In today’s Exponential Investor:

  • When smart people want to feel smarter
  • The book that tells you everything about commodities
  • The odds of finding an economical mine? Pretty slim, actually…
  • We must spend more to find the resources we need

Commodity booms and busts are simple things at their core.

Sure, you can overcomplicate things with fancy charts that explain market equilibrium, along with inverse supply and demand curves showing how and why prices get pushed up or down.

While those charts make smart people feel smarter, the crux of it is that prices rise because people want more things, and prices fall because people have enough things.

That’s basically it.

While much of today’s commodity analysis centres around whether or not we are in a commodity supercycle, there’s one thing that precedes every commodity boom…

… and that’s not having sufficient resources to meet rising demand to begin with.

The commodity bible

I’m currently re-reading a book on commodities called A Handbook of Primary Commodities in the Global Economy by Marian Radetzki and Linda Wårell. I initially read it over a decade ago when I first started out in equity analysis. The commodities market seemed so big, and I didn’t know where to start. A friend suggested this as an all-encompassing beginners’ guide.

I borrowed it from the library, learnt a thing or two, and sent it back.

This year, however, I decided to buy it. And I’m sure glad I did.

For two reasons. The first, it’s interesting to read the third edition, which now includes analysis on the 2000s commodity boom. But, most importantly, now that I own it, I can do this… (we might not be friends after you see this).

Source: Shae’s overloaded smartphone

Now, before you start… there are two types of people in the world: those of the: “Books are sacred! No dog ears and definitely no pencil or highlighter marks on them” persuasion. Then the: “Books should reflect the life they’ve lived” brigade. You can see which group I belong to.

I’ve had this chat many times. I’m a prolific note-taker, and I like my books to reveal my thought processes.

My (possibly off-putting) habits aside, let’s get back to the point.

When I reached chapter six, I was reminded of the key reasons commodity booms can be so rewarding for early investors:

There is a common perception that it takes about five years on average for new greenfield to be in place minerals, metals and fossil fuel industries. The argument then is that five years should be enough to rectify any market imbalance caused by unexpected demand. However, this assumption has been proved wrong in the latest commodities boom [2000s]. Investments are subject to a variety of perception and decision lags, comprising the time to bring together the necessary financial packages and overcome various regulatory impediments, including increasingly restrictive environmental legislation in recent times.

The idea that a commodities market imbalance can be rectified in five years is laughable. It can take significantly longer than that…

The odds are against you from the start

The odds of finding something in the ground are pretty high. The odds of finding an economical mine, on the other hand, are pretty slim.

Exploration to mine is painstakingly slow, and costs hundreds of millions of pounds. Often, I joke with investors that “if it took 400 million years for these rocks to form, we can surely wait 18 months to see what the drill results say”.

That holds true when it comes to investing in junior mining stocks. Patience is key. But once you understand how long exploration can take, you’ll see why allowing a five-year rebalancing timeframe is so shockingly wrong. And why commodity prices rise extraordinarily fast when the boom occurs.

You see, only 1 in 300 discoveries will make it from exploration project to mining development. That’s “development” mind you, not a producing mine.

When it comes to getting stuff out of the ground, only 1 in 660 early-stage exploration projects will deliver a top-level discovery.

Worse still, only 45% of all deposits (an actual internationally recognised resource) will be developed.

Assuming everything goes to plan – which rarely happens with natural-resource stocks – it will take an average of 12 years from discovery to production.

That’s more than double the estimated time to restore a market imbalance.

Which brings us to the next part of the problem.

We haven’t spent enough to ensure we have sufficient resources

The problem with commodity booms and busts is that direct future spending relies on today’s price.

You can see in the chart below that, as the 1970s commodities boom petered out and the bear phase set in, exploration spending declined.

In fact, such spending was at its lowest in 2005, just as the 2000s commodity boom got underway…

Source: Minex Consulting

Like most market boom and bust examples, money flooded in at the peak of price rises in 2012. The problem was that, by about 2012, demand was stripped from the market and the prices for raw goods began to fall, taking exploration spending with them.

The flow-on effect from this was the number of new finds per year.

As money was being pumped into the exploration sector, an increasing quantity of mineral deposits were found. When the money slowly dried up, so did the number of new finds annually.

Source: Minex Consulting

Don’t get me wrong, commodity busts hurt investors. It’s part of the reason why it takes so long for people to get excited about a natural-resource boom. Depressed prices act as a deterrent for investors.

Yet, mining is a depleting business. Every tonne out of the ground is one tonne out of the ground. Miners have to be constantly replenishing their resources to ensure they can meet future demand.

When they don’t, it risks leading to significant imbalances when demand picks up. More to the point, it falsely reassures the market that supply is secure.

But here’s the thing.

Before every commodities boom comes a demand shock. More on that tomorrow.

Until next time,

Shae Russell
Co-editor, Exponential Investor