Getting to the Bottom of It

By: Sean Corrigan | Fri, Oct 13, 2006
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    It is becoming somewhat inevitable these days, that whenever a group of analysts, traders, or investors gathers to discuss commodity matters, sooner or later someone will portentously intone the formula: "Of course, a resource is ultimately priced at the limit set by the lowest marginal cost producer".

    Given that this is usually trotted out as part of an argument that commodities are presently overpriced, sometimes this is qualified by the equally profound-sounding qualification: "... or at least it is in a bear market."

    The first thing that strikes one as odd here is that the latter addendum implicitly admits that prices are not always set by costs, but that apparently, this aberration can only apply in the upswing when the (unspoken) implication is that speculative forces can bring about such a divorce, something that they are seemingly unable to achieve in the downswing.

    In passing, it should also be observed that, if there were any merit at all to this lemma, it should hold universally for all businesses, for, surely, producers of commodities can in no way be thought to represent a special case in economics (at least, the cynic might remark, for anything other than their unenviable record as destroyers of capital over the cycle!).

    That aside, we must protest that the statement is inherently incorrect for, rather than the most EFFICIENT producer being of importance to the establishment of some theoretical equilibrium and, so, for anything other than the shortest of short runs, a good will instead be priced no lower than the marginal cost of the least INEFFICIENT producer whose output is nonetheless still needed to satisfy total demand on the market.

    For example, it is not the Saudis - who can practically stick a syringe in to the ground beneath their feet and pull out oil - who set the price of crude with their 11+ Mbpd capability, but, given an urgent, fill-at-all-costs worldwide demand of approaching 85 Mbpd, it needs to be priced to reward those operating at great expense and considerable risk out at the edge of the continental shelf, or those coaxing a recalcitrant hard-to-refine sludge out of its matrix in the oil sands of Canada.

    Naturally, as in all such cases, the most able producer will enjoy the fattest margins - exactly as it should be, for the best will thus be both financially empowered and personally incentivised to re-invest much of his handsome profits with the aim of growing his total production and with the consequence of benefiting both him and his future customers.

    However, if we accept that he may not easily be able to achieve such an expansion of output in the short-to-medium term (often a realistic constraint for miners and drillers), he will not ordinarily be able to deny all revenues to other, less adept or less geologically-favoured entrepreneurs who share in his field.

    Instead, even if these stragglers can do no more than to scrape by at a price which may only cover their cash costs - or even if they must otherwise sacrifice tomorrow to the needs of today by indulging in the accelerated depletion which proceeds from high-grading ore bodies or poorly managing oil & gas reservoirs - it will be their pain threshold which will tend to influence the lower price bound, right up to the point that their undepreciated machines wear out and their unreplaced reserves are exhausted and they can no longer bring any supply to the market whatsoever.

    We say 'influence' here , rather than 'specify', since this cut-off will only be effective under the condition that demand will persist for long enough to absorb any stockpiles which may be thrown on the market at a loss by those no longer willing or able to finance their retention.

Further, for this fuzzy lower bound to come into play, we must also wait to outlast the efforts of those who cannot even manage to generate any positive cash flow at all at the prevailing price, but who choose to burn directly through their capital in the forlorn hope of surviving until better times return.

    Needless to say, we cannot apply economic reasoning to non-economic actors, either, so this also all supposes that no uneconomic deposits continue in use, thanks to state support, whether this takes the form of say-so or subvention.

    More fundamentally, we should realize that it is the buyers' preference schedules, not the happenstance of the suppliers' costs, which is the prime determinant of prices (pace, Marx and Ricardo).

    Thus, just as bull markets deliver temporary windfalls to all, by setting bids at prices greatly exceeding existing marginal costs, bear markets can also push prices far below these levels - not least when margin-driven liquidations of those long and wrong of claims on the relevant resources are taking place!

    Nonetheless, it may be a useful rule of thumb for gauging when a market is clearing at too low a price to be sustained to say that, over a longer horizon, the most efficient company may well indicate the whereabouts of the lowest, long-term floor - as, arguably, the likes of Newmont were on the brink of doing when gold was at its 1999-2001 lows of close to $250 an ounce.

    Even here, in extremis, we must temper our conviction by allowing that the buyers may still not want any of the product at all, or rather not want it more insistently than any of the myriad other goods which are simultaneously competing for the last, marginal dollars in their wallets.

    If not, if even the last-surviving paragon of efficiency is not offered a price which fully compensates his efforts for anything beyond the briefest (though not necessarily most quantitatively insignificant) of overshoots - and assuming, further, that no entrepreneurial progress will be made in adjusting the producer's cost side in order to restore his profitability - he, too, will be forced to shut up shop and to move into another line of business entirely, taking with him whatever vestiges of capital he can salvage from the wreckage.

    At that point, having proved its economic irrelevance to its customers, the entire industry will vanish into the Darwinian twilight of commercial history, an unlamented victim of progress and/or changing consumer tastes.

    At root, such an outcome simply means that no-one wanted to pay the prices our producer needed in order to attract the necessary productive factors away from what will have now been revealed as their more highly-valued employment elsewhere in the overall structure of the economy.

    Despite the current whiff of panic in the air, it should be fairly uncontroversial to say that this last eventuality is most unlikely to hold in the case of copper, corn or crude - not for some good, long, foreseeable future; not until technological advance, entrepreneurial skill and political sanity conduct us, at last, to the long-sought Land of Milk and Honey.

    So, in the meanwhile, if you are looking for bullish arguments based on costs (while staying alert to the fact that they can never be predicative), listen to those who will tell you that a near 60% increase in oil E&P over the last two years was basically eaten up in higher outlays; that it now takes $1 million a day to run an offshore drilling programme; or that some industry experts fret that barely half the investments needed to meet secularly-rising energy demands may have been initiated.

    Pay attention to miners complaining of operating cost hikes of as much as 30%; of 'cost-curves' both moving up and steepening; of exploration costs rising by approaching 15% in the last twelve months alone.

    When it comes to sustainable prices, consider that US No2 Nat gas producer Chesapeake idled 6% of its wells a few weeks back, saying spot prices "aren't economically feasible"; think of the impact on rig operators when spot has traded with a $4-handle, nearly 80% below the summer's peak and a price not seen since early 2003.

    Think of OPEC vacillating over production cuts and grumbling about 'security of demand' as it compares falling prices with its raft of multi-billion investment projects, many of which are already suffering budget overruns and input constraints.

    But, similarly, think about bad positions held on slender margins in speculative markets; think about misplaced bets in the context of poor news flow and higher inventories. Reflect on a market still tending to overweight the bad macro headlines from the US and to dismiss the positives originating both there and elsewhere around the word.

    In short, remember that costs can only set a long-term foundation, never a short-term one, and that the urgency of some to quit losing trades can meanwhile force successive tranches of 'least efficient producers whose output is nonetheless still needed' to curtail activity or shut up shop altogether, especially when stockpiles are high and storage is fit to burst.

    Conversely, bear in mind that the long term trends for many of these key resources are so far unimpaired; that the hard-fought battle to match supply to demand is still far from decided and now you may take a little comfort in thinking that the more the current - largely leverage-driven - weakness depresses output, deters new investment, and defers upgrades and expansion plans, the longer these key commodity markets will remain short of regaining any sort of reliable and durable balance.

    Barring a significant slump in real activity - well beyond the current mild deceleration - and absent an outbreak of systemic woe in the Looking Glass world of casino finance, the economic verity still holds that it is the buyers' appetites which set prices - and not the producers' aspirations.

    This can only imply that - assuming it does not collapse the entire house of cards in the process - today's distress-driven overshoot will be of tremendous help in laying the ground work for tomorrow's gratifying rebound.



Author: Sean Corrigan

Sean Corrigan,
Chief Investment Strategist,
Diapason Commodities Management,
Lausanne & London

Copyright © 2006-2007 Sean Corrigan

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