, as Frank Veneroso argued in his 2007 World Bank presentation.

Commodities prices surged in the 1970s, and this figures prominently in the commodity supercycle story. But Veneroso points out that the '70s aren't comparable to the more recent commodity price surge because inflation was so much higher in the '70s. To a large extent the commodity price gains during that period merely kept pace with inflation, with the real gains staying within historical norms. Commodities had similar nominal price increases during the 1970s and the 2000s, but the 2000s witnessed much larger real increases.

Veneroso also points out that the rise in commodity prices during the 2000s coincided with explosive growth in both the trading volume and outstanding notional value of commodity derivatives. [... He] devotes much of his presentation to refuting the bull arguments for commodities. He claims that these arguments, while superficially plausible, are really just the kind of new era arguments that are used to justify every bubble.
His conclusion:
"[T]he mining industry is heading for a perfect storm in which: 1) Chinese demand will fall as they stop building empty cities, 2) there will be a supply glut as the industry finishes bringing enormous amounts of new capacity online, and 3) financial demand will disappear and metals stocks that have been hoarded will flood the market as prices fall. There will be a huge sell-off that pushes prices below the marginal cost of production and keeps them there for years, and that will put the commodity supercycle theory to rest."
Just as with silver and gold, significant amounts of commodities are owned by momentum investors, by which I mean owners whose desire to own is a function of the derivative of price appreciation.

The resource extraction industry went through significant debt-fueled consolidation during the peak of the so-called commodity supercycle (2011, now several years ago). A prime example of this is met coal producer Walter Energy. The mergers resulted in a funny kind of adverse selection where the most bullish managements with the worst historical sense and facility at market timing ended up controlling capital allocation for the whole industry:
"Jefferies LLC, however, in a note released March 25, said it has long been skeptical of mining acquisitions because merging two mining companies typically offers 'very little' in the way of synergies. Jefferies was particularly critical of Alpha Natural Resources Inc.'s acquisition of Massey Energy Co.

'In our opinion, the problem for U.S. coal did not start with the weak natural gas prices of 2012. Rather, we'd argue the problems started with a wave of M&A during the previous year,' Jefferies analyst Peter Ward said. 'In two decades covering the mining industry, these were some of the most regrettable transactions we had ever seen. And, we said so at the time. Sadly, we have seen too much of a desire to get bigger simply for the sake of getting bigger throughout the mining industry.'"
Just as so many of the leveraged solar panel and renewable energy companies went under in 2012 and 2013, I think we will see many, many resource extraction companies go bankrupt over the next two years: coal, iron ore, oil, and some of the big diversified mining companies.

Look how much leverage this big companies in these industries have: Steel & Iron (AKS 3x debt/mcap, MT 1x, PKX 1x), Industrial Metals & Minerals (BHP, RIO, VALE not as much but gigantic market caps and no doubt operating leverage; BTU has big leverage), in copper FCX has a good amount of debt.

Big leverage many years into a "boom" is a sign that the emperor has no clothes. This reminds me at looking at all of the banks, mortgage lenders, homebuilders, and mortgage insurers in 2006.


Anonymous said...

Thanks for the mention. I agree there's going to be a huge wave of bankruptcies-- I would guess 80-90% of the industry over the next five years, and some of the survivors will have to dilute their shareholders to hang on.

Also, that's a great point about adverse selection. Loose credit markets select for the most obtusely bullish managements.

CP said...

"If the Chinese knew what assets their retirements were being secured by, they'd probably prefer to spend more now and less in the future."


CP said...

"You can't have a politically stable island society where 45 working people support 20 children and 35 retirees, if the retirees demand to spend at a high fraction of their working-age rate. [...] There's just no way 35% of the population can afford to drive around in Winnebagos"


CP said...

Did you see Friday's list of new lows?


CP said...

ABCO The Advisory Board Company 38.99 -0.68 -1.71% 40.40 38.87 340,800 12/05/14
AG First Majestic Silver 4.08 -0.08 -1.92% 4.23 4.02 1,312,000 12/05/14
APA Apache Corp 61.64 -1.61 -2.55% 62.85 60.12 7,447,300 12/05/14
AR Antero Resources Corp 42.28 -1.69 -3.84% 44.13 41.64 1,796,600 12/05/14
ARCI Appliance Recycling Centers 2.69 -0.04 -1.47% 2.74 2.60 15,500 12/05/14
AREX Approach Resources Inc 7.01 -0.35 -4.76% 7.45 6.61 1,776,500 12/05/14
ARP Atlas Resource Partners L.P. C 12.32 -0.70 -5.38% 12.98 12.32 983,300 12/05/14
ATAI Ata Inc 3.11 -0.19 -5.76% 3.45 3.11 15,400 12/05/14
ATU Actuant Corp 29.00 -0.13 -0.45% 29.08 28.01 1,022,000 12/05/14
ATW Atwood Oceanics 29.81 -1.16 -3.75% 31.04 29.73 2,377,100 12/05/14
AVAL Grupo Aval Acciones Y Valores S 11.82 -0.16 -1.34% 12.02 11.64 1,942,100 12/05/14
AVH Avianca Holdings S.A. 11.99 -0.05 -0.42% 12.12 11.75 160,600 12/05/14
AWX Avalon Holdings Corp 3.34 -0.02 -0.60% 3.63 3.15 63,100 12/05/14
AXAS Abraxas Petroleum Corp 2.65 -0.14 -5.02% 2.88 2.54 4,380,100 12/05/14
BAS Basic Energy Services 6.10 -0.59 -8.82% 6.85 6.06 5,578,300 12/05/14
BBEP Breitburn Energy Partners L.P. 10.29 -0.71 -6.45% 11.11 10.12 3,124,000 12/05/14
BBL Bhp Billiton Plc 46.09 -1.04 -2.21% 46.35 45.75 1,302,100 12/05/14
BCEI Bonanza Creek Energy Inc 20.10 -1.07 -5.05% 21.68 20.06 2,205,500 12/05/14
BHP Bhp Billiton Limited 50.38 -0.86 -1.68% 50.72 50.10 2,414,200 12/05/14
BIND Bind Therapeutics Inc 5.74 -0.40 -6.51% 6.11 5.61 294,700 12/05/14
BONT The Bon-Ton Stores 6.92 -0.06 -0.86% 7.20 6.88 301,100 12/05/14
BTE Baytex Energy Corp 16.53 -0.77 -4.45% 17.34 16.36 1,737,700 12/05/14
BVSN Broadvision 6.08 -0.24 -3.80% 6.30 6.00 37,400 12/05/14
CBK Christopher & Banks Corp 4.60 -0.35 -7.07% 5.07 4.52 1,285,900 12/05/14
CBT Cabot Corp 42.25 -1.39 -3.19% 43.42 42.01 694,100 12/05/14
CCU Compania Cervecerias Unidas S.A. 19.80 -0.10 -0.50% 19.91 19.73 104,600 12/05/14
CCXI Chemocentryx Inc 4.37 +0.23 +5.56% 4.50 4.06 279,700 12/05/14
CELP Cypress Energy Partners L.P. 12.81 -2.01 -13.56% 14.71 12.20 236,800 12/05/14
CEQP Crestwood Equity Partners LP 7.18 -0.60 -7.71% 7.77 7.15 464,200 12/05/14
CHKR Chesapeake Granite Wash Trust 6.13 -0.08 -1.29% 6.60 6.10 653,400 12/05/14
CIR Circor International 57.20 -3.41 -5.63% 60.93 57.14 343,300 12/05/14
CJES C&J Energy Services Inc 13.49 -0.42 -3.02% 14.03 13.38 1,131,000 12/05/14
CLB Core Laboratories N.V. 117.75 -6.97 -5.59% 124.53 117.34 971,300 12/05/14
CLNE Clean Energy Fuels 5.10 -0.05 -0.97% 5.28 5.04 2,142,600 12/05/14
CLR Continental Resources 38.23 -0.63 -1.62% 39.24 37.43 4,580,700 12/05/14
CNCO Cencosud S.A. 7.44 -0.08 -1.06% 7.60 7.37 107,300 12/05/14
CNV Cnova N.V. 7.00 -0.01 -0.14% 7.08 6.76 262,300 12/05/14
CPG Crescent Pt Energy 23.37 -0.90 -3.71% 24.25 23.11 231,000 12/05/14
CRCM Care.Com Inc 7.85 -0.13 -1.63% 8.10 7.74 87,700 12/05/14
CRK Comstock Resources 6.68 -0.15 -2.20% 6.99 6.44 3,695,200 12/05/14
CRZO Carrizo Oil & Gas 35.23 -0.69 -1.92% 36.81 34.40 1,367,100 12/05/14
CVE Cenovus Energy Inc 21.35 -0.71 -3.22% 22.02 21.34 2,423,000 12/05/14
CZZ Cosan Limited 8.19 -0.10 -1.21% 8.33 7.95 1,789,800 12/05/14
DNR Denbury Resources 7.43 -0.24 -3.13% 7.74 7.40 10,278,200 12/05/14
DWSN Dawson Geophysical Company 11.83 +0.01 +0.08% 12.14 11.76 65,600 12/05/14

CP said...

That's just A-D. Let's remember to check back on them.