Are resources a curse?

The resource curse typically describes the apparent relationship between the increase in a country’s exploitation of natural resources and a decline in the manufacturing or agricultural sector of an economy.

An abundance of natural resource wealth can also distort economies in a number of other ways. Private investment in other less exploitable/profitable sectors of the economy may stagnate, leaving the government and economy highly dependent on resource revenues. This may be okay when commodity prices are high, but if they decline or suffer high volatility, and the economy is reliant on one commodity, then the economy becomes very vulnerable.
The commodity bust since 2011 exposed deep-seated problems that were covered up during the boom, as governments and citizens expected the good times to carry on. Over-optimism about Chinese commodity demand caused unneeded investments to be made in many emerging economies that fed the commodity boom and political corruption that only led to even worse capital mis-allocation.

A further problem is the potentially corrosive effect of commodity production on political institutions. Many commodities incorporate rents (ie, excess profits derived from the fact that supply is usually limited in the short term). Given that many commodity producers are owned and managed by the government, it is in the state’s interest to capture those rents, but corruption often follows when it does.

The danger is that once commodity prices fall it can leave economies dangerously exposed. Whole countries can become “white elephants”.
Even the expectation of a resource boom can lead to some of the problems associated with the “resource curse”, even if not a single mineral is actually extracted. Researchers from Oxford University found that the mere expectation of future natural resource booms in São Tomé e Príncipe and Madagascar led to “resource curse” effects, even though neither country actually experienced the expected boom. Both countries experienced significantly more volatile economic growth and eroded political governance.

What role do unrealistic expectations have in aggravating the effects of the “resource curse”? Well, first the mere expectation of a commodity boom can increase corruption and can lead to a change in the allocation of public resources. Over-optimistic price expectations only make the necessary adjustment to public finances that bit more painful. Terry-Lynn Karl and Ian Gary from the Institute of Policy Studies asserted that “oil booms raise expectations and increase appetites for spending” and that, as a result, “governments dramatically increase public spending based on unrealistic revenue projections”.

Secondly, expectations of future resource revenues from commodities can cause economic effects, such as changes in the real exchange rate that adversely affect the manufacturing and service sectors. Richard Auty of Lancaster University pointed out that the neglect of non-resource sectors resulted “in part from over-optimistic expectations for both mineral prices and RBI [resource-based industry] output”. Furthermore, unmatched expectations of higher personal incomes among the population can cause popular discontent and lead to societal conflicts. As Gisa Weszkalnys from the London School of Economics notes in reference to an oil boom, “occasionally, it is thought to be just the expectation of oil that causes the curse to happen”.

Brazil

The highest profile country that has suffered the most since the commodity bust has been Brazil. Yet Brazil was the first letter of the moniker BRICs, popularised by Goldman Sachs to represent some of the major emerging economies of the early 2000s. Not long ago, Brazil stood as the leading example of how a developing nation could rise toward global prominence on the back of a China-driven commodity boom. As its economy surged, Brazil stormed the world stage – hosting a World Cup, demanding more say at the United Nations and blocking a US free-trade plan for the Americas and hosting the Olympics. Now Brazil is looking like a symbol of something else: resource-rich nations have a habit of ending their booms with spectacular busts.

Looking back, it is easy to understand the frenzy of optimism. If the biggest economic story this century was China’s rise, Brazil was uniquely poised to benefit from it. Rich in iron ore, soybeans, beef and oil, Brazil was positioned as a supplier of many of the things that China desperately needed. Its annual trade with China soared from $2 billion in 2000 to $83 billion in 2013, supplanting the US as Brazil’s largest trading partner.

China’s rise helped spur global investors to pour more than $1 trillion a year into emerging markets by 2011, a five-fold increase in a decade. Brazil was a leading destination. Its securities markets were more transparent than China’s, therefore some investors bought Brazil as way to play China.
Jim O’Neil recognised the potential for problems in the first letter of BRICs in his book “The Growth Map”:

These days I do worry that Brazil might be partially suffering from the so-called “Dutch disease” [so called after the Netherlands experienced a decline in its manufacturing sector after gas was discovered]. As a result of the country’s richness in commodity wealth, and with its high interest rates, the currency might have risen too far too fast, and this may damage the manufacturing part of the economy.

O’Neil went on to say:

In mid-2011, Brazil possibly has the most overvalued currency of the BRIC’s. In the long term, I remain extremely optimistic about Brazil, and its recent success after decades of economic failure, are grounds for great hope. In the shorter term, I suspect that the strength of the real will be problematical.

Commodity prices then began to decline in early 2011 and like the tide retreating from the shore left Brazil without its proverbial bathing gown. Brazil’s economic decline is partly due to the fall in commodity prices, but partly due to the build up of liabilities and the mismanagement built on the premise that revenues from commodities would continue to rise and Brazil’s economic growth would remain strong. In turn, this was used to justify the government’s fiscal largess in terms of public spending commitments.

Brazil turned itself into an expensive place to do business. A complex tax system, over generous pensions, poor transport infrastructure, high wages relative to its competitors and pointless regulation. In dollar terms, movies and taxis in downtown São Paulo were more expensive than in New York. The country’s intoxication with its commodity boom with China also helped to turbo-charge many other unhealthy practices. From corruption to bribery, the intoxication eventually claimed the head of Ms Rouseff, Brazil’s president, accused of corruption and mismanagement.

Even resource companies most exposed to the country were in denial over the extent of the problem. “In the corporate world, you spend half your life making forecasts and the other half explaining why that forecast was wrong.” That was Vale’s ferrous-division director, José Carlos Martins, who in mid-2014 kept telling investors that iron ore prices would remain high even as they kept on falling.

It’s worth noting that while the Goldman Sachs paper from 2003, “Dreaming with BRICs: The Path to 2050”, sets out the economic rationale for why the five members of the group are included, it does not include a single mention of the role that commodity prices could have in binding their relationship together. It also does not mention the risk that a fall in commodity prices could have on the performance of Brazil or any of the other countries, or the risk that resources could be mismanaged. Indeed as soon as Brazil and the other members of the BRICs became tainted, or at least lost some of their shine, the search was on for another group of even more emerging economies upon which the growth of the global economy and rising demand for commodities would be based.

Brazil, according to an old joke is “…the country of the future—and always will be.”

“Minegolia”

Another example of a country that rode on China’s economic coattails was Mongolia. During the commodity super-cycle that peaked in 2011, Mongolia had an epic run. Stoked by a booming Chinese economy and brisk foreign direct investment flows, Mongolia was one of the fastest-growing economies in the decade that ended in 2015. Its economy clocked in with an average real GDP growth rate of 8%, while per capita income surged to about $4,000.

The country of roughly 3 million people is blessed with abundant natural resources (estimated by the International Monetary Fund to be valued at somewhere between $1–$3 trillion in 2011), and so attracted billions of dollars in mining investment. According to The World Bank, Mongolia was “at the threshold of a major transformation driven by the exploitation of its vast mineral resources.”

It all went bad when China’s growth throttled back from double-digit levels in 2011, just as the Mongolian government went on a debt-fuelled spending binge. Then, in August 2016, came the collapse of the currency, the tugrik. Construction groups, thought to have borrowed heavily from abroad and in particular from China, were now saddled with much higher debts with no way of paying them off.

The authorities were also stuck in a similar position, having borrowed heavily on the back of the boom in commodity prices. Foreign exchange reserves tumbled to $1.3 billion by mid-2016, a 23% decline from a year earlier. Steep salary cuts of up to 60% were forced on some staff on the state payroll. The debt-fuelled binge also extended to individual families and communities too, with workers borrowing heavily against their salaries and pensions and contributing to a boom in demand for upmarket foreign cars and other luxuries.

Although I have some sympathy for Marc Faber’s point that investment manias are an integral part of capitalism, I would prefer my money is not on the line when an investment turns sour. I hope it is not your money either. Unfortunately, as night follows day examples of capital misallocation from the dairy, minor metals and petrochemical industries and those economies most exposed to Chinese demand for commodities will not be the last. As an investor, you may not be totally dependent on the outlook for commodity prices. However, for many individuals, communities, and even whole countries their futures may turn decidedly bleak if commodity markets turn against them.

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A growth business: Potash market shows signs of life

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.

You can listen to me talking about the potash market here with Mike Alkin.

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What is resource nationalism?

“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.

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