What lessons does rhodium have for commodity investors?

All investors should occasionally look to the past to guide their views on what could happen in the future. For as they saying goes history doesnt repeat itself, but it often rhymes. Almost ten years ago the eyes of many commodity investors were focused on a little known precious metal called rhodium. What are the similarities to the present day surge in cobalt prices and can investors learn anything from that episode and others like it?

Rhodium is similar to cobalt in that it has a very small, very concentrated supply base. Around 80% of rhodium supply comes from South Africa, while around two-thirds of cobalt comes from the DRC. Much like cobalt, the supply of rhodium is also an indirect supply – the precious metal being a byproduct of platinum and nickel mining. That means that supply doesnt typically respond in the same way to high prices. Since the economics of the mine is governed by the value of the predominant metal rather than the byproduct supply tends to only respond after a big step up in prices. The relatively low prices for both nickel and platinum at the present time do not bode well for cobalt supply.

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Like cobalt which is predominantly used in batteries, the demand for rhodium is also very concentrated. Eighty percent of rhodium is consumed in autocatalysts, with the remainder in chemicals, glass and the electricals industry. Meanwhile, in the same way that Tesla and other companies are keen to get their hands on as cobalt now amid supply risks in its main producing country, the same was true for rhodium in the eary 2000’s. From a $440 low in January 2004, prices ballooned near 23-fold to more than $10,000 over five years as industrial users hoarded the metal amid concern that South African mine supply would fall.

You could argue that the straw that broke the camels back for rhodium prices was the start of the global financial crisis. With car manufacturers holding large stocks of rhodium procurement decisions resulted in large swings in prices. Indeed, it is rumoured that the decision by one car manufacturer in the US to offload its rhodium stocks in 2008 set off the subsequent price collapse. Due to the ultra small nature of the cobalt market the same thing could happen there if one or more manufacturer becomes a forced seller for whatever reason.

The financial crisis was the final straw for rhodium, but it can be argued the crash would have come soon enough as car manufacturers were substituting with other materials. As the price of rhodium soared car manufacturers looked to cheaper alternative metals and reducing the amount of precious metals that they needed to use in catalytic converters. Could the same happen for cobalt? A complete shift away from high-energy batteries looks hypothetical at this stage with all high energy batteries currently requiring cobalt. However, there has been recently efforts to produce other types of battery chemistries that do not require cobalt. Tesla has reportedly also been trying to remove cobalt from the equation and add nickel instead. So far attempts for substituting cobalt resulted in a loss in product performance. But nothing is set in stone.

At least until recently there was little way that retail investors could gain exposure to rhodium directly. At the moment the only way for investors to gain exposure to cobalt is by investing in a company that mines it (e.g. eCobalt Solutions). There have been rumours that some financial institutions who have built up large stocks of cobalt are looking to create a product that would allow retail investors to ‘gain exposure’ directly. This should, in the same way that the launch of the rhodium ETF as a sign that some are trying to take some profit.

The rhodium market has seen several price spikes. The most recent being a major rally in the early 1990’s, a smaller one around the millennium and then the enormous 2004-08 boom. The cobalt market is no different. The last major spike in cobalt prices occurred in 2006/07 when prices surged from around $30 per tonne to over $110 per tonne.

One major factor that characterises rhodium, cobalt and a range of other minor metals is the short time in which prices spike and then fall back to earth, quite often right back where they started. How long do minor metal super-cycles typically last? Not very long is the answer. Prices typically increase sharply for 1-3 years before prices crash, often back to where they started 6-12 months later. What does that imply for cobalt? Well, cobalt’s rally is still relatively young by these standards, but come the end of this year it may start to look a little weathered.

Investors take note. By the end of 2008 the price of rhodium had declined by 88% to $1250 per oz. Remember miners are often (but not always a very good one) a leveraged bet on the underlying commodity. Trying to pick the peak in the price of rhodium will probably be just as difficult with cobalt. But by the time that happens the share price of a cobalt miner may have already gone in reverse.

Ride the narrative for as long as you dare.

Related article: Batteries now included: You’ll meet a bad fate if you extrapolate

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Batteries now included: You’ll meet a bad fate if you extrapolate

“The course of human history is strongly influenced by the growth of human knowledge…But it’s impossible to ‘predict’, by rational or scientific methods, the future growth of our scientific knowledge because doing so would require us to know that future knowledge and, if we did, it would be present knowledge, not future knowledge.”

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This was how philosopher Karl Popper described the struggle to anticipate future innovations. Yet to understand the potential price dynamics of oil, lead, cobalt and every other commodity we need to make some assumption about how technology will make it easier to extract these commodities and how technological development will affect their demand.

Implicit in any forecast of commodity prices is an assumption of how technology could evolve and how its adoption will affect commodity prices. Yet true to Popper, innovation is unpredictable. No one predicted the invention of pig iron and how it would affect the nickel market. Neither did anyone anticipate the introduction of hydraulic fracking and how it would turn the market for oil on its head.

Commodity prices provide the incentive for new technology, yet also influence commodity production and consumption. Innovations, once introduced, may lead to higher yields from agriculture, more oil being extracted from offshore wells and deeper and deeper mines to extract metals and minerals. All of which could eventually lead to rising commodity supplies.

Technology doesn’t just affect the commodity in question, there are substitution factors too. Consider the outlook for coal prices. Anyone looking into the future of coal needs to consider the potential competitors to this fuel source. But how do you decide how current renewable energy technologies will evolve and its impact on costs and competition between sources of energy?

One example from the 1970’s is instructive. Late in the decade OPEC’s Long-Term Price Policy Committee recommended that the price of oil should be increased gradually until it was just below the cost of the nearest substitute.
OPEC identified its main competition as synthetic diesel and gasoline fuels processed from coal. Since the cost of producing synfuels was thought to be near $60 per barrel, almost $200 in today’s prices, that became OPEC’s implicit long-run target.

OPEC pushed average prices to a high of almost $37 per barrel in 1980 (around $107 per barrel in real terms). But then the market slumped over the next six years, hitting a low of just $14 in 1986, about $30 in real terms. As it turned out, the main competitors to OPEC’s were not expensive synfuels plants but rival oil producers in Alaska, the Gulf of Mexico and elsewhere that were much cheaper.
The same could be said now for the cost of renewable energy technologies such as solar. It is a mistake to draw the connection that just because the cost of solar is coming down the price of a barrel of oil will also come down.

Recent attention has focused on the potential growth of electric vehicles (EV’s). Recent estimates from UBS suggest that in a world where EVs reach 100% of the market demand for lithium will increase by 2,898%, cobalt by 1,928% and rare earths by 655% relative to today’s global production.

However, just as high oil prices arguably helped enabled the development of EV’s, so higher prices for those metals and minerals currently considered essential for the growth in EV development will also have their own impact. This could involve their substitution with other metals and minerals not currently thought economical or a product change resulting in a less resource intensive design. Or if neither of these are possible, demand for the final product (e.g. a Tesla) may not grow as much as anticipated if it costs too much relative to the alternatives.

Uncertainty over how current technology can be utilised and how technology could evolve that makes forecasting commodity demand under rapid change very difficult.  This creates a problem for executives of resource companies trying to match supply with anticipated demand many years into the future. The allure for investors of many of the companies operating in the supply of ‘energy metals’ (those metals that could be used in applications as diverse as renewable energy, electric vehicles, batteries, etc.) is that the pace of innovation and therefore our demand for metals such as rare earths, lithium, cobalt and others could increase at a much far faster pace the ability to supply.

Just as earlier this decade rare earth miners and their investors extrapolated several months of price gains years into the future, there is a risk now that investors in the ‘EV theme’ and the commodities that could underpin it extrapolate the past year’s growth in EV use and commodity price gains ad infinitum over-paying for assets that may never generate a return.

Expectations matter elsewhere too, which can create opportunities. For example, if oil producers are worried about the growth in EV’s they may decide to postpone large scale, multi decade, multi billion dollar investments. If they get it wrong and EV’s don’t take off as fast as expected then oil prices may rise sharply if there isn’t enough supply to meet demand.

Rapid change inevitably involves lots of failed experiments as the market weeds out those most likely to survive. Its often said that you could have lost your shirt betting that the internal combustion engine would replace the horse and cart. While that was certainly the case for the early automobile manufacturers that era also holds some important lessons for today’s investors in cobalt, lithium and other metals. If you had bet that crude oil and its derivative was the fuel of the future back in 1908 when the Model T Ford was introduced the price of oil was about $15 per barrel in today’s money. Oil prices doubled in real terms over the next ten years, but fast forward to 1927 when production on the car stopped oil prices were back to where they had been less than 20 years earlier.

I’ll finish with a great quote from George Soros.

“Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.”

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Its oh so quiet: On commodity volatility

Much attention recently has focused on the low level of volatility present in equity, bond, foreign exchange and commodity markets. Bloomberg Gadfly had this to say about commodities in particular, “The 90-day volatility of the Bloomberg Commodity Index touched its lowest level since November 2014 this month, driven by declines in energy, crops and precious metals. Volatility in spot gold has been running at levels almost unseen so far this century.”

While the fall in commodity price volatility is bad for trading businesses that thrive on price disconnects between commodities, regions and over time it is generally good news for consumers as they can now better plan their budgets and investments.

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Some commentators have pointed to the spread of better data and social media as a reason for the drop in commodity price volatility. I think this is at best only a marginal factor in the current low volatility environment. Access to information may be better but most commodity markets are still very opaque and are still prone to the same fears and euphoria as they ever have been.

The danger of course becomes when low volatility becomes the new normal. Its then that businesses, governments and other make bad decisions based on a belief that prices will stay in a broadly stable range.

Whatever the explanation, low volatility will inevitably signal its own demise. This time is not different.

One of the 50 chapters in my book “Commodities: 50 Things You Really Need To Know” is devoted to discussing commodity volatility – printed in full below.

“What commodity prices lack in trend, they make up for in variance.” – Angus Deaton

 A crucial distinction when talking about commodity price volatility is that of variability and unpredictability. Prices exhibit variability for many reasons, but some price changes may be more predictable than others. For example, agricultural prices tend to be lowest during and soon after harvest, and highest immediately before harvest. Although seasonal changes are not exactly constant from year to year, they are often similar from one year to the next. Weather shocks, on the other hand, are typically unpredictable. Adverse weather conditions may lead to unpredictable changes in prices, especially if stocks are low to begin with.

Commodity prices tend to be more volatile than many other prices in the economy because, in the short term, both supply and demand are relatively price inelastic. Increasing commodity production takes time if new crops must be grown, mineral exploration undertaken or oil wells drilled. Similarly, it can take considerable time to change consumption habits, such as shifting from coal-fired electricity generation to gas or altering the share of more fuel-efficient cars. This sluggish response means that supply and demand shocks, whether it is an adverse weather event or a natural disaster, can result in large price movements. If demand grows faster than supply, then stock levels will run down, perhaps alongside higher commodity prices. The absence of a buffer means that in turn the market may now be more vulnerable to a further shock to demand or supply. Note that this does not mean that high prices are by necessity always correlated with high volatility.

In commodities, inventories may be measured in terms of “weeks’ consumption” – an estimate of the number of weeks of consumption that existing inventories can last. When inventories fall below a certain number of weeks, it breaches a psychological barrier in which people get nervous, and coupled with a strong transient shock (such as a strike at a mine or a crop failure affecting a particular season’s produce), this uncertainty may cause price volatility to increase.

Commodity price volatility is closely related to the ability to store the commodity. In the most extreme example in which the commodity cannot be stored for immediate delivery, such as electricity, prices are the most volatile. In terms of natural gas and oil, which can be stored but require specialised infrastructure, volatility is low when inventories are available, but spikes occur when infrastructure constraints are approached.

Metals and agriculture stand in sharp contrast to energy because they do not run into storage capacity constraints as quickly. For metals, all one needs is a parking lot and a chain link fence and you can stack the metals as high as you want. As a result, the volatility of non-energy commodities is generally lower and only spikes when inventories approach depletion.

The steepness of the commodity cost curve can also influence the volatility of a commodity. The commodity cost curve tends to influence commodity prices over the longer term. Different commodities have different shaped commodity cost curves depending on their underlying production characteristics. For example, iron ore has a particularly steep curve at the high end of the cost curve. In this example, so long as prices are relatively high and the whole cost curve is in play, iron ore prices are very sensitive to shifts in the supply/demand balance and so are subject to high volatility. As demand falls, the market quickly becomes less reliant on the higher cost producers and therefore the commodity price drops sharply because these producers are no longer required to satisfy demand.

High commodity price volatility tends to hurt producers the most, especially farmers who make all their investments in seeds, fertiliser and equipment at the start of the growing season, before the post-harvest price is known. If prices in the year ahead look unstable, farmers may invest less than usual, with the consequence that they no longer maximise profits and also produce less food to sell.

Commodity price volatility also presents a cost to the consumer of those commodities too. Thinking about a manufacturer of an essential widget for the iPhone, a significant change in the price of a significant input can negatively affect the economics of manufacturing and the commercial viability of the end product. Uncertainty over the cost structure of a business can deter investment because businesses are less able to budget for the future.

Commodity price volatility can also have implications for whole economies. Many commodity producing countries are significantly dependent on the production and the export of a handful of commodities. The performance of their overall economy, government revenues and hence the amount they have to spend on things like health and education will fluctuate with commodity prices.

At first sight, unstable food prices are likely to have a greater detrimental effect on consumers in low income countries. Here, food accounts for a large share of consumer spending, although people tend to have less access to banking facilities to be able to cope with the volatility. However, since different food staples are often substitutable, commodity price volatility may not be quite as damaging for consumers. For instance, changes in the price of one commodity are not perfectly correlated with changes in the price of another, so consumers may be able to adjust their purchases to take advantage of relative discounts.

Economies dependent on commodities for manufacturing and supporting service industries may also be exposed to commodity price volatility. As global supply chains become increasingly entwined and have moved towards “just in time delivery”, this has meant that volatility in primary commodities is likely to be transmitted through supply chains to the end consumer much faster than ever before.

The essential thing:

Commodity prices are inherently volatile, creating uncertainty for business, deterring investment and/or leading to less than optimal decisions.

My next book, on predictions and pundits in the commodity forecasting industry should be available to buy later in the summer.

Buy the book Commodities: 50 Things You Really Need To Know from Amazon (US and UK), iBooks, Barnes and Noble, Google and Kobo.If you like the book please leave a review on Amazon. Reviews really do make a difference. Thanks.