Materials Risk

As you may know I’m always on the look out for commodity markets that have fallen out of favour. Ones that are hated by investors so such that any sense of fair value is so far down the list that they start to look like there is little in the way of downside risks. This brings out the potential for asymmetric returns for us as investors where the downside is limited, but the upside is potentially (but not always) very high.

One market that has been getting my attention recently has been the market for potash. Along with phosphorus and nitrogen, potash constitutes one of the three nutrients used in the production of fertilisers, and are used in varying proportions according to the nature of the crops and soil types. Essentially potash is used to strengthen plant roots and boost drought resistance.

The potash backstory

Potash prices began to rise in early 2007 from $172 per tonne to $875 per tonne by the end of the year. Prices were essentially driven up by a perfect storm, an extreme imbalance between tight supply and rapidly expanding demand. Increased demand for biofuels in the United States, Brazil, and Europe coupled with higher livestock production created still more demand for grain and thus for fertilisers. Grain reserves became historically low and prices rose sharply. Further worsening the situation were China’s imposition of high tariffs on fertiliser exports and the devaluation of the U.S. dollar in 2007 and 2008.

High fertiliser prices combined with the onset of recession resulted in rapid ‘demand destruction.’ While the price of phosphorus and nitrogen fell sharply potash prices remained relatively strong, buoyed by shortage and difficulties in transporting Russian potash as a result of an expanding sinkhole near its Silvinit mines (more on the importance of sinkholes later).

High prices attracted new businesses including mining companies such as BHP and other entrants with development projects to unearth new supplies of potash. Potash prices then fell back to around $300 per tonne two years later, and although a brief rebound saw prices rise to near $500 per tonne the price of potash has gradually declined to $200 per tonne, a level it has been stuck near for the past two years.

Weak crop prices have played a large part in the moribund price. Benign weather conditions and genetic engineering of crops have resulted in record yields causing global grain inventories to surge. Weak agricultural commodity prices reduce the need and the ability of farmers to pay for fertiliser. The exchange rate of large agricultural producers versus the US dollar has exacerbated the impact, i.e. the drop in the Brazilian real made it more expensive for farmers to import fertiliser.

Potash prices have also remained weak due to the breakdown of longstanding supply agreements. The potash market has long been characterised by cartel arrangements between major producing and exporting countries. In the early 20th Century Germany had a monopoly on the export market while restricting production along with its neighbour France. More recently the market has been dominated by a production agreement between Russia and Belarus. The Belarusian company, Belaruskali and the Russian group Uralkali, had formed a cartel known as the Belarusian Potash Company (BPC). This changed in mid-2013 with the end of the Russian-Belarusian agreement. The Russian contingent announced it was leaving the cartel in order to increase its market share. Perhaps predictably the Belarusian’s responded in kind embarking on an aggressive pricing strategy, signing deals with China and the US at levels that would penalise its competitors.

The buying power of the major consumers also needs to be factored in. India has to import all its potash while China imports about half its annual requirements of 10-11 million tonnes. China, which has 20% of the world’s population but only 10% of its arable land, has long been trying to bring potash prices down. As prices fell the market for potash became a buyers market. In 2012 China used its monopsony power to obtain potash price discounts after staging a buyer’s strike that lasted several months. The subsequent break-up of the BPC cartel gave these two major buyers of potash even more ammunition to demand hefty discounts.

All in all pretty depressing!

So why might now be the start of a recovery in potash prices? It revolves around the following five central themes.

– The short and long term outlook for protein based food.
– Agricultural commodity prices are unlikely to weaken further while supply prospects are due an upset.
– Signs of supply discipline in the potash market.
– Potential supply shortfall.
– Steepening production cost curve

As ever its always important to consider what milestones to look out for. As these milestones fall by an investor can become more confident that a particular narrative is taking hold. On the flip-side its important to consider where the thesis might be wrong. Not hitting these milestones is one such indicator, but there could be others.

The short and long term demand outlook for protein based foods is strong

A growing world population and increased demand for protein based food are the structural factors why potash prices could increase significantly over the coming decades. In most of the world outside of the United States, soybeans are the feed of choice for both pigs and poultry, two of the most popular protein sources in Asia. Although China’s soybean consumption over the last twenty years has exploded soybean demand is now surging across the rest of Asia, especially in emerging market economies like Indonesia, Thailand, India, and Vietnam.

Agricultural commodity prices are unlikely to weaken further while supply prospects are due an upset.

With global grain demand so strong, agricultural markets have come to rely on near-perfect global growing conditions to support record-breaking crops. If weather trends turn for the worse any resulting degradation in yields will have a huge impact on global inventories. Any adverse weather conditions in any of the world’s growing basins negatively impacting yields could cause global grain inventories to swing from record surpluses to huge deficits in a very short time with huge upward pressure on grain prices.

Signs of supply discipline

One of the best signs of a commodity market that is close to finding a floor is supply discipline, i.e. mothballing mines in a bid to take supply out of the market. We have seen it in other commodity markets in the past few years – Glencore’s decision to mothball a third of its zinc output in 2015 and Cameco’s more recent decision to shut their McArthur River and Key Lake uranium mines. We are starting to see that in the potash market now too. In late 2017 Canadian producer idled two of its mines for around two months while also running production at their most profitable mine (Bethune) around 400,000 tonnes lower than what the nameplate capacity would imply.

Supply shortfall

New projects delivering less than anticipated, and supply restraints (including idling and closures) have kept the market relatively tight. However, new capacity is coming online this year, notably in Canada and Russia, although the sector has a history of large greenfield projects typically taking much longer to commission and ramp up than advertised.

The risk of sudden supply shocks is always a feature of the potash market. In 2006, Uralkali lost a mine after a sinkhole wider than 100 meters opened above the site. In 2014, a flood at Uralkali boosted prices at a time when companies were curbing output following the breakup of the company’s sales alliance with Belarus. In March this year the ceiling of a potash mine in Belarus collapsed. Although the accident has not affected mine output, it reminded the market how vulnerable the industry is. According to Goldman Sachs the removal of just one of Belaruskali’s mines would take out about 2.5 million tons, or roughly 4% of global production.

Steepening production cost curve

Production costs have been driven down by the depreciation of key potash producing countries. Between 2013 and 2015 the cash cost for the lowest two potash producers halved as a result of currency depreciation. The increasing risk of protectionist measures by the US and retaliatory measures by many of its trading partners, a slew of bad news emanating out of many emerging economies and investors continued attraction to the dollar has led to the recent battering to emerging market currencies. Potash producing countries have not escaped the selloff suggesting that production costs at the low end of the cost curve are much lower than shown in the chart below. At the same time the production cost of marginal producers has risen sharply as energy, material and labour costs have increased. Together this has resulted in a gradual steeping in the potash production cost curve.

Chart 1: 2015 global cash costs (including royalties, SGA, excluding freight) FOB mine

Summary

The potash market is one of the most opaque commodity markets. The major producers publish little in the way of information about their activities. However, all commodity markets share some similarities. They all follow cycles of varying length and depth. Right now the potash market looks very depressed, but there are encouraging signs that the low is in, particularly evidence of supply discipline.

What is less clear is the extent to which buyers of potash are under pressure to pay higher prices. There are long term demand pressures of course, but in the short term, without a spark that leads to an increase in demand, its difficult to be clear when the market will be forced to move higher.

Early days for the potash market. One I will be keeping my radar on during the rest of the year.

“If there was any armed aggression against Venezuela from Colombian territory or from anywhere else, promoted by the Yankee empire, we would suspend oil shipments to the United States, even if we have to eat stones here.”

Hugo Chavez, former Venezuelan President

Resource nationalism describes a government’s effort to gain greater control or value from its natural resources. This can range from outright expropriation – when a government takes away a private company’s assets – to more creeping forms of appropriation – such as higher taxation or tougher regulation. Although resource nationalism may be driven by economic interest, improving bilateral relations, diplomatic ambitions and popular sentiment also play a role in nationalism policies.

In 1938, the Mexican oil industry was nationalised. Seen in the context of its people, it was viewed that, at last, a poor country, long buffeted by predatory foreign powers, had exercised its right to own the wealth of its subsoil, seeing off rich countries that treated access to these resources at low cost as their right. Meanwhile, in 1951, the Iranian government nationalised the assets of the Anglo–Iranian Oil Company (now known as BP). The decision was enormously popular within the country and seen as a long overdue staunching of its national wealth that could now be harnessed to fighting poverty in Iran. More recently, in Venezuela, the late Hugo Chávez grasped strategic assets to propagate his Bolivarian revolution. Bolivia and Ecuador followed his cue.

Resource nationalism may also result in higher and more volatile commodity prices. Higher political risks associated with conflicts of this sort will also compound uncertainty in global resource markets. Should fear of expropriation or resource nationalism keep investors away from attractive deposits and deter future investments, it could result in global supply constraints and higher commodity price volatility.

Although a government may appear to be good, transparent and welcoming to foreign producers, years later – once a mine or an oil well has opened – they may change their tune. This time inconsistency and resulting uncertainty may reduce longer term investment in the country’s resource productivity; leading to a loss of skills and capital from the private sector, reducing production and potentially leading to higher volatility.

A recent example of this process in action is Venezuela, where in 2003 Hugo Chávez, the president at the time, fired more than 18,000 employees of the state-run oil corporation, Petróleos de Venezuela (PDVSA), and banned them from working for any company doing business with PDVSA. At the stroke of a pen, the oil company lost approximately half of its managers and technicians. Despite the strong rise in oil prices since 2003, the loss of so many experienced workers was one reason why the country has failed to benefit and oil production in Venezuela has stagnated.

Countries such as Russia and Ukraine introduced export bans on agricultural commodities during the period 2008–12, a decision designed to protect domestic consumers from higher food prices. However, these export restrictions may have exacerbated concerns about global agricultural supplies and in turn contributed to higher global food prices.

Restrictions on agricultural commodity exports are legal under global commerce rules, even for those countries (such as Ukraine) that are bound by their membership to the World Trade Organisation (WTO). The General Agreement on Tariffs and Trade, the core treaty of the WTO, has banned “prohibitions or restrictions” on exports of commodities since 1947. However, it permits them when “temporarily applied to prevent or relieve critical shortages of foodstuffs or other products essential” to the exporting country. The treaty also fails to explain what it means by “temporarily” or what a “critical shortage” is, leaving countries ample room for manoeuvre.

What are the causes of resource nationalism? High commodity prices have been a significant driver of resource nationalism in the past, with foreign multinationals often accused of pocketing excessive windfalls or not doing enough to extract a valuable and scarce resource. However, as the shale revolution has taken hold in the US and the perceptions of the relative scarcity of oil and other commodities have changed, there are tentative signs that this may have reduced the ability of the governments of commodity producing countries to negotiate (or impose) better terms on international resource companies.

A decline in commodity prices doesn’t necessarily signal the end of resource nationalism though. A slowdown in economic growth may also drive resource nationalism because governments dependent on their sale try and get a bigger share of a shrinking pie.

Earlier in May I had the opportunity to be interviewed by former hedge fund manager Mike Alkin. One of the things we discussed was the power of incentives, how they can crop up in unexpected places and the reason investors in commodities and indeed all financial markets need to be wary of them, especially when considering advice on where markets will go in the future. You can listen to me talking to Mike from 58.44. In this article I expand upon my interview with Mike.

“Never, ever, think about something else when you should be thinking about the power of incentives.”

– Charlie Munger

You will often see reports on financial TV, social media and the press pick up on a story that one or another famous investor or investment bank is bullish on this or bearish on that. Should you follow them blindly and invest? No, absolutely not. You don’t know what level of risk they are taking to enter that position. Have they hedged it and how? Do they even have any “skin-in-the-game” anyway and are following up their forecast with a position in the market? The best investors should also be able to change their minds if the evidence no longer supports their original hypothesis, and the same can be said for institutions that publish price forecasts. However, if the bank changes its mind will it get picked up by the press, or even get published? It might do, but it might not.

Think about why the financial media publish forecasts next time you see them on TV or on the internet. Are they to help inform those not fortunate enough to be able to afford buying their forecasts off the shelf? Are they meant as “entertainment”, as a way of gathering publicity to sell other “services”? Or are they setting up the sucker to invest in a particular commodity market, just as the forecaster has pulled out of the market or, even worse, is on the other side of the trade?

Various consultancies also operate in different commodity markets. Often they might be involved in collecting prices for opaque commodity markets, while using their experience and understanding of the underlying physical market to provide forecasts. Others might operate outside of commodity markets altogether, relying on their macroeconomic skills and models to provide forecasts.

At first glance these commodity forecasters might be seen as being the most independent from the actual market, since they have much less incentive to tailor the forecast to suit their client base or a position that they hold. That isn’t necessarily true however and ultimately depends on which of its client (buyers or sellers) have the most money to spend. Mining companies and other commodity producers often commission consultancies to provide ‘independent’ commodity forecasts to go into their prospectuses. On the other hand if buyers hold the purse strings in a particular commodity market then, incentives being what they are forecasts and analysis may be well be tailored to what that client wants.

Miners, commodity trading houses and others often release their own forecasts of where they expect one or a range of commodity prices to be in the near or long-term future. In the case of a mining company, these forecasts might be released around the same time as annual reports detailing the company’s activities are published, or when they are trying to raise funding for new investments. These forecasts can be said to have “skin-in-the-game”, with many commodity investors hanging on every word for clues as to how underlying physical demand and supply is likely to evolve. On the flip side, it’s difficult to argue that they are an unbiased prediction of commodity prices.

Forecasters are exposed to other incentives that may influence their behaviour. Researchers at the European University Viadrina Frankfurt (EUVF) analysed over 20,000 forecasts of nine different metal prices over different forecasting horizons during the fifteen years between 1995 and 2011. Instead of finding the institutional inertia and forecasting herding that we might expect, they found strong evidence of “anti-herding”.

So why might some forecasters want to stray from the herd? According to the EUVF paper it all comes down to incentives; and the incentive to herd or stay away depend upon the mix of clients, both existing and prospective. Think about who buys commodity forecasts. There are two groups of buyers. The first are those that buy forecasts regularly, perhaps as part of a subscription to a company’s analysis or for free as clients of an investment bank. Examples of frequent buyers of commodity forecasts might include an oil company or a manufacturing company that regularly buys a certain small range of commodities. Given they are long-time consumers, they may have based their decision on how accurate a forecaster was over several forecasting periods.

In contrast to the regular buyer, there are also onetime or irregular consumers of commodity price predictions. This second group of buyer is more likely to be swayed by the commodity forecaster that was most accurate in the past year or so, or has been the most vocal about his or her success. This is rational from the irregular buyer’s point of view in that perhaps movements in the price of copper or another commodity only have a minor impact on their business, or maybe they only need to buy or take a view on a commodity infrequently. Either way, the cost/benefit of monitoring whether the commodity forecast they are buying has been accurate in the longer term is much higher than in the first group of buyers.

If the second group of buyers dominates (the infrequent consumer), forecasters have a strong incentive to differentiate their forecasts from the predictions of others by making extreme (or non-consensus) predictions. Even though an extreme forecast may have a small probability of being accurate, the expected payoff of such a forecast can be high, since the number of other pundits making the same extreme prediction is likely to be small. Should they be successful in their prediction, then the forecaster can capture the attention and the wallets of the infrequent consumer of forecasts.

In contrast, if a forecaster publishes a less extreme forecast, one close to the consensus forecast, then by definition there is a high probability that other forecasters will make similar forecasts. If this is the case then even if a forecaster’s price prediction is spot on, then the impact on his income and reputation will be minimal. The infrequent buyer will ask, “why pay for a forecast from an average forecaster?”

Herding behaviour isn’t specific to explaining how the commodity forecasting firm appears to the outside world, it can also affect internal incentives. Career concerns can also play a part too. Just as at the level of the firm (whether a bank, consultancy or something else), you might think there is the temptation for an analyst to produce a bold prediction. If the analyst makes an “outlier” forecast that turns out to be spot on, this is likely to capture a lot of attention in the financial media, raising the prospect of the analyst being recruited by a rival firm touting a bigger salary and an even bigger bonus. However, set against this is the risk of being fired (or at least having a few rungs taken from under the career progression of a young analyst) for a bad call.

To examine what the age and experience of the forecaster has on the degree of herding, research published in the RAND Journal of Economics examined over 8,000 forecasts by equity analysts between 1983 and 1996. Equity analysts should produce reliable forecasts of future earnings of the companies that they monitor, which are then used to produce recommendations on what their clients should buy. Equity analysts face their own quandary, having to balance the interests of the buy-side (ie, their clients who prefer accurate forecasts) and those on the sell-side (other parts of the same bank they work for that might value trading commissions and large initial public offerings more than the accuracy of their analysts forecasts). Note that commodity analysts may face their own conflicting internal objectives too. From trading commissions on a commodity-related exchange traded fund, to a bank’s own proprietary trading on commodities and on to gaining profitable consulting business from a highly valued client. There is more than one incentive.

What the researchers found is that younger analysts tend to herd more than their more experienced colleagues do. Less experienced analysts, meanwhile, are more heavily punished for getting their forecasts wrong and so they have every incentive to stick with the herd. In contrast, older analysts, who have presumably built up their reputations, face less risk of termination. The researchers also found that, contrary to expectations, making bold and accurate predictions does not significantly improve a young analyst’s career prospects.

The final type of herding is known as investigative herding. Investigative herding arises when investors trade similarly by reacting to the arrival of a commonly observed information signal. Analysts have an incentive to investigate a piece of information or a market that he knows other analysts may also investigate and trade in. From the point of view of getting a return on the forecast, there is no incentive to build a position in a particular market if other investors won’t join on the same side and push the price in the direction of the forecast. Illiquid markets tend to be less well served precisely because it is not worthwhile for banks and other financial institutions to trade them. It follows that the reputational risk of making forecasts about illiquid and volatile commodity markets is much higher.

Incentives, they’re everywhere if you know where to look. Ignore them at your own risk.