Cracking the commodities code

Understanding the commodities life cycle will help investors find value in exploration and mining shares.

PORTFOLIO POINT: Beyond general price fundamentals, investors need to know the difference between 'convex' and 'concave' commodities.

Commodities can be grouped in many different ways. At school, we all learned about commodities using the periodic table: hydrogen first, then helium, lithium, beryllium, boron and so forth. Elements were organised into chemical groups. In minerals markets, we tend to hear about other groupings of commodities: the precious metals, the bulk commodities (iron ore, alumina, coal) and the base metals, for instance.

While these groupings are very useful for describing mineral markets, they are not designed as optimal commodity groupings to aid investment decisions. In the present context, for investment purposes, there are only two fundamental types of commodities at a generic level, although I doubt that many readers will have heard of them. They are known as 'convex’ and 'concave’ commodities; some examples are listed in the table below.

-Convex Commodities Concave Commodities
Gold Nickel (laterite)
Nickel (sulphide) Tantalum
Manganese Molybdenum
Copper Bauxite
Platinum Magnetite (Fe)
Diamonds Tungsten
Direct-shipping iron ore (hematite) Vanadium

So have you worked out the difference between a concave and a convex commodity from the representative examples in the table? It’s simple – and it is a critical distinction when it comes to share price market impact of early-stage drilling results (and transition to producer status).

Just imagine a timeline from first drill intersection through to resource delineation, then to feasibility work, reserve certification, financing, construction, mine production, mineral processing and successful marketing and off-take. Think of that as an X-axis.

Now think of the value created by each step along the process as the corresponding Y-axis. 'Convex’ commodities realise the project’s true value very early on in the mining cycle – potentially right from the first drill hole. The graph of value realised to stage of project advancement is convex in shape. Why? Because once discovered in economic quantities, the rest of the mining cycle should follow on smoothly for these commodities. For example, selling gold isn’t all that difficult, but finding a good gold deposit is. The classification simplifies reality, of course, and notably should (and will) be fine-tuned further to accommodate subtleties of geology, location and metallurgy, but it is nonetheless a useful high-level framework. Complexities, for example, exist even with some gold deposits, which being refractory and therefore not simple to process, may not behave in a 'convex’ fashion when discovered akin to most gold assets. (The problem of 'stranded discoveries’, located too far from infrastructure to easily develop, is another example of how the market may treat convex mineral discoveries more like concave minerals.)

On the contrary, the concave commodities are not valued by the market until fairly late in the development cycle. This makes sense, of course. With concave commodities, the devil can lie in the detail (or at least in overcoming difficult mineral processing issues and/or finding a reliable buyer). So the project’s owners may need to have offtake agreements all signed and sealed – and even reach the point of finished metal popping out the back end of the plant – before the market is willing to reflect the project’s true value in the company’s share price. The shape of the graph depicting value capture to stage of the mining cycle is therefore concave, as the steep part comes late-on; mineral discovery of itself counts for little.

Readers interested in achieving rapid share price impact and hence returns from investment in mineral explorers should focus their interest on companies which are exploring for 'convex’ rather than 'concave’ commodity types – in theory at least. Conversely, the advantage for 'concave’ commodities is that the share price impact of successful delivery of the project to production is greater.

Of course, the market does not always behave as it theoretically should do. Indeed, some mineral commodities can behave on occasions as 'swingers’ between convex and concave behaviour. A 'swing’ from concave to convex value-accretion behaviour for a particular commodity, for example, can be an example of market exuberance. Bring home a gold nugget from a prospecting trip and you have something you can rapidly turn into cash (as gold is the end-member convex mineral). Bring home a rock containing rare earth oxides or tantalum, however, and you have a nice ornament for your home office – an ornament that you will find quite difficult to turn into cash (and in some instances, even harder to extract the actual metals from). Classically, therefore, rare earths and tantalum should be concave commodities, although when the market was particularly excited about rare earth prices in 2010 and early 2011, rare earths behaved more like convex metals (the same scenario occurred for tantalum early in the last decade).

Questions to ask about the commodity effect on a company’s progressive value-accretion are therefore as follows:

1) Is the company seeking to develop a convex or a concave commodity into production? Is the market valuing the company from the correct convex or concave perspective?

2) Are there any clear, significant, identifiable milestones in coming weeks, months (or years) that will prompt a rerating of the company’s value upwards? How great will that rerating be based upon the type of mineral – convex or concave – that is the company’s focus?

Beyond the split of convex and concave minerals lies the commodity price outlook for each mineral or metal. Commodities do not behave in simple boom-to-bust cycles across the periodic table. At any point in time, some commodities are 'more equal than others’, one might say.

With the help of the commodity teams at CRU Group, here are some 22 separate mineral commodity forecasts out to 2015.

Some words on the mechanics of compiling the 2015 outlook are appropriate: These were straightforward but are recounted here for the record and for clarity. Firstly, the respective CRU analysts across the various markets compiled their forecast average mineral market prices for calendar 2015. Secondly, a recent reference date was chosen, set at the average price for Q4 2011. Finally, a quick comparison of the 2015 to the 2011 Q4 benchmark gives the directional indicator – whether a particular market will go up or down.

Caution should apply at this juncture to avoid misinterpretation of these directional price indicators. A higher forecast for 2015 above prevailing Q4 2011 (which was a low point for calendar 2011) does not imply a steadily rising commodity price over the intervening period. Likewise, a lower price in 2015 than the 2011 benchmark does not imply a steady fall either. Gold, for example, is actually forecast to rise in 2012 (but then fall back by 2015). Furthermore, lower prices do not mean that prices will fall below costs, although they do imply reduced margins – especially as production costs may further escalate from early 2012 levels, as several forecasts have indicated.

The commodity price crystal ball is loaded in favour of the bulls: 15 markets are forecast to see higher average 2015 prices than Q4 2011 – and seven other markets are forecast to be somewhat lower in 2015 than at present.

Going Up: The bulls (in order of performance, starting with the strongest)

  • Palladium
  • Tin
  • Zinc
  • Uranium
  • Aluminium
  • Nickel
  • Alumina
  • Vanadium
  • Lead
  • Manganese
  • Platinum
  • Molybdenum
  • Iron Ore
  • Potash
  • Copper

Coming Down: The bears (starting with those commodities close to retaining parity with Q4 2011 prices)

  • Phosphate
  • Cobalt
  • Gold
  • Ammonia
  • Coking Coal
  • Silver
  • Sulphur

So, when it comes to value, there are two factors investors must consider in order to assess the potential for share price increases for a given company. Firstly, an assessment must be made of a company’s commodity focus, in terms of either convex or concave minerals. Secondly, and in parallel, a consideration of the price outlook for the respective minerals must be made, based upon underlying fundamental factors that influence commodity prices at a given time (being, at a high level, supply and demand issues, and the impact of commodity investors, particularly in the exchange-traded metals encompassing the precious and base metals). Armed with insights on those two factors, investors are better placed to evaluate value-accretion opportunities.

Another factor is the relevant technical and corporate risks that apply as a company moves from exploration stage through project delivery and into production. But that, as they say, is another story.

(This is an adapted excerpt from the 2012 book by Dr Allan Trench & Dr Dan Packey, Australia’s next top mining shares, majorstreet.com.au)

Dr Allan Trench, author of Australia’s Next Top Mining Shares, introduces a simple classification of metals and minerals that explains the progressive value accretion shareholders can expect as exploration and mineral development companies move forward through the stage-gates of early-stage then advanced exploration, project feasibility, construction and finally to production ramp-up to achieve producer status.

References:
Trench, A. & Packey, D. 2012. Australia’s Next Top Mining Shares – Understanding Risk and Value in Minerals Equities. Major Street Press. 336pp.
Trench, A. 2011. A Sharebuyer’s Guide to Investing in the Australian Mining Boom. Major Street Press. 475pp.