Chip Goodyear, CEO, BHP Billiton
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Commodities will post a healthy correction
David McKay
Posted: Fri, 23 Jun 2006

[miningmx.com] -- CHIP Goodyear, CEO of BHP Billiton, the world’s largest mining company, normally pulls a good crowd. It was no exception in September 2005 when, during a relatively rare public appearance in Johannesburg, Goodyear told an Investment Analysts’ Association meeting that the improvement in commodity prices would transform into a major bull market.

In short, metals were going to remain hotter for longer.

There were millions of Chinese taking to the cities from rural areas over the next few years, said Goodyear with typical Texan élan. But mining firms the world over were massively under-prepared for the demand shock. The mining industry had a systemic problem of supply and it would take years to resolve itself. “This is China’s century,” he said.

There’s no doubting the inexorable advance of one of the world’s most memorable commodity cycles, a trend Deutsche Bank analyst Peter Richardson dates from around 2001. However, nervous indecision has lately entered the market; in some cases, disbelief at recent metal price gains, particularly this year.

For example, copper gained 86% between January and May; silver was 83% higher; and gold was 31% more expensive to buy. The fundamental story for metal prices has been good lately, but not this good. There have also been similar gains in other metals.
That says a lot of paper trading, but no new money of consequence
Statistics published on the London Metal Exchange’s website show that the mean price for nickel for delivery in three months – one of the most popular ways of measuring its worth – had gained 22,2% from January to end-April. Tin for delivery in three months was 25% higher over the first four months of 2006. The cost of a ton of aluminium increased 10,6%. Only the price of lead had contracted over that period.

It’s been suggested that the problem was that the price appreciation, while underpinned by a good fundamental story of demand outstripping supply, may have been too meteoric, too elevated. The fear was that fund buying, some of it hot, had entered the market.

Ian McAvity, editor of the newsletter Ian McAvity’s Deliberations on the World Markets, in an interview with Bloomberg News in May, made the point. “The US$125 increase in the gold price from November to January saw 135 ton go into the vault” of the exchange traded fund (ETF). “The next $160 run added less than three tons. That says a lot of paper trading – but no new money of consequence.”


“Calling the end to a speculative bubble is always difficult, but anyone buying commodities now must be aware that the only certainty is that most prices are going to be a lot lower in the future,” says John Clemmow, an analyst at Investec. He thinks speculative funds had infiltrated the market and that the only way was down.

One question for the market sceptic is just how far down does the metal market have to travel? Anton Berlin, head of market analysis and development at Norilsk Nickel, speaking on the sidelines of a presentation at Mitsui Metals in London, said the commodity market was a bubble due for a burst.
Decline in economic activity could result in lower metal demand
Commenting on how non-specialist mining funds dealt in the market, Berlin said: “There are not separate markets anymore – there are just commodities. There are indications of a bubble like that of the Eighties. All the negative signs are there; for example, in the nickel market.” Berlin recommended investors consider buying property rather than more commodities.

Berlin said: “It’s a self-fulfilling prophecy for the investment funds. As they continue to invest the prices move higher. What we do know from experience is that bubbles do happen and bubbles burst. It’s not what people want to hear. There’s a fundamental story for metals – but that’s not what’s behind the increase in prices.”

The hype in the market could also leave speculators stranded. In a note dated 26 May, John Meyer, an analyst at Numis Securities, speculated that a trading house scandal could be imminent. “Volatility has recently gone through the roof and we feel that price swings of these magnitudes are likely to carry out traders holding significant positions and the inability to meet the very substantial margin requirement.”

However, some analysts take heart from the fresh participation of investment funds in the relatively small commodity indices, estimated by Barclays Capital to be $80bn last year, increasing to $120bn by 2008.

Record inflows of investment buying – which had totalled $10bn in retail alone in the year to May, almost twice the net buying posted over the same period in 2005 and more than 50% of the $17bn total seen in 2005 – would be “supportive broadly near term,” said JP Morgan in a recent note.

The stockbroker also made the interesting observation that the apparent unstoppable drive upwards in metal buying by general investment funds was structural and that the shift was in its early stages. “Those flows will likely persist as long as the cyclical and policy backdrop is favourable for commodities, which may explain why this market seems to move higher on no new news.

“Unlike in equity or bond markets, where investors already hold a benchmark allocation and only adjust to new information, commodities still benefit from a continued stream of new entrants largely satisfied with stable current conditions.”

And how deep is that well of general funds? Predicting flows is almost impossible because the information isn’t readily available. However, statistics are produced for retail commodity holdings as well as the assets under the control of US households. Comparing them shows how a shift in emphasis in both can disturb the relatively tiny commodity market.
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JP Morgan estimates US households have total financial assets of $38 trillion, of which the largest holdings are in equities and pension reserves. In contrast, retail holdings in commodities total $40bn – negligible, says JP Morgan, because it’s only a tenth of 1% of household wealth. “That flow will become weaker if rate rises slow growth, but at the current pace of central bank normalisation such a retrenchment is more likely in late 2006/early 2007.”

Generally speaking, the buying by investment funds has been motivated by lack of exciting opportunities in other parts of the market. Interestingly, the importance of commodities as a viable alternative investment has been given a degree of perspective by a recent Yale University/Pennsylvania University study, the results of which were highlighted by Bloomberg News in March.

The report said commodity prices had gained more than twice as much as US corporate bonds over 45 years. They also nearly matched gains in US equities. “The big surprise was that commodities had a return that’s almost the same number as stocks,” said Gary Gorton, a professor of finance at the Wharton School at the University of Pennsylvania.

Despite fears the general investment buying of commodities is fickle, most analysts believe the trend is up, notwithstanding occasional corrections. In most cases the corrections must be deemed healthy for the market.

Says Richardson: “Whatever the particular star of the commodity universe at any given time the resultant elevated pricing environment is expected to continue to attract investment into commodities as an asset class, driven by perceptions of changing risk premiums in equities, bonds and currencies.”

However, the improvement in commodity prices began with surprising demand growth, primarily out of China, to which mining companies were unable to properly react. That was partly owing to underinvestment in the sector after years of relative depression. The longer-term consequence is that there’s no solid pipeline of projects to structurally increase supply.

Gold Fields, the world’s fourth largest gold producer, reported research in May showing the concurrent dwindling of available gold resources against a backdrop of slowing investment. Total ounces discovered fell to just under 20m in 2005 compared to nearly 120m ounces in 1997. There were 15 new deposits discovered in 1995 compared to one in 2005.

It’s estimated that about $34bn worth of capital investment has been made by the six largest mining companies between 2004 and now.

One consequence of the decline in exploration and capital expenditure in the late Nineties is the sharp rise in merger and acquisition activity. A function of that increasing concentration in ownership is inherently more cautious approaches to capacity expansion that, in turn, exacerbates supply.

There are dissenting voices. Berlin believes that most of the major mining companies still own properties with lives of 20 years or more. “If they went under 10 years that would be a problem, as the exploration cycle – from discovery to mining – is about seven years.”

But a fundamental view of the commodity cycle wouldn’t be complete without revisiting the effect of China growth, the premium mobile of the commodity cycle today and the basis for Goodyear’s optimism. There are fears that interest rate increases could see growth slow in China. However, the counter view is that destocking of ferrous metals, for example, could presage another spurt in demand growth. A lot rides on China.

According to RBC Capital Markets it’s the main risk to the future health of commodities. “A decline in economic activity in China, or an economic slowdown in the US, could result in lower metal demand, pushing the markets into surplus and putting downward pressure on prices,” the Canadian broker says. However, it remained confident concerning metal prices, believing that the funds would continue to support commodities in the near term.