Commodity Prices in Mineral Markets

At the heart of it, what ultimately makes a profitable enterpriseis the price (and
expected future price) received for the product. Individuals who dont
understand what is driving the price are at a distinct disadvantage in the
investment arena. As any economist is dying to tell you, prices are determined
by supply and demand. In general and at the international level, this is true for
mineral markets. However, mineral markets are different than other goods
markets and, for the unwary, there are traps. Let us talk about the demand for
minerals first. (I am assuming a normally behaving upward sloping supply
curve for my discussions on price changes)
Derived Demand
When asked what he wanted for a gift; Thomas Edison asked for a cubic foot of
copper. This was one of the few times that a mineral was wanted purely for
itself. (Gold, silver, and to a lesser extent platinum are different. We will talk
about them later.)Minerals are different than other goods. The demand for
minerals is a derived demand. We do not want lead. We want a car battery.
We do not want copper (apologies to Edison). We want an electric stove. We
do not want steel. We want a car. But in order to obtain all of these things -
batteries, stoves and cars- we must have the underlying minerals from which
they are made.
By in large, minerals are factor inputs in the production of other goods and so
the demand for the end product influences the pricing of the mineral input. In
order to predict what the demand for minerals is going to be, you must first
predict what the demand will be for the end product that uses the mineral.For
example, to understand the derived demand foriron ore,we should have a
working knowledge of the interactions of demand and supply for those products
that use steel (e.g. transportation vehicles, white goods, buildings and
construction materials). Thus, the deriveddemand is more complex and
challenging then estimating the demand for a single final product (i.e. the good
actually purchased and used). This is what makes the demand for minerals both
interesting and complicated.
Commodity Goods
To make things even more interesting, minerals are commodity goods.
Commodity goods are goods that are supplied with little qualitative
differentiability in the market. They are fungible and the market tends to treat
them equally regardless of producer. The production (or mined) location makes
little difference to the purchaser of a sheet of 99.9999% pure copper. While
there is some limited product differentiation, the price of the commodity is
determined by the market taken as a whole.
Product Differentiation
Product differentiation occurs mainly with regards to impurities. Buyers will
specify a certain mineral content and then stipulate a maximum level of
impurity. For example, sulphur, silica and phosphorous are common impurities.
When the maximum impurity levels are exceeded then penalties are assessed.
International Markets
Impurities aside, we see that mineral prices are determined internationally in
huge aggregated markets. This helps us a little bit. Because we are looking at
large national and international markets, we do not have to be concerned about
small details. For example, we do not care which type of car a person chooses.
While this may be important to the Ford Motor Company, it is irrelevant to us.
We are concerned with the iron content in the car. As long as the iron content
across automobile types is close to the same, we are indifferent to which car is
selected. The relevant point to us is, Are automobile sales increasing? Be
careful here. A large number of people (some of them respected analysts) use
the total value of automobile sales to look for changes. This can be misleading.
What you want to look at is the actual number of physical vehicles sold.
Remember we are ultimately looking for mineral content not value.
Standard Demand Analysis
We have selected our mineral, determined the relevant final products that
comprise the lion share of our market (you will never get them all so dont
worry about that). What do we need to consider (again using vehicles as an
example)? The standard demand analysis would include (in some form):
income (Gross Domestic Product at the national level),
number of demanders (population),
prices of substitutes (mass transit fares) and complements (petrol prices)
to the final product and
tastes and preferences (e.g. any discernible change in attitudes towards
mass transit or smaller cars).
We would then get estimates of the average mineral content for each of the final
goods and we cross check that with our mineral and scrap output numbers to
verify. When we have done this for the relevant final goods forthe relevant
countries, we have completed the first step.
Input Elasticities
Next we have to look at input elasticity of demand for our mineral in the final
products. Elasticities are simply a measure of the sensitivity of the quantity
demanded for an input given a change in price of the input. It revolves around:
the necessity of the input,
substitute availability and
how much of the total cost is attributed to the input.
If the input is vital to the production of the final product, and there are no
substitutes, then as output of the final good increases the amount of input use
will increase.
If the input priceincreases and there is no change in the demand for the input,we
call that an inelastic demand. It is inflexible. We would see an increase in the
mineral demand as the demand for the final good increases.Also, if the amount
of input cost to the total cost of the product is small, then changes in the price of
the input have little overall effect on the total cost and the input demand would
be inelastic. Finally, if there are no substitutes for the input and the input is
necessary, the input demand will be inelastic.
The reverse is also true.For example, if an input in not necessary and there are
readily available substitutes, then a change in price would see a greater than
proportional decrease in demand for the input. That is called elastic.
Obtaining the input elasticity allows us to see the relationship between the sale
of the final product and its requirements for the mineral input. Understanding:
first, the demand for final goods containing mineral content,
second,utilizing the input demand elasticity and
third, couplingthis with a reliable forecast of future market movements,
provides the basis for an objective view on the likely demand for the mineral. It
is not easy and that is why a good number of analysts get it wrong.
Supply Analysis
We can now turn to the supply side of mineral economics. All of these market
structures have a list of things in common. They are affected by:
technological change (e.g., automation),
input prices (e.g., wage rates),
number of suppliers (e.g., market expansion), and
Market barriers (e.g., institutional, financial and governmental).
Remote controlled ore trucks and advances in mineral exploration targeting are
examples of the positive benefit of technological change. The development of
new ore bodies capable of being brought to market by new suppliers are
examples of market expansion. Increases in transportation costs can choke off
supply; as can decreases in government export quotas (typically done for
strategic materials). Increases in technological change and market expansion
tend to increase supply. Whereas, increases in input prices and market barriers
decrease supply.
Market Structure
Unfortunately for us, one supply side model does not fit all. There are many
different mineral supply marketstructures. They cover a broad spectrum of
types. The mineral sector is a lively one; from the past near monopoly market
by the Chinese in the rare earths, dominating oligopoly (a few large suppliers)
with a competitive fringe like the iron ore industry, to a near competitive market
in gold. Where supply market structures differ is in their ability to exert market
power and influence price.
We will look atnear monopoly markets, dominating oligopolies with a
competitive fringe and near competitive markets.
Starting with competitive markets, the producer has little or no influence
on price. It is a basic take it or leave it proposition. The producers
decision is reduced to staying in the market and supplying product at the
stated price or closing down. In these markets the price is determined
based on international supply and demand. The resulting prices are then
given to the markets and provide the basis for contracts and negotiations.
For oligopoly (or oligopoly with a competitive fringe) markets the
individual companies are aware of the individual supply movements of
their large competitors. Prices have a tendency to be sticky but when
they move they tend to move together. Private companies are legally
forbidden to collude on prices but because of the intense interest that
exists among the companies and active tracking; price changes do not
remain secret for long. Once the majors have set the price, the price is
given to the competitive fringe.
An exception to this is the sovereign producers (resources owned
exclusively by the state) such as OPEC. Because OPEC is a comprised of
state owned producers, they lie outside the non-collusion requirement
place on private companies. They meet and set their production
collectively.
It is not surprising that monopolies or near monopolies have considerable
market power to set prices. They are sole or near sole producers. You
have to buy it from them or you cannot have it. This is especially true if
there are difficulties in reclaiming or recycling the mineral from the final
product.
Price InfluencingMarket Power
Some market proponents argue that price setting ability is restricted by the
customers willingness to pay and that the reduction in the quantity demanded
acts as a check. We need to be careful when making that argument because it
hinges on the concept of elasticity- the relative responsiveness to price changes.
This is true for markets will large competitive components. However, it may
not be true of all markets. For example, when the Chinese increased the price
of rare earths by triple digits, the quantity demanded of rare earths fell - but it
only fell by double digits. Consequently, large increases in price with a
relatively small decrease in quantity demanded results in a net increase in total
revenue. An increase in total revenue hardly acts as a deterrent to future price
changes. Not only that but, because they reduced their production, their cost to
produce the rare earths decreased. This increase in total revenue and decrease
in total cost added to the profitability of the decision.
(On an aside, Lynas has obtained a temporary permit to refine rare earths in
Malaysia. This market expansion may challenge the Chinese monopoly
position and potentially weaken their market power or not. The outcome
depends on what China does in the market to address this new competition.)
Demand and Supply
Now we can return to our economist friends and state that the price of minerals
will be determined where the derived demand for minerals is equal to its supply.
Changes to the price results from changes to the underlying structures of
demand and supply. Usually we rely on government forecasts, trade
associations and internationally recognized analysts for help. There is a reason
for this. Analysis can get complicated quickly.
For example, in the Chinese twelfth five year plan, there were plans put in place
that used considerable amounts of steel. An airport, 45,000 kilometres of rail,
85,000 kilometres of road, 35 million new apartments, and an increase of
automobile production of 90% to name a few. An argument can be made that
the derived demand for iron ore from China overwhelmed the decreases in
demand from Europe and the United States of America(and given supply levels)
forced the price up.
Will the price continue in the short run? The answer to that depends on whether
you believe that:
China will achieve their plan (they have successfully completed the last 5
twelve year plans) and derived demand in the west does not worsen or
China achieves their five year plan and the Western economies recover or
China fails to achieve its five year plan but the West recovers sufficiently
to maintain a high iron ore price or
China achieves their five year plan but effects are is insufficient to
counter act the reduced derived demand from the West or
Events in the west worsen such that the reductions in derived demand in
the west overwhelm the upward pressure on iron ore prices from China
(plan achieved or not) or
Events in the west worsen and China fails to achieve its five year plan or
Events in the west worsen and China fails to achieve its five year plan but
growth in India increases or
Etc.
It is easy to see why the analysis can get complicated quickly.
Force Majeure
Economic systems work efficiently. However, there are other factors that can
influence mineral prices. These are external to the inner workings of the
market. They can be human (e.g., wars), geologic (e.g., earthquakes) or
climatic (e.g., cyclones). These events are unpredictable and unavoidable.
These events can affect demand or supply or both. Even the best analysts can
be caught unawares. The recent civil unrest in the Middle East and the tsunami
in Japan are examples of this.
Precious Metals
In addition to the above effects, the precious metal markets have special
considerations. Gold and silver have historically been used as money.
Consequently, they possess other characteristics that give them additional value.
They are looked at as a store of value, a unit of account and a medium of
exchange. In some parts of the world, precious metals are trusted more than the
local currency. In others, gold and silver are considered a way to reduce
risk.Thevalue of precious metals is considered safe because they are believed
toretain their relative value better than other assets.This may or may not be true,
but it is a widely held belief nevertheless.
This is particularly important to peoples in uncertain situations. For example,
when I lived in Kuwait, I noticed a large number of expatriated women had a
significant amount of gold bangles on their arms. I asked one why this was the
case. She told me she didnt trust her circumstances (or the banks) and that if
she had to leave hurriedly -she raised her arms and shook her wrists -she had
her money with her.
An interesting side-bar, some nations require the reporting of movements of
significant amount of currency (e.g., $10,000) but not jewellery. Gold at over
$1500 an ouncemeans a family of four could wear the equivalent value of gold
necklaces, bracelets and bangles without being asked to declare it. To some
individuals this could be important. All of these factors make precious metals
demand (and consequently prices) very difficult to estimate. Fortunes have
been made and lost over the latest sure-fire method to predict gold prices.
Bilateral Contracts
A bilateral contract is an agreement between two parties a demander and a
supplier. (A similar situation exists for multilateral contracts - only there are
numerous suppliers and demanders rather than one each). For the mineral
market, these tend to be made at the ends of the market. These are usually (but
not always) the small (or start-up) and the large mineral suppliers.
The small or start-up suppliers need some evidence of consistent sales/revenues
in order to obtain financing. A document from the demander indicating a
multiyear contract, at a certain price, is often used. In some cases, the demander
of the commodity will go so far as to provide some of the financing themselves
(usually for a favourable price consideration and specific product requirements.)
At the other end of the spectrum, the large producers negotiate directly with
large customers to form multiyear agreements. This is done because the scale
and scope of these large operations are such that neither the supplier nor the
demander wants interruptions in the orderly flow of output/inputs.
Bilateral contracts are difficult for the outside market to take into consideration.
We know they exist but we do not know to what extent. The bilateral contract
negotiations are conducted in confidence and sometimes just presented to the
market, sometimes not.
In most instances there are adjustment mechanisms included in the contracts
that allow for price changes to occur. These allowances stipulate the price will
remain constant over a certain time period and then can be adjusted in whole (or
by a certain percentage) to reflect the current market price. These adjustment
mechanisms act as a buffer to the active (non-contracted) commodity market.
The buffers slow the rate of increase and dampen the rate of decline in the
market according to the allowed adjustment percentage. This is what provides
some of the stickiness (resistance to change) in the large oligopoly type markets
we mentioned earlier.
An interesting side-note here is: we can often tell whether the expectations for
future market supply or demand is greater, by who wants to remove (or change)
the price adjustment scheme for the contract.
If market demand is anticipated to increase (thereby causing prices to
increase) then, the supplier will want to void the adjustment process and
take the spot market price.
If market demand is anticipated to decrease (thereby causing prices to
fall) then, the demander will want to void the adjustment process and take
the spot market price.
If market supply is anticipated to increase (thereby causing prices to
decrease) then, the demander will want to void the adjustment process
and take the spot market price.
If market supply is anticipated to decrease (thereby causing prices to rise)
then, the supplier will want to void the adjustment process and take the
spot market price.
So even in a bilateral contractual market, supply and demand act to help
determine the market price. Our economist friends will be pleased to hear that.
Reclaimed and Recycled
The final topic we will discuss is reclaimed and recycled minerals (R&R) also
known as scrap. The R&RM market is a secondary market that primarily exists
for the metals markets. R&R metals usually cost more to produce than those
from the original ore. Consequently, the R&R market is sensitive to price.
R&R operators enter into the market if the price is sufficiently high enough to
justify the effort. The scrap merchants try to buy at a discount and sell at a
premium.
This is most easily seen in the gold R&R market. Recently, I wished to sell an
old gold ring I had. I was told that the ring was 9 karat gold and worth only
$600. I sold it to be rid of it (and its memories). When I walked past the shop
later in the week and there was the ring. Only this time, it was described as 18
karat gold and worth $1800. This illustrated clearly to me the machinations of
some of the scrap metal markets.
Similar situations can exist in other scrap metal markets. The price differentials
may not be as dramatic as those with gold, but the operations of the markets are
the same. Buy low and sell high.