The paths taken by gold, oil, copper and coal prices are supposed to be simple to forecast...
Increased demand leads to higher prices, inviting new exploration and investment...which increases supply just in time for consumers to lose their appetite thanks to those higher prices.
In other words, the commodity market pedals about on a cycle. Up, down, up, down...or so the theory goes.
To be sure, the "commodity cycle" is clear to see if you look at the last 25 years – especially if you have the advantage of hindsight. Oil and gold both set record prices at the start of 1980. That led to massive investment in new production. Gold and oil then both spent the best part of 20 years falling in price as that new production came on-stream. New demand just couldn't keep pace.
Oil dropped from above $40 to just $10 per barrel. Gold sank from $850 to just $250 per ounce. And to prove that the "commodity cycle" is a fact – not merely a theory - mining and drilling investment then dried up and future capacity shrank.
Surprise! Prices began climbing again at the turn of the millennium thanks to the new shortfall in supply. Oil has risen more than six-fold so far. Gold has nearly trebled in Dollar terms, and doubled in terms of just about everything else.
So fast forward to December 2006, and the commodity cycle is now nearing its top once again. So says a slew of analysts' reports published this week. What's an investor to make of it?
Merrill Lynch expects price pullbacks for all base metals in 2007, with copper hit hardest. The causes, it says, will be a slowing US economy driven by collapsing US house prices, plus a weakened Dollar, easier demand from China, and the growing substitution by end-users where possible. Macquarie Bank in Australia agrees, forecasting lower prices starting in early 2007. Come the last quarter of 2007, and analysts at BIS Shrapnel predict that metals prices will go into freefall.
"As mining projects are completed, supply comes onstream and inventories are re-stocked," says Richard Robinson at BIS Shrapnel, "commodity prices will begin falling, particularly after speculative activity drops-off."
He reckons that the world economy will slow down just as global commodities production expands rapidly. The resulting over could lead to "dramatic price falls" over the next 3 to 4 years – most notably in nickel (forecast to fall 60%), copper (down 59%) and zinc (down 46%).
"The [Australian] forecaster believes there's an enormous amount of work in the pipeline," reports FN Arena News, "and with several more projects still to commence, total investment by the mining sector should still rise by circa 11% over the next two years."
But can the global market in metals or energy really be this simple to call? Firstly, rising costs are eating up a huge chunk of new exploration and production spending (E&P). "Data compiled by the International Energy Agency show that investment in the oil-and-gas industry was $340 billion in 2005, up 70% from 2000," reports the Wall Street Journal. "But cost inflation for goods and services used by the industry accounted for almost all of that increase, according to the IEA, the energy club of 26 of the world's major industrial nations. Adjusted for inflation, the oil industry's investment increased by 5% between 2000 and 2005, the IEA, based in Paris, said..."
It's the same story amongst the major mining firms too, not least in the gold market. Frontier Pacific Mining Corp. said last week that its Perama Hill gold mine in northeastern Greece will cost 15% more than its original estimate. Newmont Mining, the gold mining giant, said last month that its costs per ounce have risen 35% year on year to $318 an ounce.
Next comes the risk of delays, accidents and industrial action. BHP Billiton lost 19% of its total copper production in the 3rd quarter, thanks to a month-long strike at its key Escondida mine in Chile. Teck Cominco said its zinc output for the quarter would drop 28% after unseasonal weather delayed shipments from its Red Dog mine in Alaska. The explosion at a BP refinery in Texas last year killed 15 workers and cost the oil-giant US$1.6bn in compensation. This March it lost 200,000 barrels of crude from leaky pipes at its Prudhoe Bay field in Alaska.
Finally, there's M&A activity. Amid the greatest bubble in stock market mergers and acquisition in history – a bubble that surpassed the peak of 2000 in the first 10 months of this year alone, with a spend-to-date of US$3.37 trillion - medium and larger-sized mining companies are looking to grow through acquisition, not new exploration. Mittal Steel this year bought French rival Arcelor for $39.5bn. Copper giant Freeport-McMoran spent $26bn on its rival, Phelps Dodge. Suez Gas tied-up with its French counterpart Gaz de France at a cost of $43.1bn.
Of course, merger and acquisition activity is supposed to peak out at the top of an investment cycle. With price/earnings ratio in the mining sector still sat in single digits, buying proven reserves and productive capacity is much safer than hiring geologists and drilling new bore-holes. But simply bolting on another firm's productive capacity to your own does not increase the sum total of available barrels, ounces or tonnes in the years ahead.
And all the while, this "commodity cycle" is now barely 6 years old. Given that the last bear market took 20 years to work through, history repeating itself would mean there's much further to run for base metals, oil and gold before over-supply and high prices turn the market upside down.
Expect to use your brakes along the way. Don't rely on Wall Street analysts to fix your stabilisers.