What happens when a commodity goes up in price? They produce more of it. What happens when it goes up way beyond the cost of production?They produce a even more of it. What then happens to the price? There will be a whole lot of disappointed longs.
As I went through my commodity charts this weekend, I was surprised at just how strong these charts have been. Many of them are simply going parabolic. That’s fine if you are long, but it’s time for a word of caution. Some of these products are starting to defy logic.
Take silver for instance. According to CPM Group, the industry’s cash cost averages $5.17 an ounce (thank-you byproduct credits). The all in cost is a bit over $10 an ounce. Silver is now trading for nearly three times the cost of producing the stuff. What would you expect to happen? Production is exploding!! There’s something like 200 million ounces a year of increased production planned by 2014. That’s a whole lot of production for a commodity that has annual mine production of less than 600 million ounces. What happens if silver stays at current prices? You will probably see production increase by 100 million ounces a year forever. Why not? It’s easy to ramp up silver production.
So where is all this silver supply going? It’s going into ETFs and it’s going into bars in people’s basements. Investors bought something like 250 million ounces in 2010. I hope they keep buying because actual demand from consumers is collapsing. This is what happens when the price of something goes up—consumers use less of it. Four years ago, investment demand was less than 100 million ounces. We’ve seen a big increase in investment demand and that’s responsible for a lot of the recent price rise.
When something is going up, investors pile in. What happens when the price stops increasing—or even declines? Will investment demand double from here? How much can they soak up? Eventually, production supply will overwhelm the investors. That’s always been the history of these big moves. Eventually, producers can make more of it than investors want. It’s just a question of when and how high of a price is needed to make that happen.
Let’s take a step back. When I first started buying silver in late 2003, it traded for $5 which was significantly below the all-in cost of producing it. What production that did exist was almost exclusively from byproduct lead and zinc mines. For over a decade, demand outpaced supply by a hundred million ounces. It was blatantly obvious that a move higher was imminent. At the production deficit in 2003, aboveground stocks would have been completely depleted in under two years. That was unsustainable.
With zinc and lead prices up, the current cost of silver mining has dropped. Mine production is ramping up. There are multiple sizable projects in the hopper. There are also thousands of smaller projects ramping up all throughout the world. Silver forms in narrow high-grade veins. At a certain price, whole villages in the third world empty out and go underground pulling out potato sacks full of high grade ore. Sure, they’re using pick-axes and production per capita is low, but at $31 silver, there are millions of people around the world now doing this. Every day thousands more join them. These guys will overwhelm the speculators—then they will go back to farming.
The commodity bull market is about two things to me. Increased demand from the emerging markets and increased costs of production due to money printing. I have dozens of commodities to choose from. I always want to own those that have the best supply and demand fundamentals. I want to own those that are nearest to the cost of production. I constantly want to cycle out of the ones that are significantly above the cost of production because eventually production will ramp up. I need to actively manage my commodity portfolio.
Seven years ago, silver was an obvious long. Now, I’m not so sure. The questions now are: Is investment demand sustainable? Is it a substitute for real commercial demand? How big will investment demand ultimately be? How much will commercial demand decline with silver north of $30 an ounce? Before, silver was a supply and demand story for me. As long as silver production was in a deficit, I couldn’t really lose money. Now it’s a momentum story. I like low risk trades. This is no longer low risk.
Am I selling my silver? Hell no!! I think the crazy phase is around the corner, but I’m starting to consider it. I don’t need to catch the whole move. The easy money is made. I’d rather own something that is “cheap” on a relative basis. Silver is no longer cheap. The same can be said of a lot of commodities now. After such a huge move in nearly every commodity, it’s time to reevaluate and redeploy capital.
In the end, commodities are about fundamentals. The price is simply a function of supply and demand. You cannot invest in these as part of a greater fool theory. Ben Bernanke may have your back, but does he intend to buy 200 million ounces of silver a year? If not, you need someone else to buy it. It’s time to look for the cheap commodities with strong fundamentals. Find me something where demand exceeds production and no one makes much money producing it.