29/07/2010 - 00:00

Commodity constraints to drive prices

29/07/2010 - 00:00


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Iluka Resources has had some good news of late, but many may have missed it.

HAVE you ever noticed how financial forecasts are so often wrong? The high error rate means that we tend to treat projections about the future with the same contempt as weather forecasts – and miss the tips that are correct.

Time is often the missing factor in forecasting because people close to a situation believe their predictions about future profits, or the demand for certain goods and services, will arrive quicker than they invariably do.

Iluka Resources, the local titanium and zircon miner, is a case study of premature optimism that damaged the company’s reputation, followed by investor disregard, which has cost investors money.

Every year, for much of the past decade, Iluka executives repeated forecasts that the world was running low on zircon, a mineral used extensively in basic ceramics such as bathroom fixtures, and titanium pigment used in paint.

If that ancient Greek story teller, Aesop, had not created the fable of the little boy who cried wolf Australian parents would today be telling the tale of Iluka, the mining company no-one believed – until it was too late.

Over the past year, with everyone yawning as Iluka management trotted out its forecasts about rising demand and falling supply, a strange thing happened. They finally got it right.

One comment in last week’s excellent June quarter report sums up the Iluka situation: “In the case of zircon (there was) an inability to meet customer requirements fully”.

In other words, the long-predicted gap between stagnant global supply and rising demand, especially from China as a zillion new bathrooms are fitted out, triggered a scramble for supplies of zircon, driving the price sharply higher.

On the stock market Iluka, which has been the sick man of Australia’s mid-tier miners, has suddenly become a bit of a star, scaling the $5 price barrier and hitting a 12-month high of $5.59, aided somewhat by recognition of a previously under-valued iron ore royalty.

Since July last year, Iluka has doubled in value, a performance that falls into the better-late-than-never category.

If you study Iluka’s 10-year record of over-promising and under-delivery, followed by a blaze of enlightenment, you might even detect a similar pattern in other commodities as the world stumbles towards a condition the management consulting firm, McKinsey & Company, calls ‘commodity constrained’ – code for not enough stuff to satisfy global demand.

Consider two other examples.

• Uranium. Like zircon, uranium has been the subject of years of forecasting about a supply shortfall and demand surge from new nuclear power plants, leading to a price boom. In Fremantle last week the same old tune was played, and no-one outside a hardy band of true believers stopped to listen. In time, and this is probably a prediction in the weather forecasting category, uranium will “do a zircon”. Supply will struggle to meet demand and the price will shoot sharply higher. When, you might ask? Best guess is that the supply/demand crunch will start to be felt in about two years’ time, and get steadily worse.

• Gold. Despite being a metal with few useful purposes once you exclude body adornment and dentistry, gold is a commodity that has been causing arguments about its value for about 5,000 years. During the past few months, as the gold price has scaled the impossible height of $US1,200 an ounce, the non-believers have broken cover and penned derogatory stories about the metal. The common theme is that a thinking man can recognise that gold has no real value because you can’t consume it in some way – an argument that fails two tests. Firstly, and the one the non-believers hate, gold has risen because there are more buyers than sellers (Adam Smith 101), and secondly because even thinking men recognise that governments around the world continue to destroy the value of paper currencies, perhaps at an accelerating rate as they seek to ‘inflate their way’ out of their communal debt crisis.

Cornering cocoa

FOR anyone not interested in the great supply/demand crunch the world faces as McKinsey’s era of commodity constraint nears, there is a marvellous ‘soft’ example of what happens when buyers outnumber sellers.

Cocoa, the critical ingredient in chocolate, and a product more important than gold, was treated to a demonstration of market forces at work when ‘Mr Choc Finger’, a commodity dealer also known as Anthony Ward, spent $US1 billion to buy 240,100 tonnes of cocoa beans.

That purchase pushed cocoa prices to a 33-year high and will force most of the world’s chocolate makers to deal with Mr Ward’s trading house, Armajaro, which has been cleared of ‘abusive behaviour’ in the market by the London Cocoa Exchange.

Cornering a market, which is what Armajaro seems to be attempting in an effort to drive prices high, was last seen on such a scale back in 1979 when the Hunt brothers (Nelson Bunker and Herbert) snatched control of about half the world’s silver, driving the price from $US11 to $US50 an ounce – only to watch their fortune dissolve when commodity market rules were changed.

The lesson for investors from Iluka, uranium and gold is that the McKinsey prediction of future commodity constraint is real, and while it is unwise to not have exposure to commodities there is never any certainty about when demand will exceed supply, with the biggest game in that space being the day we really (as in truly, rooly) start to run out of oil.

Talking about gold ...

KALGOORLIE’S annual gabfest and combined swim-thru, Diggers & Dealers, kicks off on Monday with a keynote address from visiting British financial historian Niall Ferguson, who might provide a few useful comments about the future price of gold.

While unlikely to fall into the trap of tipping a particular price at a particular time, Mr Ferguson will be pressed by the Kalgoorlie crowd to say more than the obvious; that people in the Western world have become very wary of soaring government debt.

But is gold the answer? We await the arrival of a man who has thought more about that question than most.


“He who owns the gold makes the rules.”



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