Becoming an astute investor in the resource sector requires a long learning curve. A knowledge base consisting solely of economics and corporate finance won’t cut it here. It really is a place of its own, with its own idiosyncrasies. Besides finance, any potential investor would do good by immersing him- or herself in the field of (economic) geology and rigidly studying the quirks of commodity markets. Luckily, there is a variety of good literature available. Besides literature, having an ear for the old and experienced folks can provide great insight as well. They say that history doesn’t repeat itself, but it certainly does rime at times. This aphorism looks to be applicable to the commodity markets as well. Over the years, as booms and busts have taken the stage, this yielded various important observations - which over time have become some of the best known adages in the resource sector. One of the most ubiquitous - and crucial to know for any resource investor - is the following axiom; the cure for high prices is high prices, and the cure for low prices is low prices. This essentially condenses the fact that in commodity markets, commodity price setting follows a so-called feedback control cycle. In a nutshell; In times of high prices, new - and previously unfeasible/uneconomic - mines come on stream, therefore easing the supply-demand imbalance. Conversely, when prices are low, supply leaves the market as mines become unprofitable and pause/foreclose operations. Many more factors play a role in this phenomenon, such as substitution and easing demand at high prices (with the converse happening at low prices). This does not mean that any commodity is restricted from increasing or decreasing in price - it just points to the fact that high or low prices awaken new initiatives and open new possibilities, pressuring the price to oscillate to a long term mean.
Figure 1: The feedback control cycle of mineral supply
As a resource investor, it’s important to keep this aphorism in mind at all times. Supply-demand mechanics are of intricate nature, and have proven to be highly unpredictable. To illustrate this further, I thought it would be insightful to look at a case study of the transition metal Tantalum (Ta). Tantalum is not a widely known commodity nowadays, but does play an important role in several industries, and is even deemed a critical component in many items. The most important function of the metal is in the manufacture of electrolytic capacitors for the electronics industry. These types of capacitors make use of Tantalum’s tendency to form a protective oxide surface layer. This in turn results in a very high capacitance to volume ratio - providing many benefits in products like mobile phones and other electronics.
Now to the case study. In the late 1970’s, the growth of the electronics industry fueled a sentiment among market participants that Tantalum - for rehearsal; the critical component in capacitors - would become scarce in supply. This anticipated scarcity fueled a hype in the metal, resulting in a significant price peak. After the bubble had burst, market insiders acknowledged there had been no shortage at all. In fact, there was more than adequate Tantalum to supply the industry. This was a fine example of how market theories can quickly convert into self-fulfilling prophecies. Thereby following the theory of Thomas and Thomas (1928); If a situation is believed to be real, the consequences of that imaginary situation can become real. An anticipated shortage can trigger excessive hoarding of the commodity in question, thereby creating a factual shortage. This was definitely the case with Tantalum. However, regardless if the shortage is real or presumed, this is where the earlier mentioned feedback control cycle comes into play.
At the time, about 50% of worldwide Tantalum supply came from columbite-tantalite ores found in Australia and Africa. The other 50% was sourced from Tin slags in Malaysia and Thailand. During times when the Tantalum price was depressed, the majority of these Tin slags proved to be uneconomic for Tantalum recovery due to the minimal Tantalum grade, and were therefore disposed of. These slags were subsequently used as a landfill to build roads and houses on. However, during the Tantalum boom, when Tantalum prices quickly rose multifold, these slags were readily uncovered as an available Tantalum source. Suddenly, mining took place on recreational and private properties, and parking lots were stripped away to reach the now valuable Tin slag. Subsequently, this readily new supply shifted the market from a seller’s market to a buyer’s market - causing Tantalum prices to plummet.
Figure 2: Tantalum nominal and real prices from 1965 to 2015 (data: USGS Historical Statistics 2019)
Furthermore, the above figure illustrates that a price spike (such as in 2000) - followed by a severe reaction on the supply side - can often depress prices for long periods, as overproduction by new mines is not reduced for years.
Figure 3: For illustration only - an unconventional mine
All in all, it proves that the feedback control cycle plays a fundamental role in the commodity markets. To illustrate this further, a citate from Friedrich-W. Wellmer & Christian Hagelüken (2015) could provide more insight.
“In the graph below, supply and demand curves are plotted as functions of price vs. quantity. The higher the price of a commodity the larger the supply and smaller the demand. The two curves intersect at point S1, i.e., demand and supply are in balance. Let us assume the market believes there is a shortage of a commodity. The price rises from P1 to P2. At price P2 the quantity a2 can be produced, e.g., new mines come on stream. However, because of the higher price, sooner or later demand will decrease, the price now falls from P2 to P3, and only a smaller quantity a3 can be produced economically, and so on. This shows that supply and demand counteract.”
Figure 4: The case of convergent fluctuation
Conclusion
The old adage “high prices are the cure for high prices” and the inherent feedback control cycle is one of the fundamental forces in commodity markets. For the natural resource investor, this is a mechanism to keep an eye on at all times. I know it’s tempting to fantasize of times where copper hits $10/lbs or Nickel climbs to new heights, but keep in mind that the feedback control cycle tries its absolute best to counteract any such scenario. As highlighted with Tantalum, supply can come from unconventional sources - consequently taking market participants completely by surprise. That’s not to say that copper couldn’t hit $10/lbs. The feedback control cycle is highly idiosyncratic to any commodity. In the case of copper, where an anticipated market imbalance is likely to be caused by lack of primary supply and long lead-times for new mines to come on stream, higher prices may indeed be realized. However, it remains crucial to appreciate the other side of the equation here, for instance that a higher copper price incentivizes the extension of life-of-mines by means of a lower cut-off grade - thereby bringing new supply to the market.
There is an inherent danger in clinging to a certain narrative e.g. commodity x is going to hit y price because z. Commodity markets are intricate, and should be approached like that. For the natural resource investor, it’s crucial to understand the dynamics that rule it, and to take nothing at first sight.
Sources and further reading;
Wellmer, F. (z.d.). The Feedback Control Cycle of Mineral Supply, Increase of Raw Material Efficiency, and Sustainable Development. MDPI. https://www.mdpi.com/2075-163X/5/4/527/htm
Wellmer, F. (z.d.). Volatility drivers on the metal market and exposure of producing countries
