Materials Risk

At one point Herbert Bunker Hunt and his younger brother Nelson, as well as other members of the Hunt clan owned around two-thirds of all the privately held silver on the planet.

According to their subsequent legal defense the vast stockpile wasn’t a ploy to manipulate the price of silver higher only for them to ultimately cash in. Instead, their motive – according to their defense at least – was to hedge against the surge in inflation of the 1970’s and the debasement of the US dollar.

Older brother Bunker (who went by his middle name) was the richest man in the world in the 1960’s; his father having made a fortune drilling for oil in Texas. But at the beginning of the 1970’s the brothers began to worry that all was not well with the US economy.

A number of domino’s were to fall. First, the 1960’s was characterised by huge levels of government spending to service the Vietnam War. Second, in 1971 the US under Nixon abandoned the US dollar link to gold (pegged at $35 per once since the first Roosevelt administration). Third, war broke out in the Middle East in 1973 and an oil embargo was declared against the United States. Inflation jumped above 10% and would eventually peak in 1980 at 13.5% in the aftermath of the Iranian Revolution.

As inflation began to rise they started to worry that their wealth was beginning to melt away like an ice cube on a hot day in summer. But in the early 1970’s it was illegal to trade gold, and so the brothers looked at the next best thing to hedge that risk – silver.

In 1973 the brothers acquired 35 million ounces of silver, flying the metal to Switzerland in specially designed planes. At the start of the year the price of silver was a little per $2 per ounce. Early the following year the price had tripled as the Hunt brothers stockpile resulted in a shortage. Over the next five year the silver price did…nothing. All told it had been an expensive bet. High storage costs with precious little profit to show for it.

And then in the autumn of 1979 the Hunt’s – perhaps impatient for a return – were back with a vengeance. By the end of the year their stockpile of physical silver had swelled to 42 million ounces, but this time they had even larger positions in the futures market. Together the Hunt clan had over 65 million ounces of silver futures. Unlike every other investor they took physical delivery of the silver when the contracts expired, flying the metal to their Swiss vault and in turn creating an even larger shortage.

This time the price of silver went parabolic. From just $6 per ounce in early 1979, prices rose more than eight-fold to a high of $50.42 per ounce twelve months later. At the time the Hunt’s controlled over two-thirds of all silver contracts on the New York commodity exchange (COMEX).

Silver may have been the next best alternative to gold, but it also comes with some significant characteristics that would mean it wouldn’t perform quite how the Hunt clan intended. Back in the 1970’s silver was increasingly being used in photography. Then, as now silver was both a precious metal, and an industrial metal.

As more and more people became aware of the high silver prices extra supplies suddenly began to appear. Silver jewelry, coins with silver content, anything with a scrap of silver was melted down to capitalise on the surge in prices. Thieves also suddenly took an interest – often a sign that a peak is close by – with the police in the US warning households of pilferers with a renewed penchant for shiny metal.

The Hunt’s had succeeded in engineering a boom in the price of silver. But in order to achieve that they had to spend $6.6 billion, of which only $1 billion was their own money. The rest was borrowed from over 20 banks and brokerage houses. But as supply gradually rose and more and more kept on being delivered to their Swiss vault, the brothers ran out of the means to pay for it.

The commodity exchange COMEX, recognising the potential for the market to collapse introduced tighter restrictions on the issue of new futures contracts. Predictably this led to margin calls being issued as banks began to fear for their money. But the Hunt’s were in a sticky position. Unable to sell their position they decided to borrow even more in an effort to try and prop up the market.

By the end of March things were starting to come to a head. The Hunt’s largest backer had been unable to secure any collateral from the brothers and so began offloading their silver. By 27th March, “Silver Thursday” the price of silver dropped to $10.80 per ounce.

Whether they were guilty of manipulation or not the brothers made some fundamental errors. Fundamentally they forgot to take account of the actions of other players in the market. First, they never appeared to realise that by holding such a large position in the futures market they would be left with no one to sell to. Second, they didn’t pay enough attention to the stock-flow characteristics of the silver market.

Silver is similar to gold but its a poor substitute to its illustrious precious metal cousin when it comes to hedging against a currency debasement. Divide the stock of gold (the amount ever mined) by the flow (the annual production) and you get a ratio of 66 years. Silver meanwhile has a much lower stock-to-flow ratio of ~22. As prices rise supply will come onto the market – as the Hunt’s discovered to their cost.

Whether they were guilty of ‘cornering’ the silver market remains an open question. Irrespective of whether they had malicious intent the whole episode has some important lessons for investors. Forty years later the global economy is facing a similar position – vast government and private sector debts and a loss of confidence in fiat currencies. The ‘war’ on covid-19 has – and will continue to mean those debts escalate further. A ‘hard asset’ that cannot be debased by increased supply is the only thing that will hold its value in that environment. It pays to think about the stock-to-flow.

Related article: The gold stock-to-flow model

Related article: Silver prices: The top 10 most important drivers

Food security is back on the agenda in 2020. Flooding in China and elsewhere in Asia, a plague of locusts across East Africa and the Middle East and finally COVID-19 induced precautionary stockpiling as a hedge against future supply disruptions. All around the globe governments have seen how precarious food supplies can be.

Consumption of fertiliser is expected to increase significantly in many parts of the world as countries look to lock in self-sufficiency. Meanwhile, rising populations and improved diets are likely to put even greater pressure on available farmland.

Crop yields are low in many regions, partly due to the historical under-application of fertiliser in many developing countries. Fertile tracts of land have dwindled through pollution and urbanisation. It is Africa where the problem is most acute, and the potential future demand for fertiliser is most promising. For example, a 2016 report from the UN Food and Agriculture Organization (FAO) said 40% of soils in Africa were suffering from some form of degradation, including erosion and loss of nutrients.

According to the World Bank there are huge regional differences in fertiliser consumption. In East Asia and the Pacific, countries typically use around 330 kgs of fertiliser per hectare of arable land. Across North and South America and Europe farmers use around 130-150 kgs. This falls to 95 kgs in North Africa and the Middle East and to a meager 20 kgs in Sub-Saharan Africa.

China and India dominate the demand side of the potash market. Yet the areas of strong population growth and demand for fertiliser all centre on Africa. It’s population is forecast to rise by 1 billion by 2050 to reach 2.2 billion. Africa’s food and agricultural import bill averages $72bn a year, according to the FAO, this despite having 60% of the world’s uncultivated arable land. Asia accounts for 57% of global fertiliser consumption, Africa consumes a mere 3%.

That’s where potash comes into play. Most fertilisers that are commonly used in agriculture contain the three basic plant nutrients: nitrogen, phosphorus, and potassium. Potash is essentially potassium, a critical nutrient enabling high agricultural yields to be achieved. It’s known as ‘pink gold’ and is arguably a hedge against food insecurity.

Potash prices have suffered a brutal bear market over the past decade. After peaking around $450-475 per tonne in 2011, prices have slumped by 50% to $225-250 per tonne in 2020.

If other countries now commit to increasing their own food security then this could start to result in higher prices as countries compete for potash. Indeed it could lead to a breakdown to the annual contract negotiations that have pervaded the potash market, and eventually lead to a more commodity market based system, similar to how the iron ore market transitioned a decade ago.

Chart: Potash prices

Related article: A growth business: Potash market shows signs of life

Paul Ehrlich (Stanford University biologist and and author of the 1968 book “The Population Bomb”) thought that overpopulation would cause disaster and widespread scarcity. Ehrlich’s bleak vision was anything but that of a lone crank. Countless experts made similar forecasts in the 1950s and 1960s. In his book, Ehrlich declared that:

“the battle to feed all of humanity is over. In the 1970s, the world will undergo famines – hundreds of millions of people will starve to death in spite of any crash programs embarked upon now.”

Neo-Malthusian Ehrlich thought like a biologist. He believed that there was an inverse relationship between population growth and the availability of resources, i.e. as population grows, resources become scarcer. In the animal world at least a sudden increase in the availability of resources leads to a population explosion. The population explosion then leads to the exhaustion of resources. The final act is the exhaustion of resources which leads to population collapse.

“Currently there are very large supplies of many mineral resources, including iron and coal. But when they become “depleted” or “scarce” will depend not simply on how much is in the ground but also on the rate at which they can be produced and the amount societies can afford to pay, in standard economic or environmental terms, for their extraction and use. For most resources, economic and environmental constraints will limit consumption while substantial quantities remain… For others, however, global “depletion”—that is, decline to a point where worldwide demand can no longer be met economically—is already on the horizon. Petroleum is a textbook example of such a resource.”

University of Maryland economist, Julian Simon thought differently. He suggested people would find substitutes for scarce resources, employing technological improvements to adapt to their environment and that everything would turn out fine.

To resolve their dispute, the two sides (Simon on one side and Ehrlich and two of his partners on the other) agreed to have a $1,000 bet on the price of a basket of commodities. The wager was based on the inflation-adjusted prices of five metals: chromium, copper, nickel, tin, and tungsten, and lasted from October 1980 to October 1990. Ehrlich predicted that because of population growth these metals would become more expensive. Simon argued that because of population growth, the incentive to find more or use an alternative would increase, and so metal prices would become cheaper.

If the sale price of the commodities, adjusted for inflation were higher, then Ehrlich and his two partners would win and reap the profit. If the proceeds were lower, Simon would win and Ehrlich’s side would pay him the difference. Ten years passed and the Earth’s population grew by 800 million, yet the basket of metals were worth 36% less.

Simon won. Ehrlich lost. Ehrlich sent a cheque to his rival for $576.07. There was no note congratulating his rival or recognition of his insights.

The tale of their encounter was retold by the author Paul Sabin in his book “The Bet: Paul Ehrlich, Julian Simon, and Our Gamble Over Earth’s Future“. Simon originally proposed that the bet should be for $10,000. But after Ehrlich agreed to the idea, Simon reduced the amount to $1,000. Simon argued that the purpose of the wager was the principle, not the amount. This didn’t stop Ehrlich and his partners complaining about the reduced size of the wager.

Simon was so confident in his lower for longer prognosis for commodity prices that in the two editions of his book “The Ultimate Resource”, published in 1981 and 1996, he wrote the following:

“This is a public offer to stake $10,000, in separate transactions of $1,000 or $100 each, on my belief that mineral resources (or food or other commodities) will not rise in price in future years, adjusted for inflation. You choose any mineral or other raw material (including grain and fossil fuels) that is not government controlled, and the date of settlement.”

Simon was lucky with his bet. The spike in oil prices in the late 1970s was one factor that contributed to the slowing in industrial growth in the 1980s, which in turn resulted in lower prices for the five metals. As the maxim goes, “The cure for high prices, is high prices”.

Although the principle of the bet was correct, we all know now that commodity prices go through cycles. Simon was either lucky or he knew where we were in the commodity cycle, and bet accordingly.

A comprehensive study by Kiel et al. looked at price changes of the five metals in ten-year intervals between 1900 and 2007. They used nominal price data collected and reported by the U.S. Geological Survey, and then adjusted those prices for inflation using the US Consumer Price Index (CPI). Using 98 ten-year intervals based on successive years between 1910 and 2007, they found that Ehrlich would have won the bet 61.2% of the time with an average return of 10.5%.

A more recent study by Pooley at al. expanded the period to cover 1900 to 2019, but made two modifications to the Kiel et al. methodology. First, they argued that prices ought to be compared with income in order fully to understand changes in abundance. Time prices are equal to nominal prices divided by nominal hourly compensation. When analysed with time prices, Simon wins the bet 54.2% of the time. The average return over this 110-year range also favours Simon at 2.22%.

The second modification related to the clause underpinning the original bet between Simon and Ehrlich. This clause said that the wager would be null and void if the USA should be at war on 24th September 1990. Stripping out the years that the US has been at war the researchers found that Simon would have won 69.9% of the time with a return of 18%.

And what about Ehrlich’s dire warnings? Well, there weren’t mass famines in the 1970s, or in the 1980s. Thanks to the dramatic improvements in agriculture collectively known as “the Green Revolution” (which were well underway by the time Ehrlich wrote his book), food production not only kept up with population growth, it greatly surpassed it. Between 1961 and 2000, the world’s population doubled and the calories of food consumed per person increased 24%. Ehrlich said it was impossible.

Even today, many people still insist that Paul Ehrlich was essentially on the mark in “The Population Bomb”. One of those people is Paul Ehrlich himself! In a 2009 essay, Ehrlich acknowledged that the book:

“underestimated the impact of the Green Revolution” and so the starvation he expected wasn’t as bad as he predicted. However, he insisted that the book’s grim vision was accurate, stating that its “most serious flaw” was that it was “much too optimistic about the future”.

Ehrlich never did acknowledge the superiority of his opponents outlook and that cost him. For while commodity prices are prone to prolonged and sometimes dramatic increases, over a long enough time period human ingenuity wins out.

The lesson for investors to draw from the Simon-Ehrlich wager is first to be humble and to not be wedded to a certain world-view, and second to know when the odds are in your favour and to have the fortitude to act.