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If you want to be a successful investor in commodity stocks, start thinking like a CEO.
Most investors in the sector are still making investment decisions based on the demand side. Will demand in the United States fall? Will demand from China hold up? They calculate their potential risk and profit based on the answers to such questions.
The CEOs at commodity companies are much more focused on the supply side. At this point in the commodity cycle, they know that what's important to their companies is how quickly record prices will bring new capacity into production.
In past commodity cycles, a surge in production has led the market to swing from scarcity to glut, destroying the economics of their companies. They know that's how commodity cycles end -- with a rapid growth in production that sends prices plunging.
A supply-side glut, not a demand-side collapse, is how a commodity boom always comes to an end. These CEOs are watching very carefully for any signs of a glut. Every decision the industry's smartest veteran CEOs are making these days is about the supply side.
Demand can take care of itself
Investors in commodity stocks should follow their lead. It's time to worry about supply and stop obsessing about demand or projections that try to calculate when the boom will end based on the length of past boom-bust cycles.Demand can take care of itself very well, thank you, without any help from worried investors.
Take a look at the oil market, for example. A slowing U.S. economy hasn't been the disaster investors feared. The Energy Information Agency of the Department of Energy now projects U.S. oil consumption will fall by 330,000 barrels a day in 2008, yet oil has still climbed to $120 a barrel.
Whoops, better make that $125 a barrel.
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Growing demand from China, the Middle East, Russia, Brazil and India has more than made up the difference. Chinese demand alone is projected to climb 400,000 barrels a day in 2008.
Outside the United States, strong economic growth, rising incomes, rising consumerism, government subsidies and price controls mean the oil market has so many sources of growing demand and so many consumers who don't care much about prices that the rising global thirst for oil for the next five to 10 years is as close to a certainty as anything ever gets in macroeconomics.
The current global economy and history show that commodity booms turn to busts not when demand collapses -- well, OK, you do get a commodity bust if the global economy goes into depression, as it did in the 1930s -- but when growth in supply overwhelms demand and causes prices to plummet.
So far, the story from the supply side says this commodity boom and the attendant rally in commodity stocks have much longer to run, but no commodity company CEO is taking the current supply-side discipline for granted. And neither should investors.
Case study: Molybdenum
So how do you go about thinking about the supply side? Let me give you an example of a recent decision faced by the CEO of Thompson Creek Metals (TC, news, msgs), a Canadian miner of molybdenum.What would you do if you were the CEO of Thompson Creek Metals? Your engineers have brought you a preliminary report on developing the new Davidson mine. They tell you the mine is likely to have a 10-year life and produce 4 million pounds of molybdenum a year. Developing the mine, they estimate, will cost about $110 million.
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You notice your finance people screwing up their faces. They point out that the costs of developing this mine were estimated at just $60 million in 2005. That's inflation of $50 million in just three years. They calculate that if the current cost projections are correct -- a big if, their faces make clear -- then, after subtracting operating costs, the company will be able to meet its targeted 20% internal rate of return for capital projects if molybdenum prices average $16.13 a pound over the next 10 years.
Done deal, the engineers say. Molybdenum is now selling for $32 a pound. And they get up to leave the room.
Continued: Look to supply-side thinking
READ MORE: COMMODITY - OIL - MINING - CHINA
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