Category Archives: Commodities

Shorting Palladium… Again

It’s not often that one gets an opportunity to execute the exact same trade based on the same investment thesis after closing out the initial trade profitably. But that is exactly what I am facing and decided to take advantage of by shorting Palladium last Friday at $802.

My first trade was initiated on March 27, 2015 at $742 per ounce and closed on November 25, 2015 for $540 per ounce. My rationale for that trade can be read here, so I won’t rehash anything that was stated in that post.

I will only add that we are closer to the mass production of electric vehicles, with the Chevy Bolt EV just released and the Tesla Model 3 coming out later this year. A drop-off in gasoline-powered car sales will reduce a major source of demand for palladium.

It’s interesting to note that the Palladium market is the only commodity that has remained resilient in the midst of a commodity bear market. The recent improvement in global growth has helped palladium to rally back close towards its mulit-year high price of just over $900/ounce.

But when (not if) China experiences another slow down, global growth will weaken and palladium prices will come under pressure, falling towards $500/ounce.

Shorting Palladium

A lot of my financial wealth was created riding the great commodity super cycle during the previous decade. In 2004, when I first had enough money to invest, it was apparent to me that the industrialization of China, the underinvestment in mining, and easy US monetary policy would create an ideal setting for commodities to rally. To speculate on this, I bought a basket of Junior gold exploration companies and watched their value multiply several-fold.

But in 2010, short seller Jim Chanos opened my eyes to the growing fixed asset investment bubble occurring in China. Fearing that a popping of the bubble could lead to a drop in demand for commodities and a stronger US dollar led me to believe that the great commodity super cycle was about to end.

Sure enough, commodities have been a house of pain for investors since then.

Commodities Price Performance

Most commodities have declined by 30-50% during the past 4 years with one exception: palladium. Palladium has been resilient while even platinum (a fellow PGM metal) lost 35%. Why did the palladium price decouple from the rest of the commodity complex in 2014?

Early 2014 saw the rise of tensions between Russia and Ukraine leading western countries to slap sanctions on Russia. That spooked the palladium market because Russia is the world’s largest palladium producer supplying 40% of mine supply annually.

Palladium 20 Year Price

In the late ’90s, western countries implemented stringent auto emissions restrictions requiring car companies to fit their cars with catalytic converters which require palladium. This caused a surge in palladium demand that Russian mines could not fully supply. The Russian government, desperate to build up foreign exchange reserves after their debt default, sold off its palladium stockpiles to meet the increased demand until it ran out of inventory. To rebuild its inventory, the government delayed issuing palladium export licenses causing a spike in palladium prices.

That experience has made market participants worried about any sanctions that may affect Russian palladium exports. In addition, mine workers in South Africa, the second largest palladium producer, were on strike during the first half of 2014. However, a resolution was reached last June and palladium prices topped out shortly thereafter.

Fears of western sanctions that block Russian palladium exports appear overblown to me because they would hurt western auto manufacturers, while Russia could still sell their supply to China and India. The global automobile industry consumes almost two-thirds of annual palladium supply.

As a side note, I believe the rise of electrical vehicles (which do not have catalytic converters), could cause a significant drop off in palladium demand down the road. But it will take a few more years for battery technology to be price competitive with and as efficient as internal combustion engines.

Nonetheless, I still believe that the palladium price will soon join other commodities and experience a significant decline. My confidence is based on chart analysis.

palladium price

From 2010 to 2013 palladium prices were tracing an alternating series of lower highs and higher lows – a pattern that chartists call a triangle. When the price eventually breaks out of the triangle, it could lead to a sharp move in the direction of the break. However, a false break could arise where the price fails to move quickly and reverses to fall back inside the triangle. This would signal that a sharp move could be forthcoming in the opposite direction of the false break.

In my experience, a well traced out triangle pattern in a widely followed market such as palladium often leads to false breaks. Sure enough, the Russian invasion of Crimea in 2014 led to a breakout, but the price failed to rise much and made only a marginal high before falling back below the lower trend line of the triangle.

I believe that palladium has experienced a false breakout and shorted it on Friday at an average price of $742. The beauty of this trade is that I can stop myself out if the price rises back above the trend line to approximately $775 on a weekly closing basis and take a small loss. Alternatively, I may add to my short position if the price breaks the downward sloping support line at $700.

I will be tracking the trade here.

 

Copper Prices Return to Earth

Base metals prices have collapsed this year with losses particularly steep in just the past few weeks. For the last two years, I have been writing bearish posts on base metals with the viewpoint that when the global economy slumps, demand for industrial metals will decline significantly, and prices will fall. I even put my money where my mouth is and shorted base metals stocks last year. Now that prices of industrial metals have substantially declined, it is worthwhile to examine whether they have fallen too much. Here is a price chart of copper dating back to 1980.

Microsoft Excel

I prefer to view the prices of commodities in terms of a stable monetary unit such as gold rather than a depreciating one such as the US dollar. This ignores the effect of monetary inflation and more precisely shows the real value of the commodity. Here is a long term chart of the price of copper in terms of ounces of gold per 100 pounds of copper dating back to 1840.

copper historical price

Here is a chart of the real price of copper in terms of gold since 1980.

Copper Price

The ratio peaked at 0.579 in September 2006 and is currently 0.239 which is slightly below its average since 1980 of 0.277. A glance at this chart suggests copper is significantly undervalued when its price is less than one-fifth of the gold price.

The real price of copper has been declining over the past 170 years. This should be expected given that technological advancement and accumulating savings has reduced the real cost of production over time and will continue to do so in the future. In the long run, the price of any commodity is equal to its cost of production plus a reasonable profit for the producer. However, in the short run there could be wild price swings as there is a time lag to when supply can increase or decrease to meet demand.

The speculator can make profits by betting on commodities when the market price is well below the cost of production as the market is signaling to producers that supply needs to be reduced. Eventually, the price will have to rise otherwise the commodity won’t be produced. On the other hand, money can be made shorting a commodity when its price is significantly above the cost of production because it will encourage greater supply until demand is met, at which point the price will fall.

To get a sense of what the current cost of production of copper is I took a look at the financial statements of copper producers Southern Peru Copper (NYSE:PCU) and First Quantum Minerals (TSX:FM). A summary of their quarterly results are provided below using both recent and current base metals prices.

Preview of “Base Metal Producers.xlsx”.pdf (1 page)

As can be seen, the projected earnings for PCU and FM using current metals prices are still quite healthy, though they have declined substantially. Only if the copper price were to fall another 50% to $0.85/lb. would either be at risk of losing money. These companies operate some of the higher margin mines in the world. A copper price below $1/lb. would cause many miners to lose money. However, it is also important to keep in mind that if the decline in the copper price is accompanied with a drop in other commodity prices, then a mining operation’s energy costs (which account for approximately 50% of total costs) and labor costs would fall as well. So the cost of production would be lower.

In recent years there has been a lot of money spent on investment and development to expand production from current copper mines and to bring online new greenfield projects. This will add to supply. As the previous analysis shows, miners can still make money at current metals prices so there still exists an incentive to increase production. However, the global economy is beginning to contract which will cause a reduction in copper demand. Together, these factors will put downward pressure on the copper price. The best time to be bullish on copper is when the world economy is about to expand. I don’t see this occurring for the next few quarters, at least.

So what would get me to bet on copper? First, I want to be confident that the global economy is on the verge of emerging from the current downturn. Second, the copper price should be below most mining operations’ cost of production, which I estimate to be around $1/lb. And third, the real price of copper, as measured in term of gold, should be well below its long time average of the past; I think an attractive ratio would be around 0.2 ounces of gold per 100 pounds of copper.

I will concede that these are very strict conditions that are rarely met. But they were satisfied in as recently as 2002 and 2003 which, in retrospect, were terrific years to buy copper. If the market continues to value copper above where I think it is very cheap, then I will simply look elsewhere to speculate where the risk/reward ratio is more favorable.

Investing in Water Rights

I believe I have come across an attractive investment opportunity: owning water rights in the US Southwest. Rather than actually buying water rights, it is far easier to buy shares of a publicly traded company that is involved in this space. There is only one which I am aware of and I will discuss it in my next post. But in this post, I will explain why water rights in the Southwest is likely to become much more valuable.

The great basin states of Colorado, Utah, Wyoming, New Mexico, Arizona, Nevada and California mostly depend on water from the Colorado River. The river is replenished by snowmelt from the Rocky Mountains. However, an ongoing drought has reduced the flow of the Colorado to its lowest levels since measurements began 85 years ago.

The obvious culprit is rising temperatures due to either climactic variation or global warming. Indeed, the Colorado River basin is already two degrees warmer than it was in 1976. Rising temperatures can cause snowmelt runoff to decrease, reservoirs to lose far more water to evaporation, and water demand to increase because crops are thirstier.

Meanwhile, the population of the seven states that depend on the river grew by 10% between 2000 and 2006, compared with 5.6% in the rest of America. And much of the growth is in the driest parts of those states. As a result, the supply of water is struggling to keep up with demand and the price of water rights has risen. Municipalities are scrambling to secure water supplies, but there is no new readily available source and if the drought persists, the value of water could soar.

So the big question for anyone thinking of investing in water rights is whether the drought will continue or is it more likely that the Southwest will get more precipitation. This coming spring, the United Nations’ Intergovernmental Panel on Climate Change will issue a report identifying areas of the world most at risk of droughts and floods as the earth warms. The report will identify the Colorado River basin as a problem zone.

Almost without exception, recent climate models envision a reduction in water supply that range from the modest to the catastrophic by the second half of this century. One study in particular, by Martin Hoerling and Jon Eischeid, suggests the region is already “past peak water,” a milestone that means the river’s water supply will now forever trend downward.

Climatologists seem to agree that global warming means the earth will, on average, get wetter. According to Richard Seager, a scientist at Columbia University’s Lamont Doherty Earth Observatory who published a study on the Southwest last spring, more rain and snow will fall in those regions closer to the poles and more precipitation is likely to fall during sporadic, intense storms rather than from smaller, more frequent storms. But many subtropical regions closer to the equator will dry out. The models analyzed by Seager, which focus on regional climate rather than Colorado River flows, show that the Southwest will ultimately be subject to significant atmospheric and weather alterations, which probably has already begun.

I tend to be skeptical of climate models. After all, if we can’t even model the real estate market how are we going to model the weather, which is far more chaotic. However, shifts in weather trends once in place take a long time to reverse. It’s far more likely that the trend towards warmer temperatures in the Southwest over the past 30 years will continue for at least another few years. And the value of water in the region should continue to rise.

Las Vegas is almost certainly more vulnerable to water shortages than any other city in the country. Partly that’s a result of the city’s explosive growth. But the state of Nevada has the historical misfortune of receiving a smaller share of Colorado River water (300,000 acre-feet annually) than the other six states with which it signed a water-sharing compact in the 1920s.

That modest share, stored in Lake Mead, now means everything to Las Vegas. Lake Mead, the enormous reservoir in Arizona and Nevada that is fed by the Colorado River, is half-empty with less than 14 million acre-feet of water, and statistical models indicate that it will never be full again. Since 2001 the flow of water into Lake Mead has been below average for all but one year. If the drought does not break in the next few years, the Las Vegas metropolis will be the first to suffer. Its 1.8m inhabitants depend on the lake for nine-tenths of their water supply.

Fearing that the surface of Lake Mead will soon drop below the level of one of its two pumps, Las Vegas is quickly building another. It has bought ranchland in eastern Nevada and plans to build a pipeline to bring its water hundreds of miles south. Next year it will raise the sum it pays city residents to tear up their lawns and replace them with cacti and other abstemious flora.

Conservation has already reduced water use in Las Vegas from a peak in 2002. Impressively, every drop of water that enters the city’s sewers is cleaned and pumped back into Lake Mead. But conservation alone cannot stave off a crisis on the Colorado River. Its flow might be permanently reduced. The price of water is likely to go up.

Not surprisingly, the prices paid for groundwater rights have skyrocketed in recent years. In Las Vegas developers have moved west 60 miles to Pahrump and 80 miles northeast to Mesquite. There, developers pay upwards of $25,000 an acre-foot for groundwater rights when they can find any. To the north in Reno (about 425 miles north of Las Vegas), developers have paid $50,000 or more for an acre-foot. Thirty years ago, those water rights could be had for $50 an acre-foot (one acre foot is enough to supply one or two average homes). And, just two years ago, they were $4,000 an acre foot.

Under Nevada law, all water within the boundaries of the state belongs to the public. The owner of a water right does not own the physical water itself. In this light, some of the terms used to describe water rights — “vested,” “perfected” and “certificated” — might convey a false sense of title, permanence or finality. No person can own or acquire title to water. Rather, they merely have the right to beneficial use.

In the first instance, the state engineer allocates such rights to beneficial use through a permitting process. The first step is to file an application with the state engineer, including a $250 fee, and a supporting map prepared by a water rights surveyor showing the point of diversion and place of use of the water.

If the application is approved, a permit is issued granting the right to appropriate, or when it comes to groundwater, pump, a certain amount of water for a particular purpose. The permit will contain mandatory conditions, a timeline for constructing wells and associated works.

When the conditions of a permit are satisfied, and certain filings have been made, including a proof of completion of works (that is, drilling of a well or installation of pump), and a proof of beneficial use (that is, showing that the quantity of water actually being used for the intended purpose), the state engineer will issue a certificate (representing a “certificated” or “perfected” water right).

That does not mean that all certificated (or so-called perfected) water rights are equal. Nevada water law boils down to two maxims: “first in time, first in right,” and “use it or lose it.” The former recognizes the first person to put the water to use has a right to that quantity of water senior to all subsequent users. The latter means that the water must be put to a beneficial use or the right is lost and the water reverts to public ownership. These two maxims generally comprise the prior appropriation doctrine.

Farmers use the great majority of the West’s water, which they get at bargain rates. Even in California, by far the most populous state in the region, four times as much water is poured onto farmland as runs out of taps or is sprinkled over lawns. Farmers in the Imperial irrigation district, east of San Diego, pay $17 per acre-foot of water. In San Diego a household that used the same amount in a year would pay $1,311.

It makes sense to grow some crops in California. No place in America so closely resembles an open-air greenhouse as does the 400 mile-long Central Valley, which produces much of the nation’s fruits and nuts. In 2005 California’s almond crop had an export value of $1.8 billion. More ecologically dubious, however, are the state’s vast cotton and alfalfa farms. This year more than half a million acres (200,000 hectares) of what would otherwise be desert were devoted to the cultivation of rice, much of which was exported to Japan.

Because the supply of water in the West can’t really increase, water managers spend their time looking for ways to adjust its allocation in their favor. The cities would, of course, pay much more for the farmers’ water than could possibly be made growing rice. But the water is not always the farmers’ to sell. Many sources belong to water districts, which require the approval of all members before a transfer can take place. Rural politicians tend to oppose the idea of letting fields turn to dust in order to fill the swimming pools of Las Vegas and Beverly Hills. And, while California has an extensive infrastructure for moving water around between users, many states, including Nevada, do not.

Yet the cities’ desperation, and their consequent willingness to pay top dollar for water, is speeding the development of a water market. Clay Landry of WestWater, a consulting firm, points out that cities can get hold of the stuff much more quickly by buying it from farmers than by building reservoirs and desalination plants. Water contracts are becoming more sophisticated: southern California’s cities routinely buy options to guarantee supply in dry years.

Thus, the opportunity lies with those who have the capital and expertise to buy water rights currently used for agriculture and deliver them to municipalities at higher prices. There is a publicly traded company called PICO Holdings (Nasdaq:PICO) that has successfully made this its business. If the drought in the Southwest persists or worsens, PICO will be in a position to profit from it. In my next post, I will discuss why I think PICO’s shares make a good investment.

Copper Still Looks Vulnerable

At the end of last year I expressed my nervousness about the copper markets and how the price at that time of $3/lb. was incredibly expensive. Since then copper fell to a low of $2.40 before rebounding to $3.75. Currently, it’s selling for $3.34 and I am more bearish on copper now than I was before.

copper_price

My negative outlook on copper is based on a slowdown in the US economy and the likelihood it will drag the other economies of the world down along with it, which should reduce demand for base metals.

I believe that copper along with other commodities are 5 years into a secular bull market that typically lasts for 10 to 20 years. However, no asset price rises in a straight line and copper along with other base metals will eventually enter a cyclical bear market (or may have already entered one given copper prices are down 10% since May 2006) within a secular bull market.

A chart I like to look at to put the current real value of copper into historical perspective is the copper-gold ratio.

copper_gold_ratio

It can be misleading to determine copper’s real value by looking at its US dollar price. The US dollar and all fiat currencies decline in value over time, which makes everything priced in them more expensive. If instead we price copper in terms of gold we can get a better understanding of copper’s value since gold’s real value is stable over time.

I could only find a chart dating back to 1995, but looking at data since 1980, the ratio reached its highest value of 0.6 last year. Currently, the ratio is not far off at 0.5. This is well above its historical average of 0.3.

It is warranted that copper should be trading above it’s historical average given that the world is experiencing a period of synchronized growth like never before. However, if the global economy slows down the copper-gold ratio might decline to around 0.3. At current gold prices, that means copper could fall to $2. If gold declines to $550, then copper could collapse to $1.65.

Copper isn’t the only metal that looks risky. Aluminum, nickel, and zinc prices are all dependent on a strong global economy. If you are also worried about a looming US slowdown, now may be a good time to sell your base metal stocks.

By the start of this year, I had liquidated all of the stocks in my portfolio which had exposure to base metals. In fact, a collapse in base metals prices has me worried that it could temporarily affect the gold price; therefore, I have been selling some of my gold stocks, too.

Uranium Frenzy

historical_uranium_price

There is an interesting article in the NYTimes that discusses the recent excitement over uranium:

Not many. Prices for processed uranium ore, also called U308, or yellowcake, are rising rapidly. Yellowcake is trading at $90 a pound, nearing the all-time high, adjusted for inflation, of about $120 in the mid-1970s. The price has more than doubled in the last six months alone. As recently as late 2002, it was below $10.

A string of natural disasters, notably flooding of large mines in Canada and Australia, has triggered the most recent spike. Hedge funds and other institutional investors, who began buying up uranium in late 2004 to exploit the volatility in this relatively small market, have accelerated the price rally.

But the more fundamental causes of the uninterrupted ascendance of prices since 2003 can be traced to inventory constraints among power companies and a drying up of the excess supply of uranium from old Soviet-era nuclear weapons that was converted to use in power plants, coupled with the expected surge in demand from China, India, Russia and a few other countries for new nuclear power plants to fuel their growing economies.

Strathmore, with a market capitalization of $300 million, is one of about 400 publicly traded “uranium stock” companies (most of them, like Strathmore, trade on the Toronto Stock Exchange). Many of the firms are much smaller. Some are essentially shell games.“There’s so much money pouring into this sector,” said Julie Ickes, editor and publisher of StockInterview.com, which tracks uranium prices and companies. “If you put ‘uranium’ in your company name, you can look like you’re looking for property,” he said. “It’s a lot of talk.”

Globally, 180 million pounds of processed uranium is consumed each year by nuclear power plants. Production worldwide from mines amounts to only 100 million pounds. Roughly 75 million pounds come out of utility company stockpiles. What is actually traded in the spot market is only about 35 million pounds.

Some industry watchers fear the uranium market is entering the bust phase of another boom-bust cycle.

“It’s like the tech bubble,” said James Finch, senior editor of StockInterview.com. “We’re waiting for the crash.”

But others see plenty of room for prices to climb further. One is Bob Mitchell, founder of Adit Capital, a small hedge fund in Portland, Ore. In December of 2004, he became one of the first hedge fund managers to start buying uranium.

Since then other hedge funds and institutional investors have jumped into the market, some of them hoarding uranium while the price keeps rising. Even some established mining production companies are spinning off or partnering with hedge funds.

Uranium executives, investors and analysts alike agree that a major underlying cause of the current bull market is that mines are not generating enough uranium to meet growing demand. The supply constraints can be traced back to the end of the cold war when the United States and the former Soviet Union started converting enriched uranium from dismantled atomic weapons into nuclear fuel for peaceful purposes.

That program, and huge incentives offered to uranium companies by the Nuclear Regulatory Commission, flooded the market with excess supply. At the same time, demand shrunk. The price of uranium fell sharply.

As a result, most uranium producers scaled back or closed their mines. Some companies sold themselves to French, Canadian and British corporations, which now dominate the industry. Meanwhile, some nuclear power companies sold off some of their inventories when the price was low to avoid storage costs.

But by 2003 uranium inventories held by utilities in the United States were coming back into balance. Then a series of natural disasters — flooding of the world’s largest uranium mine, McArthur River in Canada, and more recently at other mines in Canada and Australia — further pinched supply. Power companies now find themselves competing with aggressive institutional investors for high-priced uranium.

Meanwhile, the people staking claims and drilling underground are happy to see the frothy market get frothier. So far this year, 2,700 new uranium claims have been filed with the Bureau of Land Management in Colorado alone. That is nearly half of the claims filed in all of last year, and a big jump from the 104 claims for 2004.

The WSJ, too, has recently chimed in on the subject:

Financial investors aren’t licensed to possess the radioactive mineral, which is subject to tight government controls aimed at keeping it out of the hands of terrorists and rogue states. Instead, several of those investors have secured access to ownership rights of material stored at licensed repositories in North America and Europe, exploiting legal channels previously used only by utilities and suppliers.

But even with only paper rights to the material, hedge funds are exacerbating what was already the biggest nuclear-fuel supply crunch in decades, according to utilities, miners and large traders. The market represents the latest corner in which hedge funds — private partnerships that cater to wealthy investors and large institutions — are seeking outsize returns, an increasingly challenging task as the number of funds multiplies.

Many funds say they are holding their uranium off the market because they expect the price to climb.

The market began taking off about two years ago. In May 2005, several months after Adit entered the market, Uranium Participation Corp. raised about $80 million for a uranium investment fund via an initial public offering on the Toronto Stock Exchange, and has raised roughly twice as much since. Managed by executives of the Canadian mining concern Denison Mines Corp., UPC controls more than 6.8 million pounds of uranium yellowcake or gas. It says its average yellowcake acquisition cost was $31.75 a pound.

A similar fund, Nufcor Uranium Ltd., went public last July on the London Stock Exchange’s AIM small-stock market and now controls 2.3 million pounds, the company says. Regulatory filings show that hedge funds invested in that IPO, including GLG Partners, Citadel Investment Group and QVT Financial LP.

Shares of both funds are trading at about 20% more than the current market price of their uranium, suggesting that investors see prices continuing to climb.

Ux says financial funds have purchased about 20 million pounds of yellowcake since entering the market in late 2004. That is roughly a fifth of the supply being mined each year. Such funds bought about 25% of the uranium sold on the spot market in 2005 and 2006. They are husbanding most of their supplies, having sold only two million pounds so far, Ux officials say.

When I first started to invest, uranium was selling for only $15/pound and it was the commodity that I was most bullish on. However, with its recent parabolic rise I have liquidated pretty much all of my uranium investments.

Some of the stocks I held were Strathmore Minerals (TSXV:STM), Energy Metals (TSX:EMC), Western Prospector (TSXV:WNP) and Strateco Resources (TSXV:RSC). I was able to make 37%, 40%, 31% and 421%, respectively on my investments in these names. For full disclosure, the only uranium stock I still own is Altius Minerals (TSX:ALS), however uranium is one of many commodities this company is involved with.

There are three reasons why I turned bearish on uranium. First, as the above articles state, speculators have purchased approximately 20 million pounds of yellowcake in the past 2 years. When this is compared to the 35 million pounds that are traded on the spot market each year, there is little doubt that investors are the main driver for the uranium price right now. If for whatever reason investors turn bearish, the uranium price could plummet just as quickly as it has spiked. Just look at how badly uranium performed in the late ’70s.

Second, the number of uranium exploration companies has increased by 40-fold in the last few years. That means that at some point, the supply of uranium is going to increase substantially.

And third, a higher uranium price will curtail demand from utilities. The mistake that many uranium investors are making is that they assume that demand from uranium users is inelastic since the cost of buying uranium is small compared to the costs of keeping a nuclear power plant running. However, this is not necessarily the case.

Utilities could reduce the amount of uranium that is used in their reactors by increasing the enrichment process. Enriching uranium has a cost, too, but for a given cost of uranium and enrichment, there is an optimal amount that minimizes costs. So when the price of uranium increases to over $90/lb. as it recently has, the utility will use less uranium and more enrichment to fuel its reactors. According to some calculations I have seen, this could significantly reduce the demand for uranium.

I am not predicting that the uranium price is about to crash. After all, uranium is such a small market that only a single billion dollar hedge fund is necessary to push its price up significantly. Also, supplies are currently tight and despite the increased exploration activity, it takes several years for uranium to be found, mined and delivered to the market.

However, when supply does eventually catch up with demand, prices will plummet and investors will get hurt badly. I don’t know when that will be, but I feel more comfortable watching from the sidelines.

Ethanol Demand Driving Up Food Prices

Earlier this year President Bush called for America to cut its petroleum consumption by 20% over the next decade, largely by using more ethanol which creates less pollution and can be produced using home-grown corn. Already there are numerous subsidies for biofuel producers which have allowed them to significantly increase ethanol production.

In the past 12 months, this has caused the price of ethanol to rise from just over $1/gallon to $1.75/gallon and corn prices to double from $2/bushel to nearly $4/bushel. Currently, corn supplies are at their lowest levels in 34 years.

The most recent CPI report seems to indicate that beef and poultry prices are being affected by higher corn prices. Most of the corn grown in Iowa is used to feed farm animals and make corn syrup for processed foods. The rising price of corn is also resulting in farmers, nationwide, planting more of it and less wheat and other crops. Therefore, rising corn prices could lead to general food price inflation.

The US could reduce these cost pressures by importing more ethanol from Brazil, where sugarcane is used as feedstock. Brazil can produce ethanol for 22 cents a liter compared to 30 cents a liter for corn-based ethanol. However, the US government is unlikely to reduce the high tariffs currently imposed on imported ethanol in deference to America’s powerful farming lobby.

This means that the Bush administration’s emphasis on ethanol as a fuel source is going to put upward pressure on food prices for the foreseeable future. I’m not sure how significant this pressure is going to be, but it’s worth keeping an eye on food prices.

Technology Improvements Increase Oil Supplies

The NY Times highlights the recent improvements in oil recovery methods that have helped old fields to become an important source of new oil supply. I don’t believe we are running out of oil any time soon because there are abundant reserves of heavy oil in the world, and improved technology — along with a high oil price — will help us to extract it.

oil_reserves

Find below some of the main points of the NY Times article:

Within the last decade, technology advances have made it possible to unlock more oil from old fields, and, at the same time, higher oil prices have made it economical for companies to go after reserves that are harder to reach. With plenty of oil still left in familiar locations, forecasts that the world’s reserves are drying out have given way to predictions that more oil can be found than ever before.

In a wide-ranging study published in 2000, the U.S. Geological Survey estimated that ultimately recoverable resources of conventional oil totaled about 3.3 trillion barrels, of which a third has already been produced. More recently, Cambridge Energy Research Associates, an energy consultant, estimated that the total base of recoverable oil was 4.8 trillion barrels. That higher estimate — which Cambridge Energy says is likely to grow — reflects how new technology can tap into more resources.

The oil industry is well known for seeking out new sources of fossil fuel in far-flung places, from the icy plains of Siberia to the deep waters off West Africa. But now the quest for new discoveries is taking place alongside a much less exotic search that is crucial to the world’s energy supplies. Oil companies are returning to old or mature fields partly because there are few virgin places left to explore, and, of those, few are open to investors.

At Bakersfield, for example, Chevron is using steam-flooding technology and computerized three-dimensional models to boost the output of the field’s heavy oil reserves. Even after a century of production, engineers say there is plenty of oil left to be pumped from Kern River.

“We’re still finding new opportunities here,” said Steve Garrett, a geophysicist with Chevron. “It’s not over until you abandon the last well, and even then it’s not over.”

Some forecasters, studying data on how much oil is used each year and how much is still believed to be in the ground, have argued that at some point by 2010, global oil production will peak — if it has not already — and begin to fall. That drop would usher in an uncertain era of shortages, price spikes and economic decline.

“I am very, very seriously worried about the future we are facing,” said Kjell Aleklett, the president of the Association for the Study of Peak Oil and Gas. “It is clear that oil is in limited supplies.”

Many oil executives say that these so-called peak-oil theorists fail to take into account the way that sophisticated technology, combined with higher prices that make searches for new oil more affordable, are opening up opportunities to develop supplies. As the industry improves its ability to draw new life from old wells and expands its forays into ever-deeper corners of the globe, it is providing a strong rebuttal in the long-running debate over when the world might run out of oil.

Typically, oil companies can only produce one barrel for every three they find. Two usually are left behind, either because they are too hard to pump out or because it would be too expensive to do so. Going after these neglected resources, energy experts say, represents a tremendous opportunity.

“Ironically, most of the oil we will discover is from oil we’ve already found,” said Lawrence Goldstein, an energy analyst at the Energy Policy Research Foundation, an industry-funded group. “What has been missing is the technology and the threshold price that will lead to a revolution in lifting that oil.”

Since the dawn of the Petroleum Age more than a century ago, the world has consumed more than 1 trillion barrels of oil. Most of that was of the light, liquid kind that was easy to find, easy to pump and easy to refine. But as these light sources are depleted, a growing share of the world’s oil reserves are made out of heavier oil.

Analysts estimate there are about 1 trillion barrels of heavy oil, tar sands, and shale-oil deposits in places like Canada, Venezuela and the United States that can be turned into liquid fuel by enhanced recovery methods like steam-flooding.

“This is an industry that moves in cycles, and right now, enormous amounts of innovation, technology and investments are being unleashed,” said Mr. Yergin, the author and energy consultant.

After years of underinvestment, oil companies are now in a global race to increase supplies to catch the growth of consumption. The world consumed about 31 billion barrels of oil last year. Because of population and economic growth, especially in Asian and developing countries, oil demand is forecast to rise 40 percent by 2030 to 43 billion barrels, according to the Energy Information Administration.

Back in California, the Kern River field itself seems little changed from what it must have looked like 100 years ago. The same dusty hills are now littered with a forest of wells, with gleaming pipes running along dusty roads. Seismic technology and satellites are now used to monitor operations while sensors inside the wells record slight changes in temperature or pressure. Each year, the company drills some 850 new wells there.

Amazingly, there are very few workers in the field. Engineers in air-conditioned control rooms can get an accurate picture of the field’s underground reservoir and pinpoint with accuracy the areas they want to explore. None of that technology was available just a decade ago.

“Yes, there are finite resources in the ground, but you never get to that point,” Jeff Hatlen, an engineer with Chevron, said on a recent tour of the field.

In 1978, when he started his career here, operators believed the field would be abandoned within 15 years. “That’s why peak oil is a moving target,” Mr. Hatlen said. “Oil is always a function of price and technology.”

Copper Prices Set to Fall

I have been nervous about base metal prices, particularly copper, for some time now. Low interest rates worldwide have allowed many hedge funds to engage in the carry trade by borrowing capital in places like Japan and investing it in everything from real estate to emerging market stocks. Earlier this year commodities became the target for their speculative buying.

How else can one explain that from December ‘05 to May ‘06 aluminum was up 50%, copper was up 100%, nickel was up 70%, and zinc was up 120%? Surely increased demand from China nor supply disruptions can entirely account for such spectacular gains.

Gold, too, increased by 60% even though the US dollar hardly fell. This was most likely due to hedge fund managers who entered the commodity markets and bought gold along with other base metals without realizing that precious metals are monetary assets that have very different factors affecting their prices. Therefore, my concern for base metals stems from the belief that once the speculators exit commodities (or start betting against them), gold could also be sold off.

Many speculators have already exited with copper down 25%, aluminum down 10%, and gold down 15% from their May highs. Incidentally both nickel and zinc are up an astounding 50% and 23%, respectively since then. Despite this, more downside could lie ahead for base metals and by extension gold as the supply-demand fundamentals paint a bearish picture.

copper_price

Copper, which is often seen as a harbinger for economic trends, looks particularly vulnerable. While the common perception is that China is the main driver for copper demand, in reality, the US economy is far more important. It may be true that China consumes 22% of global copper production compared to 13% for the US. But most of the Chinese demand can be attributed to manufacturers who use the copper they buy to produce goods that are eventually exported to the US.

Another source of copper demand is China’s growing infrastructure investments which are meant to expand manufacturing capacity. Therefore, a slowdown in the US will hurt China’s export sector and will cause a reduction in Chinese copper demand. I believe a US recession is imminent.

Already China is starting to move away from its investment-driven growth, shifting toward a more goods-related economy — a situation expected to tame its previously voracious appetite for copper. Chinese copper consumption declined by 4.7% in the first 10 months of the year according to the World Bureau of Metal Statistics.

In addition, copper demand from direct US consumption could suffer if the housing market, which consumes a quarter of the US copper demand, deteriorates. The average 2,100 sq.ft. single-family home uses 439 pounds of copper, most of which is for wiring and plumbing. If US housing starts were to fall by one million homes (about 50%) the reduction in US demand would be just under 200,000 tonnes of copper. This translates to an 8% reduction in US demand and a 1.25% reduction in global demand.

At the same time, the extended period of high copper prices has reduced demand, as alternatives have been found in aluminum and plastics. Independent industry consultant Simon Hunt estimates that around 3.5 million tons of copper in all forms could be replaced by alternative materials by 2010.

Global copper inventories monitored by exchanges in Shanghai, London and New York are the largest since 2004 after almost tripling in the past 18 months. Next year copper supplies will continue to rise, as several large-producing mines — Escondida, Codelco’s Chuquicamata, Grupo Mexico’s La Caridad and Cananea — return to full production, while expansions at Codelco’s Andina and Antofagasta’s Los Pelambres will also hit the market. Other mines such as BHP Billiton’s Spence, Phelps Dodge’s Cerro Verde, Equinox Minerals’ Lumwana and First Quantum’s Frontier will also come online for the first time.

Based on the median forecast of 11 analysts surveyed by Bloomberg copper is expected to fall to $2.61 a pound on average and will reach $2.10 in 2008. However any sort of collapse in the price of copper should be supported by a falling US dollar which I expect to pick up pace in 2007. This would cause copper’s US dollar price to appear stronger than it really is. My own forecast is that copper could trade between $2.50 and $2 per pound by the end of next year. I wouldn’t be surprised if it declines below $2 at some point in the future. However, if it reaches $1.50 I may go long.