Commodity Pricing

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When watching Canadian financial television, one is struck by the confidence of analysts in predicting long-term commodity prices; prices in the long run will be lower than commodity prices today. This may be true for some commodities like thermal coal and zinc, but it is not always the case.

Every commodity analyst graphs contango curves to project future pricing for a commodity. Most analysts consider current high prices a short-term phenomenon. Further, we will see a reversion to a balanced supply and demand situation in the near term, where suppliers will provide commodities at a reasonable price based on the marginal cost of production.

For some commodities such as iron ore, where the theoretical supply is infinite, supply will likely exceed demand (assuming the oligopoly allows it) and pricing will shift back to equilibrium. In other commodities such as copper, however, we do not have sufficient new production to replace mature and dying mines, let alone match the growth in world demand.

Copper will never go back to a cost-plus pricing environment; the price of copper will be driven by demand and not supply. Besides the occasional seasonal blip, we have just enough copper in the world where we will never go back to stable production surpluses.

The recession reduced global demand for copper in the short term, and China bought the unused Western copper. However, in the West, appliances, cars, and housing stock will be needed again, and at some point, demand destroyed by the recession will come back.

We think analysts should look at three things when developing long-term price forecasts: ability for new capacity to come online, ability for customers to substitute with another product, and condition of the current supply and demand balance. It is frustrating to see proposals to build the same “old” mines in four years, and then seeing the four-year predictions slip to six or ten. For some commodities like copper and nickel, contango is not the reality, and current high pricing is here to stay.

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