Fundamental economic relationships can, from time to time, provide great opportunities for investors. The price of a good or service in practically any economic system serves as an indicator for the supply and demand of a particular good or service. If the price of a good or service is rising, it can often be indicative of increasing demand or a possible reduction in the supply of the good or service.
Firms and individuals are typically incentivized to make adjustments to behavior as a reaction to the changes in the price of a good or service. If the price of a particular good is rising, firms, to the extent possible, are incentivized to produce more of the good for sale. This in theory plays out in a very logical and predictable way. Firms produce more of the good in high demand, with rising prices, which is followed often with the price of the good returning to where supply and demand are roughly in balance. As is often the case, firms can “over do” the new production at which point new production surpasses the increased demand for the good and the price can in fact fall below its original starting point.
The same is often true in reverse. As the price of a good falls, firms are incentivized to produce less until the level of production is cut below the level of demand–at which point the price of the good often stabilizes at an equilibrium point where supply and demand are approximately the same. A perfect real world example is housing. Rising house prices, over a long period of time, provided a tremendous incentive for individuals to buy a house and for firms to build countless subdivisions of houses. Over a significant period of time, a perfect storm built up from a whole host of factors, but the gist of the story is that homes soon became grossly oversupplied relative to demand and home prices got pummeled. This example might seem a gross oversimplification, and it probably is, but it does provide a simple story line for the implications of dynamic supply and demand and its impact on price as well as the feedback prices can provide to individuals and firms.
But, what can happen when the supply of a particular good is constrained and the ability of a firm to produce more goods is limited despite the fact that the price for the good is rising? Money, Money, Money!!!
In the real world, a firm cannot react instantaneously in ALL markets. I can’t imagine it takes a whole lot of time for Microsoft (NASDAQ:MSFT) to produce additional units of Windows 7. I am not sure how long it takes ... but my guess is it is a matter of seconds. Other industries, on the other hand, can have severe lags in how long it takes to increase production. Case in point: natural resources. If an industry is essentially maxed out on current utilization of existing production, it can take a substantial amount of time for a firm to increase the production of a good or in this case extract the supply of a natural resource to bring to the market.
On December 14th, the article "Global Resources Spending Soars," in the Financial Times, Javier Blas reports on the issue at hand: supply constraints. According to the article, “global spending on mining will surpass pre-crises levels next year.” This is largely driven by a seemingly insatiable demand from emerging markets–namely China and India. Blas attributes the boom in capital expenditures to “sharply rising prices for commodities such as copper, iron ore, crude oil, sugar, and wheat.” This is a great example of simple economics playing out (i.e. firms making capital investments to increase production amid rising prices for their goods). Blas goes on to argue, “The investment surge also raises likelihood of short-term bottlenecks in the already stretched supply of equipment and services, and project delays as costs rise.” Mike Sutherlin, the CEO of Joy Global (JOYG), a manufacturer of heavy equipment used in the natural resources industry, is quoted saying, “We are entering the earlier stages of another multiyear expansion of the industry.”
In a situation where increasing supply cannot meet increasing demand, prices for the commodity can become volatile and these commodities can frequently experience significant upward price shocks. The FT article points this fact out with Blas’ argument that, “as natural resources companies lift investment, senior executives fear that wages and cost inflation and longer lead times will limit the supply response to booming demand and drive commodities prices higher.”
The impact of these delays have the potential to result in persistently higher commodity prices, which is inherently a great thing for commodity companies as the underlying value of their production is persistently marked higher. The other implication is that natural resources services companies such as John Deere (NYSE:DE), Joy Global, Bucyrus International (NASDAQ:BUCY), and Caterpillar (NYSE:CAT) stand to prosper, tremendously, as the heightened demand for their products skyrockets while commodity producers strive to earn well above average profits via increasing production. Yet because of bottlenecks along the supply chain, the producers won’t likely overproduce for quite some time into the future–said in plain English: the supply response to market prices is slow, which will keep prices high for quite some time.
Much like every other thing in life, nothing is free or riskless. Playing in the commodity space will subject your portfolio to substantially more volatility than in other, less cyclical, investments (i.e. consumer staple equities or corporate bonds). Additionally, should China or any of the other BRIC nations, individually, or emerging markets collectively undergo a significant double dip recession or some new downturn altogether, this investment thesis will fall to the wayside (for some amount of time anyways) as the price for natural resources collapse–much like they did in 2008. Nonetheless, there is a well documented MAJOR macroeconomic shift playing out in which China, India, and countless other emerging markets develop into consumer driven economies with a robust middle class–and this theme will take decades to play out. While there may be significant hiccups along the way, the long-term trends seem to suggest staying the course is the right decision.
Good luck and thanks for reading.
Disclosure: I am long FCX, VALE, BPT, EWC.