I am going to start this blog post with two charts. Readers of my previous blog post – Anatomy of a cyclical – should recognise the first one. It is essentially the same chart I showed in my parable of Cyclical Corporation, only this one is real.
The chart is taken from the Credit Suisse HOLT model aggregate for the global diversified mining industry. The blue bars represent the profitability of the mining industry. The green line shows the industry’s cost of capital in real terms. And the little green dot shows you the future level profitability that current stock market prices are implying.
The second chart shows the performance of the FTSE mining index over this period.
These two charts tell me that investor expectations towards the mining sector are very depressed. The green dot in the first chart indicates that the Chinese commodity “super-cycle” hype of yesteryear has now firmly been confined to the dustbin of history. In fact, it tells me that investors do not even expect the mining industry to make an economic return above cost of capital for the next few years. The second chart shows how this change in expectations has happened – via a dramatic fall in valuations across the sector as commodity prices have collapsed.
Does this mean we should rush out and buy mining shares? Not necessarily. But it certainly does warrant considering whether the outlook is really as bad as everyone now seems to think. In order to do this, it is necessary to understand some basic long-term fundamental drivers of the mining industry.
Commodities such as copper and iron ore form the backbone of everything that makes up modern industrialised economies. They have done since the birth of capitalism and it seems fair to assume they will continue to do so. But what determines the price of commodities?
In the short term, the price is determined by the balance of buyers and sellers – i.e. supply and demand. Commodity prices have collapsed in recent years because China has been demanding less than expected whilst supply has been growing.
However, over longer time periods, price discovery is determined by the cost of production. This is due to natural depletion of existing mines which means that more capital must be ploughed back into the industry to maintain or grow production. If the price of a commodity is very low then new capital will not be invested in its extraction. Production and supply will fall and eventually the price will move to an equilibrium level where new investment is sufficiently incentivised to meet future demand. This is a powerful and often under estimated mean-reversionary force.
The price of commodities can themselves influence the cost of production. For example, in boom times when commodity prices are rising, the input costs for mining companies such as local labour rates, diesel fuel and local exchange rates, can also rise. And of course the opposite occurs during a bust. However these factors are ultimately cyclical in nature.
Over the long-term, the cost of extracting commodities from the ground will be determined by the quality of the resource and the productivity of the production technologies used. Prices can only be expected to go down over time if the resource becomes more abundant and / or production and extraction technologies improve.
So what, if anything, can we infer from today’s commodity price environment?
Analysts at Bernstein have done a tremendous amount of research examining the history of commodity prices and profit margins across the mining industry. Their firm conclusion based on this work is that the current low level of profitability across the industry is not sustainable.
The chart below shows mining industry profitability over the past 30 years. Since this chart was published commodity prices have continued to fall which means profitability will have declined further, most likely to the lowest point ever recorded over this period.
Importantly, there is also compelling statistical evidence pointing to mean reversion in profitability, which is exactly what we should expect to see given the reasoning outlined above. The following chart, which goes back to the 19th century, shows margins across the copper industry. The red dotted line shows the margin implied by current spot copper prices. It is clear that the current level of profitability is amongst the lowest ever recorded and way below the long-run average.
This is the reason why, for the first time in my career, the mining industry now looks interesting to me1. The combination of depressed valuations, very low market expectations, and strong historical evidence of cyclical mean reversion, suggest to me that the downside risk from here should not be that great. I believe the big money has already been lost in this sector.
I can only see two ways to construct a bear case on mining shares from here:
1) An extremely negative long-term macro-economic view on the Chinese economy. It is no secret that China is the main global consumer of commodities, accounting for over 50% of global sea-borne demand for copper and iron ore. Most of this demand has driven genuine industrialisation and deepening of the capital stock, but a significant proportion of it – no one knows quite how much – has been mis-allocated to areas where it is unlikely to generate an economic return. The result has been rising debt levels and fears that the whole edifice will come crashing down. If this does happen then commodity demand will fall further and the mean-reversion process whereby mining margins recover will take longer to happen. However, it is far from clear to me that the Chinese economy is about to collapse. It is quite possible that the economy is just in the process of moving to a lower rate of growth, where the industrialisation process will carry on albeit at a slower pace.
2) An expectation that the cyclical factors outlined above will fall a lot further, resulting in a much lower absolute level of mining profitability even though mining profit margins may still mean-revert. For example, if the dollar rises another 50% versus the Australian dollar, Brazilian real and other commodity currencies, whilst local input costs keep falling then mining profits can still fall further as commodity prices fall along with the cost of production. However, even in this scenario, the downside for mining company shares – particularly those with strong balance sheets – may not be that significant given how low market expectations already are.
1. This is no recommendation to buy or sell any particular security