End of the Beginning

The global super-cycle in gold and other commodity prices has only just got started...

A TRUE PIONEER of global investing, Adrian Day runs boutique global-investing firm Adrian Day Asset Management, says Lara Crigger at Hard Assets Investor.

Combining complete independence with a global purview and long-term value philosophy, Day has just published his latest book, Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks (Wiley). Here, he discusses how investors can profit from the global resource boom that will affect all commodities over the next decade or more...

Hard Assets Investor: In your new book, Investing in Resources, you argue we are in the midst of a commodity super-cycle. How much longer will this commodity super-cycle last?

Adrian Day: Resources, as we all know, tend to be exceptionally cyclical. We go through bull phases and bear phases, depending on how the economy is going, but for commodities, this tends to be exaggerated even more over other markets.

However, we have had very long, very sustained periods of higher prices at various times over the past several hundred years, and they tend to come along whenever we have a major step-up in demand. You always have increases in demand and supply shortages, of course, but the super-cycles that go on for years and years, they tend to be set off by a new source of demand.

That's what's causing this new super-cycle; namely, the new source of demand from China. We all have heard about it, but I'm not sure many people realize just how significant it is. Not how significant it has been. But how significant it will be in the years ahead.

To paraphrase Winston Churchill, I think we're only at the end of a beginning. I don't think we're anywhere near the end of this bull market. I think it could go on at least a decade or more.

HAI: You specifically point out China there. Is it just China that we should look to for increased resource demand for the future? Or is China just one of many emerging markets, maybe the largest, that will matter in the coming years?

Adrian Day: The way I see it, China is not just first among equals. It is far and away the prime mover, both in the past three years, but also in the next few years. It has been far and away the most dominant driver in moving commodity prices.

But having said that, if you look at the other major population centers that are developing and industrializing – India, Indonesia, Brazil – they are quite a ways behind China in terms of that great step-up in demand. The interesting thing – and perhaps the scary thing – is that when China's demand for commodities starts to flatten off in 10, 15 years, then if history is a guide, that will be right around when India will start that major step-up.

When you look at countries that change from rural economies to urban, industrialized economies, they go through similar patterns. Over a long period – perhaps a decade or two – the demand for resources slowly moves up; it might double or triple, but only from very low bases. Then they reach a critical take-off point in per capita income, and the demand for resources explodes almost exponentially.

HAI: But at some point, that demand has to level off. It can't continue forever.

Adrian Day: Of course not. As economies mature, then the demand starts to flatten off. We've seen that with Britain, Germany, the US, Japan.

Let's look at oil, which is a major resource central to an industrial economy. Japan was flat on its back after World War II, but at the end of the '50s, its economy started to develop. The per capita consumption of oil in Japan went from about 2.5 barrels per year at the beginning of the 1960s, to 15 at the end of that decade.

Then take Korea. At the same time Japan hit that take-off point, Korea was just at under 1 barrel per person. It moved up slowly, slowly to 4.5, and then suddenly it hit that take-off point in the 1980s, and within a decade, it was consuming just over 15 barrels per person.

HAI: Fifteen barrels per person sounds like a bit of a running theme...

Adrian Day: Other than the US, which is a bit of an outlier, most industrial economies consume around 15 barrels of oil per person per year. It's the same in Britain, France, Japan, Korea. Most industrialized companies – whether they're heavy industry or not, service oriented, green or not green – they all consume about 15 barrels per person. And that's where it stays. The economy matures, and that's what's needed to drive a modern industrial economy, even through recessions and deflations.

So if we look at China, China consumes considerably under 2 barrels per person now. It's at about 1.7 barrels per person, and that's up from just under half a barrel per person 10 years ago. Just imagine the effect as China starts to move from 1.7 barrels to 15. Now, I'm not saying it will go there any time soon, but that's been the pattern in history. Maybe it just goes to 7. Maybe it just goes to 3.5. It would still be a doubling of the per capita consumption of oil – and you've got 1.3 billion people in China, 20 percent of the world's population.

That's why China's impact on resource demand will be so much more significant than was Taiwan's, or Korea's or Japan's before it.

HAI: What about supply constraints? We've heard a lot of talk about diminishing supply over the past few years – how does that factor into the resource story moving forward?

Adrian Day: My view on most commodities – particularly for resources, the non-ags – is that it has become increasingly difficult to find large deposits that are economically viable at today's prices and that are politically and environmentally jurisdictions. And all those qualifications are important.

But the price and the technology and the political/environmental environments, these are just overlays to the fundamental issue, which is that even if we're not running out of resources, per se, they are finite. The resource deposits that we're finding are smaller, more technically challenging or they're in less stable countries. And it's becoming increasingly difficult to find them.

Take gold, which is a very clean example. The price of gold has quintupled over the past decade; you'd think that if the price of any good quintupled, there would be an increase in supply.

HAI: Right. But it's stayed flat; mining supply's remained flat since about 2005.

Adrian Day: Actually, up until last year, new Gold Mining supply was actually down 14%. That shows you it's not as easy as people think to ramp up your production in response to higher prices.

Now let's look at the next step, which is finding new deposits. As the price of gold has quintupled, the exploration budgets worldwide of all companies have also quintupled since 2001. You'd think with a higher price making mines more economically viable, and increased incentive to develop mines, and more money looking – you'd think we'd have an increase in the number of discoveries. But quite the opposite. For the last 10 years, we've had discoveries each year round about 10 million ounces. But 15, 20 years ago, we were finding anywhere from 30 million ounces a year.

So the number of discoveries of major deposits has just collapsed. And it's the same in copper, and the same in a bunch of other commodities. That, to me, is the compelling thing. Even with every incentive and means, we simply can't find the deposits we need.

HAI: How will this higher demand/diminishing supply story affect the volatility common in commodities markets today? Are resource markets going to remain as volatile as they are today, or become more so?

Adrian Day: Over the next five, seven, 10 years, we're likely to see more volatility on the upside. We could see very sharp spikes in prices upwards on any disruption that happens. But instead of returning to well under the mean, I suspect prices will stay higher. The long-term movement upward will be less volatile, meaning I don't think people should be waiting too long for corrections or price fallbacks. We'll get them, of course, but I don't think they'll be as long or as deep as people are used to in normal cyclical markets. Any retreat will be short-lived, because prices will come back quickly.

We saw that in 2008, 2009. The decline in commodities – although we were all worried at the time – looking back at it, it was almost insignificant. It didn't matter.

HAI: Sure. Most commodities have made back most, if not all, of what they lost in the crash.

Adrian Day: That's right. And that was an extreme circumstance, of course, and also we had this terrible imbalance that had built up in the six to nine months prior, with overstocking and over-inventory. So you had de-stocking when the economy slowed, and not buying anything because the end users like China had more than enough inventory.

HAI: Many commodities that you point out in your book – rare earth metals, many base metals, even some softs – are located in less-than-stable countries or geopolitical regions...

Adrian Day: It's clear that more and more countries, and it's not just the unstable ones, are looking to anything that moves as a source of tax and revenue. Commodities are an easy target, because if you have a mine, you can't just up and move it, like you could a factory. A mine is there. Of course, what many governments don't realize is that they think the world is static. They forget that BHP has choices – they can invest in Brazil or they can invest in Australia.

HAI: We saw this come to a head in the big debate over the Australian mining tax earlier this year.

Adrian Day: Right. You can't move Olympic Dam. But you can decide not to put the $3 billion to make the expansion there, and instead put it somewhere else. But that's just one political issue. You're going to see more of this elsewhere.

But that doesn't affect the long-term supply/demand imbalance negatively in any way. Nor does it invalidate the case that commodity prices are going to rise. But it does two things. It makes those price spikes more likely, and more significant and common; but also one has to worry about when one invests in stocks. If you're investing in cocoa, and if something happens in West Africa, then your contract would respond positively, but if you're invested in an equity of a company, then it's a different issue.

So different people have different levels of political risk. The way I look at it is this: You're going to have more than enough reward for most people by investing in the safest commodity stocks in the safest places.

HAI: You don't necessarily have to go out to frontier markets and buy up mining companies there. There are opportunities closer to home.

Adrian Day: Yes, but it's a matter of one's own risk tolerance.

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