By Rick Rule
You probably have a sense that things are cheap today. But pushing yourself to act accordingly in a bear markets requires courage.
Pay Me Now or Pay Me Later
The resource industry is in liquidation, and is “de-capitalizing” itself, meaning that it’s not making enough to cover the sunk costs of production.
These situations end in two ways.
A low price for commodities might make them more attractive to fabricators and users -- or general economic growth could stimulate demand – so that demand picks up and prices rise. This is a recovery driven by new demand.
These types of recoveries tend to be shallow recoveries. The price of the commodity sees a moderate increase because producers can step up their output as demand rises.
The second type of ending to a bear market is supply destruction. This happened in the oil business during the 1980’s. The oil price fell from around $30 to $10.1 The price of oil and gas stayed so low for so long that productive capacity around the world was destroyed. Oil fields shut down. New technologies for increasing production were shelved.
It went on for so long that the oil industry was unable to respond to increases in demand later on. As a result the increases in demand in the 2000’s took the oil price from a low of around $20 a barrel to a high in excess of $100 a barrel.2
When you destroy productive capacity in a capital-intensive business -- when you’ve shut oil fields – it takes five, six, or seven years to develop new supply when demand returns.
At around $40 to $50 per barrel today, I expect that we will see a resolution over the coming three or four years.3 If we see higher demand during that period, the price might go to $65 or $70 a barrel. In that case, the oil industry should avoid too much damage to its productive capacity, allowing it to keep up with future demand increases. The price five or six years from now might be $80 or $85 a barrel.
If no demand recovery occurs, we could see destruction of productive capacity instead.
In that case, we may see decreased capital spending in the oil sands of Alberta. We could see a shut-in of the North Sea.
The industry would lack the ability to increase production in response to higher demand. As a result of the destruction in productive capacity, we could see an oil price of $125, $135, or $150 as demand slowly returns.
You can pay me now through demand creation. You can pay me later through supply destruction. The supply destruction scenario takes longer to play out but the responses are more violent.
What we saw at the beginning of the 2000’s was a consequence of supply destruction throughout the 1990’s. It is what happens in the face of increased demand and supply destruction.
We also saw the copper price go from 65 cents a pound to $4 a pound.4 You saw the gold price go from $250 an ounce to $1,900 an ounce.5 You saw the national gas price go from around $2 per thousand cubic feet to $10.6 You saw the oil price go from $20 to $100.7
Commodities Can’t Be Out Forever – Let the Market Work
Is a recovery going to happen soon? Probably not. Is it going to happen? Absolutely positively. There’s no way around it.
However badly the resource business has performed for your own portfolios recently, it is the stuff of life.
Seven billion of us want to increase our living standards. And we are adequately supplied or oversupplied at present.
But if the industry doesn’t earn its cost of capital over time, the prices will have to go up or those commodities will become unavailable.
Let’s think about those materials. What happens if copper becomes unavailable? It means the light goes off. What’s the probability of that? I would say it’s nil.
I can’t tell you that copper is going up right away. But I can tell you that a commodities market where prices have fallen by 50% is substantially more attractive than it was before. Ironically the industry is less attractive when it is earning very large profit margins. That’s when we’re getting close to a market peak.
High prices encourage people to conserve. They’re consuming less. Meanwhile, high cash flows are encouraging companies to increase supply. That’s magnified by the fact that investors are becoming more bullish, even though we’re investing in products that are being consumed less and less because they are expensive. It’s truly perverse.
We want psychological reinforcement for our act of buying resource stocks when they have performed so poorly for the last 4 years. We need prices to rise immediately after we decide to buy.
But the market doesn’t care about what we need. The market could turn 6 months from now or 2 years from now. It’s important to size how much of your portfolio to invest according to your financial and psychological ability to endure risk and volatility.
Otherwise, you’re going to get shaken out at the bottom and risk coming back into the sector at the top.
Remember how terrified you were in 1998 and 1999. Remember how elated you were in 2004, in 2005. Remember names like Arequipa, Diamond Fields, Lumina, Silver Standard. A whole litany of things were cheap back in 1998 and 1999. We were terrified when we bought those stocks.
But we were eventually very happy that we made those purchases.
Day follows night. I can’t tell you when day will come. And I can’t tell you how. But remember that you make money buying low and selling high. And to do that, you need to buy low.
P.S.: Read more from Rick Rule, Eric Sprott, and other “thought leaders” in natural resources and precious metals by subscribing to Sprott’s free e-letter. Subscribe here.
1http://www.wsj.com/articles/back-to-the-future-oil-replays-1980s-bust-1421196361
2 http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=F000000__3&f=A
3 http://www.bloomberg.com/energy
4 http://www.infomine.com/investment/metal-prices/copper/all/
5 http://charts.kitco.com/KitcoCharts/index.jsp?Symbol=GOLD&Currency=USD&multiCurrency=true&langId=EN&utm_source=kitco&utm_medium=banner&utm_content=20110407_iCharts_gold_chart&utm_campaign=iCharts
6 http://www.eia.gov/dnav/ng/hist/n9190us3m.htm
7 http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=F000000__3&f=A
Rick Rule Bio:
Mr. Rule has dedicated his entire adult life to many aspects of natural resource securities investing. In addition to the knowledge and experience gained in a long and focused career, he has a worldwide network of contacts in the natural resource and finance worlds. As Director, President, and CEO of Sprott US Holdings, Inc., Mr. Rule leads a highly skilled team of earth science and finance professionals who enjoy a worldwide reputation for resource investment management.
Mr. Rule is a frequent speaker at industry conferences, and is interviewed for numerous radio, television, print and online media outlets concerning natural resource investment and industry topics. He is frequently quoted and referred by prominent natural resource oriented newsletters and advisories. Mr. Rule and his team have long experience in many resource sectors including agriculture, alternative energy, forestry, oil and gas, mining and water. Mr. Rule is particularly active in private placement markets, having originated and participated in hundreds of debt and equity transactions with private, pre-public and public companies.
Sprott US Holdings, Inc. is a holding company made up of three separate and distinct companies: Sprott Global Resource Investments, Ltd., a FINRA Registered Broker/Dealer; Sprott Asset Management USA Inc., an SEC Registered Investment Adviser offering managed accounts; and Resource Capital Investment Corporation, an SEC Registered Investment Adviser managing partnerships. These three companies make up the US Subsidiaries of Sprott Inc. and are active in securities brokerage, segregated account money management and investment partnership management involving both equity and debt instruments, across the entire spectrum of the natural resource industry.
