Petroleum Market Outlook

The world is currently experiencing an energy shortage. There are several reasons for the shortage:

1. Excessive intensity of consumption by the US
2. Strong growth by the US, China & India in particular, as well as other emerging markets
3. Shortfall of refining capacity

Upstream Sector – Exploration
Contrary to investor perceptions, there is no shortage of oil. For the last 30 years oil reserves have remained between 30-40years of annual consumption, or 1 trillion barrels in absolute terms. The bulk of these reserves lie in the Middle East – Saudi Arabia, Iraq, Kuwait, UAE, etc. For this reason, the OPEC countries are likely to increase their share of production capacity. In addition, there are still a lot of areas which are still eventually virgin exploration targets. These areas include:

1. Deep water areas of existing & new basins
2. Russia – particularly the Siberian peninsula
3. West Africa
4. India and the Bay of Bengal (delta)

Downstream Sector – Refining
The reason for high oil prices is not lack of oil, but largely poor planning to ensure adequate refining capacity to get that oil to the market. There are several reasons for this:

1. Planning & government licensing, eg. Land availability, government permitting greatly slows down the development of new refineries.
2. Capital intensive: Refineries are expensive so industry participants are reluctant to build new capacity
3. Diversification of energy products: Governments are demanding that producers improve the environmental rating of their fuels, which results in a broader variety of products. This greater variety complicates the product mix and reduces the flexibility of producers and consumers to purchase from other suppliers, creating bottlenecks. This results in a risk premium being added to product prices.
4. Poor returns on investment in the 1990s mean corporations were reluctant to build new capacity. Part of the problem was that corporations were more concerned with complying with meeting environmental compliance measures.

Other Factors
A number of non-market factors also have contributed to the market shortage for oil products:

1. Poor strategic planning & cooperation between governments and the private sector
2. Excessive reliance on oil for transport by many western countries. Sweden and Japan are 2 countries that have adopted transport systems to reduce oil reliance. The USA, Britain and Australia have overly relied on cars, choosing to underfund rail despite declining domestic oil production.
3. Excessive growth in the US and China in particular is creating a pressure no global refining infrastructure. These demands are the result of monetary stimulus.
4. Subsidised oil products: A number of countries have subsidised their oil product markets so the market signals are not being communicated to the market. These countries include India, Indonesia and China – whom are among the largest oil consumers.

Energy Market Outlook
The outlook for the energy markets is down for a number of reasons:

1. Softer demand: The strong global growth recorded in 2004 was cooled off in 2005, and is likely to fall further in 2006.
2. Market pricing: Those countries which are subsidising oil products are likely to remove this support because of a deteriorating in their public finances, as well as pressure from the USA and EU.
3. Substitution: There is likely to be some degree of substitution for other forms of energy which will free up capacity.
4. Inflation: Higher oil prices will feed through to general price levels, eventually causing higher interest rates, which will reduce demand.
5. Investment: Higher oil prices will spark investment in new oil capacity, but that will take time to come on-stream. When it does, there is often over-capacity, particularly as shortages usually arise during periods of excess demand.
6. Alternatives: Higher oil prices will encourage development and investment in alternative sources of energy, as well as products that utilise these types of energy. Examples include industrial batteries for energy demand (peak load) management, cars and computers powered by fuel cells.

Its already evident that higher oil prices have forced other energy sources higher. Eg. Uranium prices have risen from $US12/lb to $US28/lb, and coal prices have doubled, so additional capacity will grow in these areas as well. Because much of the global trade has grown due to US consumer largesse, its safe to say that a large over-supply will arise.

The positive aspect of higher oil prices is that you can make money out of it, whether by investing in:

1. Petroleum Refiners & other energy processors, producers, explorers equities
2. Petroleum & other energy product futures
3. Alternative energy exposures, eg. fuel cells, battery suppliers, etc
4. Railway locomotive manufacturers

In Australia my favourites are:

1. Capathian Resources (CPN): It is developing small oil fields in the Czech Republic. Because these are small, land-based fields they are cheap to develop, but under-valued, since close to infrastructure.
2. ZBB Battery Systems (ZBB): They have developed a zinc bromide-based battery to compete with the old, less efficient lead-acid batteries. Higher energy prices should prompt greater use of batteries in those markets still dependent on oil for local power generating capacity. This tends to be markets like China and India which are growing very quickly, but also countries like Venezuela and Saudi Arabia that use their abundant oil to fuel power generation, and thus are paying a significant opportunity cost. The batteries allow companies to buy power at off-peak rates and use it at peak periods, saving during those periods.

Gold - Short term price action

The gold price is rallying on fears of inflation. This is not a surprising development because of the precarious state of the US economy. What are the implications. Looking at the following chart, we might expect several things to happen.
Most people focus on the $US price of gold because gold is denominated in $US. But for people holding non-$US assets, this matters little.
The interesting news is the break-out of gold prices in non-$US terms. The chart above shows gold prices in UK pounds, Euro, and we can see that the gold price has broken up into new highs. Its the same with the Yen and $Australia. The implication is that its no longer just $US currency action, its a rise in the inherent value of gold. Gold is valued when markets are fearful of any of the following:

1. War: There is no great threat of war at the moment that threatens the financial system, however the Iraqi war has contributed to the inflationary threat.
2. Stability of the financial system: Asset values are very high, and with inflation rising, the threat of higher interest rates poses a great threat to the home affordability of new homeowners. Forced sales under a property crash is likely to send prices plummeting. Inflation is good for property, but only when valuations are reasonable. The other fear is an oil crisis as Iran attempts to pursue a nuclear option.
3. Inflation: This spells the erosion of the value of money because governments increase the supply of money relative to the amount of goods produced. Over the last decade, the global money supply has grown much faster than the global economy because of credit growth.
4. Yields: With the outlook for higher inflation, the yield on bonds and equities looks shaky. In these circumstances the 'non-yielding' precious metals look attractive. Real interest rates are essentially negative at the moment, so the capital gain on gold is attractive.
5. Supply shortage: Too much is made of the supply shortage of gold and the Indian & Chinese demand. These countries are still quite poor and the propensity of its traditional buyers to buy falls at higher prices. Industry nor jewellery will not lead this boom, it will be hedge funds and individual hedging against inflation. There is too much money in the global economy, that will feed into gold & other precious metal markets.

Its apparent from the chart above that the price of gold is heading for $US500/oz, the high posted in 1987. This point will be a major point of resistance, which is unlikely to be broken. We are already at $US466/oz, so we are looking for another 8% move. Interestingly, the outlook for gold in non-US terms is less compelling. We are less likely to see strong gold prices in other currencies, except $A terms as global commodities demand collapses with inflationary (oil) pressures and higher interest rates. Most of the gold price action will relate to a fall in the $US - despite the prospect of higher interest rates in the US. The Fed is still well behind the curve when you consider rising inflationary expectations. In fact there is no way for the US government to avoid inflation. The only corrective action is higher interest rates and credit defaults, which will burst the credit bubble, unwinding credit instruments, and thus reducing the money supply. Household super funds will be the biggest losers.

The question remains - Will the gold price in Euro and Pound terms break out of their long term uptrend? One would think so given that the Euro money supply is currently growing at 4x the growth in the EU economy. That means too much money chasing too few goods - that's inflationary.

The relationship between the $US and the gold price remains. Some analysts assert that the correlation has disappeared, but leveraged institutional investors are merely trading the $US by going long (or short) gold. Because the gold market is a lot smaller than the $US currency market, the gold price is much more volatile. Another reason for the departure of gold prices from $US correlation is that investors are taking positions in the gold market in anticipation of $US exchange rate moves. Short term trading merely obscured the relationship between the $US dollar and gold prices.

There is often the fear that European & US central banks will sell their gold reserves into the boom. The reality is that these sales are likely to be peripheral to the speculative demand. In any case, it does not change the story. There is no where else to place money safely.

In fact buying physical gold is not the best way to get exposure to gold. I would be going for the emerging miners which don't require hedging, and which have resource upside.

Go gold!

Nickel - a declining story

Nickel has been one of the most actively traded metal commodities because of its volatility and reasonable liquidity. It is a highly cyclical market, largely tied to the demand for stainless steel. Some 80% of nickel is use to produce steel products - with stainless steel being particularly important. Stainless steels are used in the building industry, automobiles, food & beverages and water industries.

Nickel is produced from a number of sources:

1. Layered intrusives: When ultramafic layered intrusives (molten rock) is emplaced in the earth's crust and precipitates layers of chemically-distinct minerals, its possible for commercial quantities of nickel to accumulate, perhaps in association with chromite, cobalt, copper of platinoid metals (PGMs).
2. Nickel laterites: When layered intrusive complexes are subjected to erosion on the earth's surface, the nickel sulphides are oxidised and re-precipitated sub-surface, forming an enriched layer of 'laterite' that often grades 0.5-2% nickel.

The bulk of nickel is produced in just 5 countries - Russia, South Africa, Australia, New Caledonia and the USA, although the Philippines, Indonesia and other African nations are significant producers. Nickel is not rare, so the focus is on the higher grade deposits that can be competitive at low prices, since nickel processing requires considerable investment to produce a high grade concentrate.

In the 1990s, the nickel market was particularly votaile for a number of reasons. The threat of new 'laterite' supply using new high-temp autoclaves meant prices were expected to fall, but 2 keystone projects in Canada & Australia had major setbacks, which undermined the financing for similar projects. The technology has been proven viable, but the experience did demonstrate the risks of new technology. The theory was proven fine, but it was design issues that undermined the project.

Investing in nickel

There are several ways to invest in nickel:

1. London Metals Exchange: You can buy spot or forward nickel contracts on the LME - see www.lme.co.uk.
2. Equities: You can buy nickel/cobalt producers on the ASX, JSX, TSX and VSE in all shapes and sizes. The largest nickel producers are Minara Res (MRE.ASX) and Sudbury Mines (TSX). You can also buy equities in stainless steel producers in EU, US and Thailand.

The outlook for nickel

In the short term we are likely to see a fall in nickel prices since the US & Chinese property markets are over-priced, as the Western property bubble comes to a close. The US has trailed other markets, but it is set to fall soon. Auto sales in the US fell 12% in Aug'05, the largest fall since 2001. Nickel prices are however unlikely to fall back to prior lows since there are now considerable cost pressures in mining. eg. Raw materials, labour and oil have risen by 30-50%. Much of the price rise has also been caused by weakness in the $US. Higher interest rates will also end the speculative demand by traders for nickel, unless the $US starts falling again.

Nickel prices can be expected to fall back to a consolidation level - remembering that the commercial building sector is still healthy and Japan might yet stage a modest recovery. In addition, buildings are not likely to cancel mid-construction, so we can expect some residual demand to flow through the market.

Long term the outlook for nickel is very strong - driven by Asian construction - particularly in China, India and Eastern Europe. But today, these are very small markets. In 3-4 years, after capacity has been absorbed, we would again expect western markets to dictate market action.

References

1. Nickel applications: See http://www.nickelinstitute.org/index.cfm/ci_id/25/la_id/1.htm
   Nickel recycling: See http://www.nickelinstitute.org/index.cfm/ci_id/6561/la_id/1.htm. There are strong incentives for recycling nickel, though its applications and chemical stability mean that the product has a long life cycle, thus limiting the available scrap supplies. eg. Buildings last for 50yrs.

Statistics

1. Base Metals.com: See www.basemetals.com/img/tabs/ni/ni.gif. News service on nickel and other base metals.
   The Nickel Institute: See http://www.nickelinstitute.org/, established to promote new & existing nickel consumption.
2. London Metals Exchange: They provide statistics on spot & forward nickel prices and stockpiles. See www.lme.co.uk.
3. Nickel production: Find some stats??
4. Nickel consumption: Find some stats??
5. Nickel recycling: Find some stats??
6. Stainless steel production: See www.stainlesssteel.com ??

Copper - a declining story

Copper is amongst the most important commodities, and hence one of the most traded commodities. The metal can be traded in several ways:

1. London Metals Exchange (LME): They quote spot & forward prices, current inventories.
2. Chicago Commodities Exchange (COMEX): They quote spot & forward prices in the US market.
3. Equities: There are a range of companies listed on the Australian Stock Exchange (ASX), Toronto Stock Exchange (TSX), Vancouver Stock Exchange (VSX), Johannesbourg Stock Exchange (JSE) and the Alternative Investment Market (AIM in London) for investing in copper equities (ie. production). The impact of exchange rates tends to increase forex gains, but reduce equity price gains.

Copper has a multitude of industrial applications including building, automotive, electrical & electronics, tube & piping, marine applications, machined products, telecommunications. For more details see http://www.copper.org/applications/homepage.html. In the US, the building industry accounts for about 46% of copper demand. Little surprise then that copper prices have rallied whilst the US housing market has boomed. Those homes are also furnished with electrical appliances requiring copper.

Copper production has recently staged a recovery as demand-led price recovery signalled a need for further capacity. Yet looking at http://www.copper.org/resources/market_data/images/c1wrld.gif, its apparent that the supply of new copper has been flat for a number of years. The reason for this is clearly innovation, since global growth was strong throughout the 1990s. In addition, copper stockpiles were high in the early 1990s, but its clear that miniaturisation has reduced demand (see http://www.copper.org/resources/market_data/images/global93-02.gif ). It was in the early 1990s that prices were languishing below $US0.80/lb, well below the current prices of around $US2.00/lb. Partly this rise can be attributed to the weak $US in which commodities are denominated.

Outlook

Despite the subdued demand for copper, producers have largely maintained discipline. Larger companies are prone to finance exploration through the 'explorers' rather than go at it alone, developing their own projects. This synergistic relation worked well at low prices, but with higher prices, 'explorers' are able to finance their own projects, so we can expect market discipline to unravel in future. The amount of new capacity has been limited to date because little money has flowed into resource equities. Regardless, commodity prices were low for so long. In the interim however, we can expect a demand-price slump by virtue of the end to US-Chinese largesse. The mercantilist policies of Asia, combined with the debt-exposure of the western markets will limit consumption for about 4 years. In the interim, the 'savings culture' of Asia is unlikely to see consumption expand greatly to cover the shortfall.

References

For more information on the copper market, follow the following links:

1. International Copper Association - see
2. Copper Development Association - see http://www.copper.org/
3. Base Metals.com - see http://www.basemetals.com/
4. London Metals Exchange - see www.lme.co.uk - for copper stop & forward prices, inventories

Copper Statistics

1. Global Copper Consumption - chart - see http://www.copper.org/resources/market_data/images/global93-02.gif
2. Global Copper Mine Production - see http://www.copper.org/resources/market_data/images/c1wrld.gif
3. Impact of emerging technologies on the copper market - see http://www.copper.org/resources/market_data/emerging_technologies.html

Iron Ore - market Outlook

The iron ore market has been a very profitable division for the major multinationals that dominate the industry in year years. The 5 biggest players below account for about 80% of global supply:

1. Rio Tinto (Aust, India?)
2. CRVD (Brazil)
3. BHP (Aust, Brazil, India)
4. Assamang (South Africa, Morroco)
5. ?? (forget the French company)

About 8-10 years ago, these companies engaged in alot of takeovers to consolidated the industry. They might have thought they had the industry wrapped up because they bought into a lot of the strategic 'long-life' resources in the major existing provinces. Since then, a number of alternative project sponsors have arisen, developing smaller deposits, some abandoned projects (AUX) & mines from previous times (AZR, TEA). Iron is concentrated in the earth in different styles of deposits, including:

1. Magnetite deposits, eg. formed by weathering of iron-rich rocks I think. They are typically higher grade. eg. WA, Brazil
2. Magnetite sands, eg. In NZ & Indonesia you get magnetite sands being concentrated along coastlines in ancient & modern deposits.
3. Haematite deposits, eg. Primary skarn (metamorphic) deposits associated with intrusive igneous rocks
4. Peat bog deposits, eg. Philippines, Indonesia, formed by chemical deposition of iron from iron-rich volcanic brines.
5. Titanomagnetite deposits, eg. Africa and WA. These are associated with layered intrusives.

The highest grade deposits are 60-70%Fe, however some of the lower grade deposits are just 30-40%Fe. This may or ma not be an issue if crushing & grinding (at cost) can release the higher grade iron. Of course few people consider the higher cost element whilst prices are running at $US100-120/tonne. Unfortunately, by the time a great number of thee projects are commissioned, the major producers will have expanded, Chinese demand would have slumped and a raft of new suppliers will have emerged. Perhaps my pessimism is premature. Regardless, there is money to be made in the short term, as long as global economics is a "growth story" rather than a "yield (bonds) story".

So lets consider some of these prospective projects. Most of them arise because sponsors have managed to get the support of brokers keen to earn commissions. Some of the projects have merit. Most of them justify themselves by reference to an "unquantified" China growth story. Regardless, its always possible to find an opinion which supports your project. Regardless, these are investments you trade. Certainly in the long term China will require alot of iron ore, but make no mistake, it will be found. I guess there will be a surplus of resources in another year, and the consequent surplus will probably take 2-3years to be absorbed by the market. Lets consider all the projects that I'm aware of:

1. Aztec Resources (AZR): Developing an old BHP mine in the Pilbara region, WA.
2. BHP, Rio expansions: These expansions are in the Pilbara region of WA.
3. Hancock Mining: Private company with project in Pilbara, WA. Financed by iron ore mining royalties
4. Fortescue Metal (FMG): Listed ASX company developing a Pilbara based mine, using established rail & port.
5. Lynas Corp (LYC): Project in the Pilbara area.
6. AKD Ltd (AKD): Indonesian peat bog iron deposit
7. Aurox Resources (ARX): Aurox Res titanomagnetite deposit in WA.
8. Mineral Commodities (MRC): South African titanomagnetite deposit (RSA financed)
9. Territory Iron (TEA): Intrusion-related skarn deposits in the Northern Territory, Australia. These were mined by Sumitomo in the 1970s. Close to the new railway.
10. Anooraq Resources (ARQ.TSX): Yemen titanomagnetite deposit (Canada financed)
11. Indian projects: I am sure there are Indian companies expanding projects to get their hands on foreign exchange.

The Rio & BHP-inspired consolidation of the iron market was intended to deliver premium prices for producers. They have benefited from that strategy for about 10years, but it was never going to last forever. The problem being they are victims of their own success. Higher prices spark new project sponsors. In defence of their strategy, these circumstances arose because of Chinese demand, not over-rationalisation to create tight market conditions.

Of the above companies, Aztec Res at 18c looks like particularly good (technical) buying, and the Aurox Res project in Indonesia is also attractive. Unfortunately I can post charts here.