Is the Natural Resource Bull Market Over?

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Published on Friday, 28 September 2012 12:37

Written by Rick Rule, Guest Editor, Inside Investing Daily

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The precipitous declines in commodity prices and the prices of natural resource equities -- particularly, junior resource equities -- have caused many commentators to declare that the natural resource bull market is dead.

Given my repeated admonition that one is either a contrarian or a victim, this question is one of some importance to my firm and me.

I believe, for reasons we will explore in this essay, that we are in a cyclical decline, in the middle stretch of a natural resource bull market that is very much alive.

A History

It is useful to examine the great resource bull market of the 1970s to understand my thesis. Readers will recall that most commodity prices soared fivefold or more over a 15-year period, headlined by gold, which advanced from $35 to $850 per ounce at its peak.

Numerous equities outpaced those lofty gains. The 1970s bull market began in response to normal supply-and-demand imbalances. On the supply side, investment in productive capacity had been constrained for nearly three decades -- first by the Depression, then by World War II and, finally, ironically, by a general securities bull market that shifted capital investment away from commodities production to more advanced manufacturing.

The supply shortages were aggravated by the politics of the Cold War, which at once restricted Western access to Eastern Bloc resources and restricted Eastern Bloc access to Western capital and technology.

On the demand side, World War II generated massive consumption pressures of all materials, and a strong postwar recovery in the 1950s and 1960s brought economic activity and commodities demand to levels that were unimaginable 20 years previously. The rebuilding of Europe from the devastation of war also consumed large material resources. As well, world trade advanced rapidly in the postwar years, which led to increases in demand from societies that had not been traditional participants on global commodities markets, most particularly in Japan, Taiwan and South Korea.

These pressures from supply and demand were exacerbated by several other factors that we must remember. Political and social pressures in the Middle East led to the Arab/Israeli conflict and the oil embargo of 1973, which caused a structural change in energy prices.

An increased level of government expenditures and increasing government debt led to rapid monetary growth and inflation, which lowered the value of the fiat currencies that resource prices were denominated in and, hence, raised the nominal prices of commodities.

Finally, new entrants and re-entrants to the world economic order, such as Germany, Japan, Korea and France, were scrambling to secure access to resource supplies in response to their economic growth and the realization of the strategic importance of secure commodities supply.

Does any of this feel immediately familiar?

Another interesting facet of the 1970s resource bull market is worth noting in the context of the current market.

A Cyclical Decline

In 1975, in the midst of the greatest gold bull market in recorded history, we experienced a 50% cyclical decline in a secular bull market. From 1970-1975, the bullion price had advanced from $35 to over $200 per ounce, and over a one-year period, the bullion price collapsed by half, to a little over $100 per ounce.

Gold equities -- particularly, small gold equities -- fared worse. Investors and speculators who lacked the cash or the courage to "stay the trade" and maintain their positions missed a six-year period in which the gold price advanced eightfold and gold related equities did much better. Might there be a lesson here?

The Genesis of This Resource Bull Market

Fast-forward to the beginning of this millennium. We were at the onset of a great natural resources bull market. The resource sector was not on anyone's mind. The 1990s equity markets, and in particular, the U.S. equities and tech bull markets, occupied center stage in the investment arena.

But in resources, the hints were apparent, for those who bothered to look.

Numerous resource commodities were priced in the market at below production cost, so clearly, supply was being constrained by extractive industries in liquidation. In fact, underinvestment in resource industries continued for two decades, through the 1980s and 1990s, as a function of falling commodity prices and more attractive returns available in other sectors. These supply shortages were aggravated by increasing "resource rents" extracted by governments' desperate searches for revenue and increased costs associated with environmental concerns and regulations -- which, in combination, increased capital and operating costs while lowering return expectations.

On the demand side, the decades of the 1980s and 1990s saw synchronized global growth and explosive demand growth for raw materials. The renaissance in Eastern Bloc, emerging and frontier markets were the most important demand changers; as billions of people became gradually more free, they became rapidly more wealthy. New economic entrants, particularly the BRIC economies, sought to secure access to resource supplies. Concerns began to mount, again, about public sector spending, government debt levels and the sanctity of fiat currencies.

Once again, the primary forces of supply and demand gave us a powerful natural resources bull market. And now, according to many, this market is over.

To test this thesis, let's examine the fundamentals: supply and demand.

Today

On the supply side, with some notable exceptions (North American natural gas, iron ore and coal), the picture is for increasing tightness. Several important commodities are priced below total costs of production, so current levels of supply cannot be maintained without price increases. These include North American natural gas, zinc, uranium and platinum.

The current credit market conditions, in which bank balance sheets are compromised and credit is mostly available to sovereigns, make it very difficult to build new large-scale resource projects. Witness BHP's shelving the Olympic Dam expansion and the inability of the mining industry to advance any of a dozen feasibility-stage, large-scale copper deposits.

In oil, in particular, state participation will constrain supply. National oil companies (NGOs) around the world have been diverting cash from sustaining capital investments in domestic energy production to politically expedient domestic expenditure (including, ironically, energy subsidies), which is dramatically reducing production capacity in Mexico, Venezuela, Peru, Ecuador, Iran and Indonesia. To that, add war-related supply disruptions in Libya and Iraq.

Reinvestment is further constrained by a global grab of resource cash flows by revenue-desperate governments and threats of outright nationalization in South Africa, Zimbabwe, Bolivia and Argentina.

Finally, social turmoil in resource-producing regions -- South Africa, Congo, Mali, Peru -- and political upheaval associated with the "Arab Spring" and, particularly, the Israel/Iran conflict present the specter of supply shortages, rather than surpluses.

As for demand, the big story is emerging and frontier markets. About 30 years ago, Deng Xiaoping famously stated, "To be rich is glorious."

Around the globe, 3.5 billion people at the bottom of the demographic pyramid have been becoming more free and, as a direct consequence, richer. They want to live as we live, and as they get wealthier, they can more readily compete with us for commodities.

It is critical to understand that when poor people get more wealth, the expenditures that provide the greatest increase in their lives are commodity intensive. They buy "stuff."

We in the West already have too much "stuff." We buy services, luxury goods and leisure. Poorer people buy calories, steel roofs to replace thatch, gasoline to replace muscle. On a global basis, per-capita demand for resources is exploding, spread over 3.5 billion "capitas." Emerging market powers, particularly China, India and the Gulf Cooperation Council (GCC) countries are investing aggressively around the planet to secure the resource assets they need to continue to grow their economies.

Once again, outside factors come into play in commodity and resource equity markets.

Many developed economies face unsustainable levels of debt and unfunded entitlement obligations. Simultaneously, many of these same nations have uncompetitive economies. The political leadership in these countries is consciously debasing these currencies, in competitive devaluations, to lower export costs and inflate away obligations.

Concurrently, the Western policy response to our ongoing financial services crisis has been to embark on a fiscal regime that substitutes liquidity for solvency. The increases in fresh injections have come from all corners of the globe: the U.S., Japan, China and Europe.

These are injections of freshly printed fiat currency at rates far greater than the aggregate increases in the value of goods and services generated by their economies.

One might describe the process as "official sector counterfeiting." This "counterfeiting" is lowering the purchasing power or devaluing these currencies. As commodities prices are denominated in these currencies (primarily, the U.S. dollar), reductions in the values of the currencies tend to result in an increase in the nominal value of the commodities.

Another factor potentially weighing on commodity markets is ongoing political and social instability. Conflicts have already greatly reduced petroleum supplies from Iraq and Libya. Western sanctions against Iran threaten to further disrupt oil markets. Social instability throughout the African continent -- and through much of the Arab world -- could further constrain global access to all types of commodities exported from those regions. In particular, the threat of Iranian efforts to obtain nuclear weapons -- and the Western and Israeli response to those efforts -- could greatly disrupt the world oil trade.

Conclusions

Readers must consider whether the current global economic conditions are still conducive to resumption in a secular bull market in commodities and resource equities.

We at Sprott believe that currency debasement will lead to increases in the nominal pricing for commodities. We believe that supplies will continue to be constrained by the availability of long-term project debt due to the financial crisis and the insolvency of banks. We believe global conflict, taxation, regulation and nationalization will also constrict supplies. We believe that demand, particularly from emerging and frontier markets, will continue to increase. We believe that a shift in the global balance of economic power toward younger, more vital and poorer nations will drive investment in resources to secure access to supply. These are not the conditions precedent to a "bear market."

Readers, what are your beliefs? If they are similar to ours at Sprott, we invite your inquiry. We are a debt-free natural resources investment company, managing or administering in excess of $10 billion in resource and bullion assets. If your beliefs are concurrent with ours, we would like to get to know you better. Visit us online at www.sprottglobal.com, or phone us at 800 477 7853 (U.S. or Canada) or 1 760 943 3939.

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Today, we're continuing the post-conference bulletin series with a piece from Rick Rule. He was one of the attendees' favorites from the "Roadmap of the New America" conference. I've often heard it said that you just need to give Rick an audience, and he'll talk forever. The same applies to writing, apparently… he’s put together a really nice piece for you today. You don’t have to miss out on Rick's presentations from the conference, either. In fact, it's not too late to see the entire conference right from the comfort of your own home. Click here to check out everything you missed...

Your No-Longer-Roving Reporter,

Nick Rose