Wednesday, March 19, 2008

Investing In a Resource Constrained World Part Three

Wow! What a turbulent marketplace lately! I took some hits lately in my holdings of PAL and SWC, my favorite precious metal palladium mining stocks. But nothing compares with the shocking collapse of BSC, which falls from $60+ to only $2 a share bought by JPM, in just two days. I have sympathy in people who lost big money in BSC. Maybe LEH is next victim? Maybe WM? CitiBank? Maybe even the invincible MER and GS could also fall. There is so much panic and chaos in the financial market.

Recently, Gene Epstein published a cover story on Barrons declaring a commodity bubble is bursting. Has commodity topped? Do we see a commodity bubble bursting? I must point out that Mr. Epstein is completely wrong! I am NOT disputing any of the numbers or facts he cited, but he completely mis-interpreted the facts, and even reversed some causual relationships.

Prices of commodity is determined by the supply/demand balance. If supply exceeds demand, price goes down, but if demand exceeds supply, price goes up. When there is a shortage, the price will keep moving up until eventually the supply/demand reaches equilibrium again, often times due to higher price stimulates increased supply and supresses demand. But there could also be cases where higher price actually stimulate demand and supresses supply!!! I will talk about that later. Depending on how price elastic or inelastic the supply and demand is, equilibrium price could be achieved quickly, or the price could be pushed to an extremely high levels, like rhodium. Price appreciation alone does NOT tell you whether something is over-priced or under-priced, supply and demand data does. Please repeat the previous sentence one more time.

Unfortunately, in his long article, Mr. Epstein meantioned not a single word, and cited not a single number regarding the supply/demand relationship. What audacity allowed him to claim there is a bubble, when he can't even tell us how many barrels of oil the world produces a day and how many barrels it needs! All he ever did was showing us some price data. Now repeat my previous highlighted sentence one more time.

Mr. Epstein talked about speculative hot money chasing a relatively narrow commodity market, and he believed that's the reason we currently have a commodity bubble and it is bursting. He got the causual relationship completely reversed! The commodity bull market is NOT caused by investments by speculators. It's the opposite, the commodity bull is the reason that attracts investors to put their money in it. Anything that is bullish or hot of course naturally attracts investor money and speculators. If that alone makes it a bubble, then a lot of things are bubble: You buy bonds and the bond market must be a bubble, you deposit your money in a bank and it must be a bubble. You go to Wal-Mart shopping and Wal-Mart must be a bubble, too. Actually Wal-Mart must be the largest economical bubble to be popped imminently, judged by how every one visits Wal-Mart daily and spend their money there. How ridiculous!

Can there be a commodity bubble? Of course. Can speculative investments cause a commodity bubble? Of course. A bubble is formed when the price is high enough to correct the natural demand/supply imbalance, but artificial demand by speculative bidders keep pushing price much higher from the level supply/demand already balanced. We are far from even reach the supply/demand equilibrium yet for any of the commodities, let alone form a bubble yet.

But Mr. Epstein did get one thing right, that is, even though only a very small number of funds are chasing the commodity market, the amount of money involved is already a huge amount comparing with the size of the commodity market. That is absolutely right. But it is NOT the reason we have a commodity bubble here. Instead it is the reason for the extreme volatility we see in the market place. We see silver price jumps up and down 2 dollars a day, an un-precedent volatility. That's exactly because too much speculative money is chasing too narrow a physical silver market. Try to squeeze 100 people into a 25 square feet room. They MUST fight fiercely. When a huge amount of money is concentrated in a narrow market, exceptional volatility must be the result, but it doesn't change the fundamentals, volatility will wash out some of the speculators, which is one way the system achieves some sort of balance.

So what does the supply and demand fundamentals say about current commodity market? Two things decide that commodity shortage will be a long term phenomena. First, governments of the world are printing exponentially increasing amount of fiat currency to flood the market. Fiat money is one thing that is definitely NOT in short supply. Their purchasing power are dropping rapidly nowaday. When purchasing power of fiat money drops, instead of supressing demand on commodities, it actually stimulates stronger demand. For money discussions I urge you to visit Gold Is Money and JSMINESET.

Here is an example. I learned last week the price of rice is going up rapidly in international market. Does the higher price make me pause to think about how I should eat less rice? No! I rushed to the nearest COSTCO and picked up TEN bags of the 50 pounds rice, at a price which is still cheap, I used up all the cash in my wallet, or I would have bought more. I am concerned that when the news of rice shortage spreads, there will be panic buying and the shelves will be empty in no time. I do not intend to cause a panic, and I am not speculating on rice to make profit. I am just hoarding some for my own consumption. But here is a good example raising price actually stimulates my purchase demand. Not only higher price stimulates demand, it also supresses supply. Vietnam, India, Cambodia all decided to cut back or totally shut down their rice export, reducing supply to the international market. Is this a bubble? No, there is a real global shortage.

China has too much of US dollars in its foreign exchange reserve, but not enough of anything else. It doesn't have a significant strategic oil reserve. It doesn't have any strategic base and precious metal reserve of any significant size. If the import oil is interrupted, China could be crippled in less than 15 days. If there is a major conflict in the future, China could not last more than a few months if its outside source of metals, and other critical commodities were cut off. China desperately needs to spend out its huge reserve of dollars before it becomes worthless, and stock up some strategic reserves of any thing and every thing that it could buy. And who is to say Japan, Korea, India, Brazil is not on the same boat? Facing an uncertainty future of a crisis looming world, every nation on earth desperately needs to hoard up something and everything to secure its own future. And individual persons are doing the same hoarding and preparation, too. This factor alone will mean we will have a very very long commodity bull cycle.

The second thing that decides that we will have a long commodity bull cycle is the fact we live in a resource constrained world. The earth has a limited size, with limited natural resource on its accessible surface. Have you heard about Peak Oil? King Bubbert's Curve? It's a flawless mathematical derivative that says when a limited, non-renewable natural resource is being produced, the annual production rate reaches a peak when about half of the resource is depleted, production enters a permanent declining phase once we go past the half depletion peak, regardless any technology progress or improved efforts to produce more.

I believe the current commodity boom cycle is different from all previous ones. Previous commodity bull cycles are just a part of economic natural cycles of boom and burst. But for the first time in history, the current commodity boom cycle is closely related to the peaking and depletion of many critical natural resources we have become addicted to. That includes oil, natural gas, coal, precious metals and base metals. We have only 9 years worth of proven reserve of natural gas, the global oil production has just peaked, global silver production has long peaked and only have 13 years worth of production left. Copper has probably peaked already and there is 27 years left. (Check out these natural resource stocks: NGAS, CHK, SWN, JRCC, PCU, FCX, TGB, PAAS, CDE, SSRI, MGN, just to name a few)

Once a none-renewable natural resource has peaked, the annual production enters a permanent ever declining phase, despite of best effort of technology to boost production. So supply will be limited and will be ever declining. Higher price will have virtually no effect in boosting supply. Therefore there is only one way left to bring equilibrium back: supression of demand, otherwise known as demand destruction.

Has commodity cycle peaked? The answer is in whether the supply/demand has be brought back into equilibrium? The answer to the later question is has demand destruction occured? I do not see demand destruction occured in any thing yet at all.

Demand destruction in food items would be massive occurance of famine and mal-nutrition globally; Demand destruction in oil would be that people give up their SUVs and ride a bike 20 miles to go to work every day; Demand destruction in copper, zinc and steel would be we see the Fed issuing plastic pennies, and auto makers promote plastic light body vehicles; Demand destruction in platinum and palladium would be that people get married with a plain silver engagement rings, with no diamond; Demand destruction in tellurium would be FSLR shut business down. I do not see any of the demand destruction happen yet. People complain about higher prices but they just pay more to get the same thing.

On engagement rings, I believe true love does NOT take a compromise. Read this story:

For some people, however, no compromise is acceptable. Take Noah Cuttler, 29, of the District. He met his true love, ... about a year and a half ago ... and Cuttler decided two months ago he was ready to pop the question. ...

He knew platinum was the metal of choice, ... Finally, he pulled out his credit card and charged $1,000 for a platinum band from his dealer and several thousand dollars more for a 1.3-carat diamond. He plans to propose after she reads this article.

". . . it's supposed to be for a lifetime," he said.

Mr. Cuttler must have proposed to his love by now and I wish the best outcome for this couple. He is surely not the only one who falls in love. Across the ocean, millions of young Chinese couples have planned to get married in China's Wedding Year 2008, a year with special significance to the Chinese, not only because the number 2008 starts with a 2, meaning "The couple" or "both of us" and ends with a lucky number 8, signifying "fortune", and the year 2008 is the Gold Ox year in Chinese zodiac, but also because it's the year of Olympics in China, which is scheduled to start on 8/8/2008, triple fortune, I guess. Estimates in China are that 2 or 3 times more people will get married in 2008 than an average year. My estimate is there will be 35 million or more weddings held, about 5% of the population or more.

Getting married is a commitment of lifetime and the Chinese do NOT take any compromise. A platinum diamond ring is a must have in a wedding preparation nowadays, among other things. People with less affordability may settle for a palladium diamond ring, but will not compromise for anything less. A typical Chinese couple would pour resources from parents and friends, on top of their lifetime savings, just to make a lavish wedding happen, because they are judged by people on how lavish a wedding they could afford to carry out. A compromise on a platinum or palladium diamond ring is just unthinkable due to the social peer pressure.

If only half of the 35 million newly wed Chinese couples buy a platinum or paladium diamond wedding band, each containing half ounce of the metals, that would be a demand of 9 million ounces just in the Chinese jewelry sector. The whole world produces only 7 million ounces of each of the two PGM metals a year from mines. The prices of PGM metals have got to shot through the roof.

Thus I encourage people to take advantage of recent price dip, and buy stocks of the only two primary palladium mining companies in the world, PAL and SWC. I have explained the two earth shattering events in the PGM metals market. The fundamentals have not changed a bit at all. South Africa is now on mandatory electric power rolling blackouts and it is entering the winter season, which makes matter worse. The Russia stockpile sale still has not shown up in the Custom of Switzerland. The recent downfall of the PGM metals, which coincidented with the knock down of gold and silver, is nothing but inherit volatility when too many speculators jumped on board. Once the excessive is shaken out, which I think is about finished by now, the PGM metals should continue the rally up in no time.

P.S. The author owns stocks of PAL and SWC, and hoards physical tellurium, gold and silver.


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Anonymous said...

JJ, several disagreements and one major agreement.

I can find no proof that native Chinese even exchange wedding rings, let alone that they're platinum. Why should American culture in D.C. (your link to the WaPost) apply to China? Also, the link you provided about a possible boom in Chinese weddings noted many young couples are getting married in the countryside to save money -- hardly a good sign for hopes of tons of platinum rings.

Since you discuss U.S.-listed stocks, I assume you live in the USA. Your rice hoarding seems hysterical and comical -- we have plenty of food. Furthermore, ever heard of the substitution effect? If grains are in short supply, eat vegetables! Their prices *fell* year over year within the CPI -- where's the inflation?

According to Wikipedia, the Chinese typically have 2 harvests of rice each year, and rice can grow on the least arable land, relative to other crops. The shortage will be over in a few months, with little opportunity for profit in easily tradeable instruments.

If Hubbert's Peak was "flawless," as you say, why was he off 3 years in predicting the U.S. land drilling peak?

You suggest that China desperately wants to "spend its dollars before it becomes worthless." They are buying dollars to maintain the yuan-dollar currency peg -- if they didn't, their goods would no longer be as attractively priced to U.S. consumers.

Finally, I am also long SWC. Lack of substitutes for platinum's characteristics (such as catalytic converters), lack of Russian supply dumping (thus far) are both bullish. You're right-on regarding the South African power shortages. The government will clearly have to let the fatcat mining firms lose production if the alternative is to leave voters in the dark or in the cold or heat during the seasons.

JJ2000426 said...


You clearly mislead the last paragraph of the Chinese Wedding article I quoted. Note early on in the article it says all major luxury hotels have been fully booked for weddings already. So in the last paragraph, the expert suggested, as an alternative, that people MAY consider going to countryside, where it is less crowded and could be cheaper, too. I don't think there will be many people actually listening to his suggestion.

You have clearly under-estimate the spending power of the Chinese nowadays, as well as under-estimate people's enthusiasm in adopting many things from the western world, including platinum diamond rings for weddings. The Chinese nowadays are eager to learn the advanced western world and eager to immitate. Pizza Hut and Starbuck Coffee etc are booming businesses in China, for example. You would be surprised at how many Chinese abandoned tea in Favor of coffee, just because that's the way in the west.

China is in a very uncomfortable position holding too much US dollars. They do not want to see US dollar falling, reducing that huge fortune. But they surely do not want to be the last bag holder, either. It's a tough situation to be in. You bet China wants to reduce the dollar holding in any way it can, including buying up natural resources.

Anonymous said...

There is nothing wrong with your ideas but the presentation leaves a lot to be desired. Consider:

1. Running a spell check on your postings. (same goes for the Seeking Alpha articles, that last one is a mess)

2. Get a readable layout! This white text on a blue background with some green text and green sidewalls has got to be the ugliest and hardest to read blog I've ever seen. Choose from one of the pre-fabricated ones that blogger offers and it will enchance your credibility.