By Rick Rule
The last part of 2014 and the beginning of 2015 have been interesting and tumultuous, with three separate and distinct outcomes for natural resources. The first two were the precipitous declines in both oil and copper prices. The third was the precipitous increase in gold prices.
Copper and Oil
Let’s first talk about the precipitous declines in the copper and oil prices, and, to a lesser degree, in other industrial metals. Why did this happen?
It happened because markets work. Very high prices for industrial commodities in the last decade, until the general decline starting in 2012, did two things. First, high prices stimulated supply because the industry had access to more capital – thanks to higher earnings and access to debt. The very strong copper and oil prices we enjoyed for 10 years allowed for higher supplies to come online over time. At the end of the last decade, oil and copper prices had increased rapidly. Supply did not increase so quickly that it stopped the run-up in its tracks. But after a few years, as high prices ruled the roost, there was a supply response.
While those high prices stimulated new capacity, they also constrained demand. Consumers tend to use less of a commodity as it becomes more expensive. An increase in supply and a decrease in demand was eventually met with the softer prices that we are now seeing. How does this end?
A run-up in general equities prices suggests that the US has entered into a recovery. Unless that ‘recovery’ actually translated into real economic growth, commodity prices will continue to be weak. It isn’t that there is a tremendous over-supply of either oil or copper right now. The problem is that demand is anemic. Absent a real recovery, it could take two or three more years for these soft prices to result in lower production and then, perhaps, higher prices.
In my opinion, if a rebound in oil prices in the near term is to occur, it will be driven by increased demand, but not decreased supply.
The most important reason for the price dips in both oil and copper is likely weak demand, and not over-supply. GDP growth (reportedly 2.6% annualized in the last quarter of 20141) appears to be the result of a recovery in financial assets such as stocks and bonds, and less a real economic recovery. It’s true that auto sales are edging up, and I would love to see them go higher as they would positively impact commodities.
But in a real economic boom, I would not expect to see weak oil and copper prices. Weak commodity prices are more symptomatic of flat economic growth. In a real recovery, commodities should be a primary beneficiary. In my view, this weakness in demand could continue for another two or three years.
On the supply side, I don’t expect significant constraints in the near term that would drive the prices of either copper or oil higher.
Industries like copper mining and oil drilling take a long time to adjust to lower prices. They are unable to quickly reduce supplies when demand is weak. Long-term capital investments in new oil production over the last decade represent ‘trapped capital’ in the sector. This capital cannot be removed from the sector just because returns are unsatisfactory. Therefore, these assets continue to produce, even if they never generate a satisfactory return on investment, as long as they generate enough cash to keep them running.
When projects generate some positive cash flows, but no significant return on the investment, then the industry loses capital. New investors stay away while the excess investments from prior years continue to prop up production. This process is called ‘de-capitalization.’ Capital available to the sector for new projects dries up, but production does not drop off right away.
A supply response will be muted while the industry is still in the de-capitalization phase. Prior experience, such as the natural gas crisis in 1982, shows that the industry can de-capitalize for at least 5 or 6 years.
The move up in gold and silver prices in January is witness to another phenomenon. According to many people the ‘trigger’ for the move up was the de-pegging of the Swiss Franc from the Euro. But I don’t think that’s true. I see it as really the result of just a tiny dent in faith in the US dollar.
If you’ve been reading our blog Sprott’s Thoughts, you will know that of all the reasons why gold might go up, I believe that the most important is the relationship between gold and the US dollar. Precious metals compete for ‘shelf space’ in investors’ portfolios with the US dollar as a means of savings. Precious metals have lost that competition pretty spectacularly over the last five years.
We are living in a general hegemony of the US dollar and US Treasuries, and I don’t think that is going to change anytime soon. But I think that precious metals are beginning to lose less badly against the dollar, and that there is more ‘shelf space’ available right now.
It is my belief that the war between the US dollar and gold will edge slightly in gold’s favor, simply because US Treasuries yield less than 2% for 10 years2. That’s not an attractive value proposition in my opinion, and I believe it will give gold a little more room in investors’ portfolios.
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Rick Rule Bio:
Mr. Rule has dedicated his entire adult life to many aspects of natural resource securities investing. In addition to the knowledge and experience gained in a long and focused career, he has a worldwide network of contacts in the natural resource and finance worlds. As Director, President, and CEO of Sprott US Holdings, Inc., Mr. Rule leads a highly skilled team of earth science and finance professionals who enjoy a worldwide reputation for resource investment management.
Mr. Rule is a frequent speaker at industry conferences, and is interviewed for numerous radio, television, print and online media outlets concerning natural resource investment and industry topics. He is frequently quoted and referred by prominent natural resource oriented newsletters and advisories. Mr. Rule and his team have long experience in many resource sectors including agriculture, alternative energy, forestry, oil and gas, mining and water. Mr. Rule is particularly active in private placement markets, having originated and participated in hundreds of debt and equity transactions with private, pre-public and public companies.
Sprott US Holdings, Inc. is a holding company made up of three separate and distinct companies: Sprott Global Resource Investments, Ltd., a FINRA Registered Broker/Dealer; Sprott Asset Management USA Inc., an SEC Registered Investment Adviser offering managed accounts; and Resource Capital Investment Corporation, an SEC Registered Investment Adviser managing partnerships. These three companies make up the US Subsidiaries of Sprott Inc. and are active in securities brokerage, segregated account money management and investment partnership management involving both equity and debt instruments, across the entire spectrum of the natural resource industry.
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