Live Long And Prosper: The Beauty Of Low-Cost Production

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Includes: ADZ, AGA, AGF, BHP, BNO, CPER, CUPM, DAG, DBA, DBO, DIRT, DNO, DTO, DWTI, FUD, GLNCY, JJA, JJCTF, OIL, OLEM, OLO, RGRA, RIO, RJA, SCO, SZO, TAGS, UAG, UCO, USAG, USL, USO, UWTI
by: Andrew Hecht

Summary

Lower commodity prices offer an opportunity.

Case study: Iron ore and crude oil.

Case study: Copper.

Case Study: The U.S. farmer.

A cyclical business.

Those of you who were fans of Star Trek will remember the Vulcan salute, "live long and prosper." In the world of commodity production, it seems that many of the world's dominant low-cost producers have embraced the mantra.

Lower commodity prices offer an opportunity

It is common sense, when commodity prices rise, producers make more money. When they fall, times get tough. Recently, lower commodity prices have strained producers. A stronger U.S. dollar and a slowdown in China, the world's dominant commodity consumer, have resulted in a bear market in many raw material markets. However, the emergence of well-capitalized and aggressive producers may be turning producer strategy around these days. Now, it seems to be all about market share. The lowest cost, well capitalized producers have always been able to ride out bad times in commodity markets. Now these dominant producers are using lower prices as an opportunity rather than a hindrance. As prices move lower in bear markets they are continuing to sell production, in some cases even increasing sales. The result is two-fold. They maintain cash flow and, perhaps more importantly, they build market share for the future.

Case study: Iron Ore and Crude Oil

Iron ore and crude oil are two perfect examples.

The price of iron ore has plunged from over $187 per dry metric ton in early 2011 to end 2014 below $70. The lowest-cost producers have all-in costs of $50 per ton and below. The higher-cost producers are extracting the commodity at prices of $80 per ton and above. As the price falls, the eight-hundred pound gorillas in the iron ore market, BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO) and Glencore (OTCPK:GLNCY) have been selling forcing prices lower. This is causing severe problems for the high-cost producers, many of whom will close up shop given the uneconomic nature of their production. If one produces a commodity like iron ore at above market prices, there is only so long they can survive - their cash burn rate eventually destroys them. As the high-cost producers fall by the wayside, the low-cost producers take up the slack and at the same time, their market share increases. When iron ore prices eventually move higher the low-cost producers will not only make more money, they will have increased control over the market for the commodity.

A similar phenomenon is occurring in the crude oil market. Oil prices moved lower starting in early summer 2014. Prices slid from over $107 per barrel to $75 when OPEC, the oil cartel, met on Thanksgiving Day in the U.S. at the end of November. The strongest members of OPEC and its lowest-cost producers, the Saudis, decided they would not cut production in light of falling oil prices, rather they would keep production steady and build market share as prices fall. In reaction to OPEC inaction, oil prices continue to fall; they are now trading below $50 per barrel. This has been a nightmare for the higher-cost producers, some of whom are members of the cartel themselves. Other high-cost producers in Canada and the U.S. are finding themselves under water - production cost is now higher than the market price for oil. The Saudis, like the dominant iron ore producers, now find themselves in a position to build market share and prosper even more when prices eventually rebound.

Case study: Copper

While iron ore and crude oil are examples of the employment of this producer strategy, copper could be the next commodity that finds itself in the clutches of the dominant and predatory producers. In copper, it is the same cast of characters. Billiton, Rio and Glencore are all major low-cost producers. All of these companies continue to produce copper. The red metal spent 2014 making a series of lower highs and lower lows. Copper closed 2014 at $2.8255 per pound on the active month March COMEX futures contract. It was down 15.78% on the year. Copper traded on the London Metal Exchange closed 2014 losing 14.59% on the year. As of Friday, January 9, COMEX copper slipped further to close at $2.7595 - only 3.95 cents or less than 1.5% above key support, which stands at the June 2010 lows of 2.72 per pound. Below that level things get ugly - copper traded down to a low of $1.2475 in December 2008. Considering what happened in crude oil and iron ore in 2014, it is not so farfetched to believe that a break of key support in copper could lead to a tremendous price plunge.

The dominant copper producers could be licking their chops waiting for copper to plunge. This will force higher cost competition out of the market, build their market share and increase their control for the future. Copper is an example of a market that is teetering on the brink with dominant producers ready to increase their influence in the market for many years to come. Not only will they be able to sell profitably at lower levels, they will have the ability to buy up higher cost and uneconomic production for pennies on the dollar.

Case Study: The U.S. Farmer

An interesting area of commodity production to look at in this light is farming in the U.S. Over recent decades, larger concerns have bought up smaller farms. The small family farm has been disappearing as costs rise and volatility in the grain markets have made farming a difficult business. Large dominant farming companies have sucked up land to grow crops on from traditional farmers who have thrown in the towel - it has become almost impossible for them to compete. Larger farming concerns create economies of scale; they get cheaper prices for farm inputs like seeds, fertilizers, farm equipment and other necessities of the business when they buy in huge bulk. This has put them in a position of dominance when compared to smaller farmers, forcing the latter to the brink of extinction. The process of consolidating farming in the U.S. into the hands of a few dominant companies has been going on for many years now.

A cyclical business

Commodity prices move around a lot. When compared to equities, debt or foreign exchange commodities always rank at the top of the list when it comes to volatility. That volatility has picked up in recent years. Corn, which traded as high as $8.50 per bushel in 2012, fell to just above $3 in 2014. Crude oil traded up to $147 per barrel in 2008 and fell to $32.48 in the same year. In 2014, crude oil fell from over $107 to under $50 per barrel. There are many more examples of commodity volatility. It has become hard, if not impossible for many commodity producers to handle price swings like this. Only the strongest, most well capitalized and lowest-cost producers can survive. Therefore, for those who have control, the strategy of increasing that influence makes total economic sense. In the world of commodities, the strongest producers will live long and prosper while the marginal producers become dinosaurs.

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The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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