Capacity Utilization Points To A Boom In The Mining Industry

Includes: GDX, XME
by: Katchum

Each month, the Federal Reserve publishes the capacity utilization rate for the previous month. This capacity utilization rate measures the ratio between the current industrial production numbers versus the maximum sustainable utilization. So it measures how much of the overall capacity is used in the industry.

The capacity utilization rate for the total industry (manufacturing, mining and electric and gas utilities) was basically flat at 77.8% for the month of October 2012. Due to Hurricane Sandy, it is estimated that total output dropped 1%, resulting in a lower capacity utilization compared to the capacity utilization rate of 78.2% the previous month.

There is one positive area, though, and that's the mining sector. The capacity utilization rate in the mining industry increased to a four-year high of 90.4%. This is 3.1% above its historical average.

It's obvious that this means that there is an expansion in business investment in the mining industry. As the average of all mining companies in the U.S. are close to full capacity (90.4%), it means that on average, only 9.6% of all mining companies are idle. This implicitly means that there is incentive to invest in the mining industry as we are quickly approaching full capacity.

Many investors, including George Soros, have probably noticed this trend and are anticipating this by buying more of the SPDR S&P Metals and Mining ETF (NYSEARCA:XME) as I pointed out on Thursday, November 15 here.

This rising capacity utilization rate is also bullish for the metals themselves, because when mining supply drops due to overcapacity, it means that metal prices will soar (if we keep the demand curve constant).

Chart 1: Capacity utilization

The World Gold Council said on Thursday that gold supply contracted 2% year on year in the third quarter. Part of this news is to be found in the increasing capacity utilization rate in the mining industry. This rising trend in mining industry capacity utilization is not only visible in the United States, but also in many other countries. For example, Canada, which is a country that specializes in mining, has had a rising capacity utilization rate (Chart 2). The same can be said about Russia, which is also prevalent in the metallurgical and mining sectors (Chart 3). As a result, global mining production fell 1% year over year.

I forecast that mining supply will keep dropping in the coming years. First, it gets harder and harder to get good grades while mining for the resource. Second, the cost of production is going up faster than the increase in the price of the commodity itself, as I noted before. In particular, we can see this tightening supply happening in the silver miners. In an interview with David Morgan this week, we noticed that the silver mining supply wouldn't be able to keep up with the demand in the coming years. He forecasts that we will come into a silver deficit starting from the year 2014.

Therefore, I conclude that today should be an opportunity for investors to start investing in the mining industry. There are several ETFs that can be bought, like the SPDR S&P Metals and Mining, or the Market Vectors Gold Miners (NYSEARCA:GDX).

Disclosure: I am long PHYS, PSLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.