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Jun 2006 - Perceptions/Reality

Perceptions and Reality

By Friday 9 June 2006, the resources stocks had taken a major fall with some stock prices down by up to 40% since the peak around 12 May and the Philadelphia Gold and Silver Index down by 30%, as the gold price dropped by 19% from US$726/oz down to US$608/oz. The fall was based on the perception that the market had run too high with commodity prices driven mainly by hedge fund speculation and share prices by almost all forms of trading. Hence the perception was that demand had to fall because such commodity prices were perceived to be unsustainable and consequently the prices similarly should fall, which they have to some degree.

But the reality is that on 9 June 2006 in Sydney unleaded petrol has continued to increase and is selling for A$1.42/litre and bananas are selling for almost A$12/kg (due to the cyclone damage in Queensland) – two real life classic examples of supply and demand.

Some of the other realities are that LME stockpiles are at perilously low levels, and China’s demand for metals (followed by India etc) does not appear to be capable of going away overnight.

At the SDIA (Stockbroker) conference in Melbourne at the end of May 2006 a number of speakers based in China referred to the demand for metals not stopping. The boom times of the 1950s and 1960s due to rebuilding the damage from WWII was a structural change. Other structural changes in nations have occurred in the past, it is just that it has not been done by a wealthy nation such as China before with a motivated population of about 1.5bn people (everyone knows that the one child policy is inaccurate), and that is why this time it is expected to be different. China and Japan now hold about 47% of the global forex reserves.

Other nations are following in China’s wake such as India apparently recently announcing a 3-year programme to upgrade their road and rail infrastructure at a cost of about US$110bn.

At that SDIA conference it was also commented that the expected fall in US GDP in 2007 based on a slowdown in household consumption (which may or may not happen) was only expected to dampen China’s growth from an official 9.7% (unofficially believed to be >10%) by 0.7% down to 9%. This was based mainly on FDI (Foreign direct investment into China being a steady US$60bn pa), and apparently only 25% of China’s growth is based on exports - the rest being domestically generated. It is apparently economically difficult to slow down global growth enough to get China to stop growing by at least 8%pa.

China is trying to mop up the excess cash (or create more ?) as shown by the IPO of the Bank of China in June 2006 floating 10% for US$10bn and already oversubscribed (the institutional component is apparently 6x oversubscribed, while the retail component is reputedly 70x oversubscribed).

In the 1980s, Japan’s steel production grew to 80mtpa, and it is now 100mtpa but of a much higher quality. China is growing its steel production from 300mtpa to 400mtpa, with the outlook being a further rise to 450mtpa – and of increasing quality. About the only threat to growth was seen as being insufficient raw metals, with some Chinese projects reputedly curtailed or postponed because it was perceived that there is currently insufficient zinc in the world to construct them.

There is a major shortage of personnel to operate the mines to produce the metals, yet alone tyres for vehicles etc. Michael Kiernan (outgoing MD of CSM) in his speech at the Sydney Mining Club on 1 June 2006, highlighted that a mining engineering graduate now gets paid A$120,000 per year on graduation for a 9 days on 5 days off fly in – fly out job, and after 3 years they are on >A$200,000 pa. More senior positions’ salaries have had to be scaled up proportionately – so production costs are rising.

I know when I graduated in mining engineering in 1973 my first salary in Zambia on contract was almost Kwacha3000 per year, and 3 years’ later when I started work in South Africa in 1976 it was ZAR8,500 per year, doubling in the following 4 years to ZAR17,000 pa in 1980 when the gold price spiked to US$850/oz. The current ZAR/A$ exchange rate is about 5 to 1. So mining engineering salaries (in South Africa) have risen about 70 times since then in the period that the US$ gold price is about the same.

The gold price rose to US$850/oz on about 20 January 1980 and comments are being made about maybe it can return to that level again, but US$850 (for 1oz) in January 1980 is certainly worth a lot less in June 2006.

It is well known that Australia’s cpi has been about 3% pa for the past 5 years, but the reality is that everyday cost items such as cab fares, hotels, petrol, parking and car insurance have risen by between 35% and 85%, petrol being up 75% in the past 3 years!

The market’s failure to believe regularly occurs. In the 1950s after WWII, stock markets were apparently hampered by the fear of deflation and depression (which occurred after WWI) all through the 20 to 30-year boom period, whereas instead what resulted was the inflation period of the 1970s.

Based on some of my earlier research it can be shown that when the gold price spiked through to US$850/oz in January 1980, the Jo’burg gold index followed it to about US$500/oz and then went sideways until the price returned to US$500/oz. Later in 1980 when the gold price recovered to US$600/oz and US$700/oz, the Jo’burg gold index doubled, and after following the market down, then tripled in 1982/3 as the gold price rose from about US$350/oz to US$500/oz.

Other commodity prices are also viewed and perceived on a static scale. Figure 1 shows the nickel price in US$/t and US$lb monthly from January 1989 to June 2006 with many people more comfortable with a long-term price of US$4.50/lb because it spent so long in that area, yet for the past 3 years it has been closer to US$15,000/t or US$6.75/lb.

The current high prices for nickel are not unprecedented, with the previous highest monthly average of ~US$8.50/lb occurring in 1988, when apparently a peak of US$10.84/lb was attained in March 1988. If nickel were to be quoted in real money terms then the fixed INCO price of US$1.33/lb in the late 1960s becomes US$6/lb due to the weaker US$, while the apparent then free market price of ~US$7/lb becomes ~US$31/lb (ref : Brian Hurley, Paydirt Nickel Conference, October 2003……..when the unleaded petrol price was closer to A$0.80/ltr).

We have commented in this column before that the market also has to re-learn the concept of volatility. Before all that gold hedging, the gold price would bounce around, often with daily movements of US$20/oz or US$30/oz or so. The hedging era was like pouring oil on troubled waters where the movements became more like US1/oz to US$3/oz, and now we are back in post hedging, the gold price appears to be returning to mountainous and troubled seas again – or in other words, volatility.

If commodity prices cannot rise (based on perceived historical height levels) then mines are going to have to close due to rising costs despite demand for the metals that the mines are producing – which means that commodity prices are likely to rise.

The reality is that the market has to adjust to the fact that commodity prices appear likely to exceed any level previously seen before and that volatility has returned to the market (even if the market cannot perceive it, just yet).

Disclosure and Disclaimer : This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (ERA, an independent research company) who is an Authorised Representative with Taylor Collison Ltd, and with his associates, may hold interests in some of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.

Figure 1. The Nickel Price in US$/t and US$lb Monthly January 1989 to June 2006 (Source : LME)GDNjun06

  • Written by: Keith Goode
  • Thursday, 01 June 2006