Why prices will soon catch up with the commodity supply crunch

Today we’re unpacking the poorly understood world of commodity inventories.

We’ll look at the critical role they play in maintaining market stability and why it could come unstuck in the years to come.

Inventories refers to the stockpiles held at various commodity exchanges — storehouses for industrial metals like nickel, copper and zinc. These facilities act as an intermediary between supplier (the miner) and buyer (manufacturer).

The London Metal Exchange (LME) is one of the world’s oldest exchanges. It doesn’t own or operate warehouses. It doesn’t own the physical inventories either. It acts as an authority that allows warehouses to store LME-registered brands of metal.

While the LME’s role has diminished over time, it still offers useful data for tracking global stock levels.

It releases a daily stockpile record for common industrial metals. The information, which is freely available and accessible in chart form, offers a glimpse of where the market might head over the medium term.

Now, the important point is this: Declining inventories CAN signal future supply problems that can deliver higher commodity prices if the root cause is structural.

That’s what I believe is happening in today’s resource market.

Check out the LME inventories for nickel, below. As you can see, stock levels are well down in 2023, sitting 85% below the peak from 2021.

Five-year LME nickel inventory. Credit: Kitco

But have declining inventories resulted in a higher price? Absolutely not!

Nickel prices have collapsed over the last 12 months.

The metal has fallen around 40% and now sits at just US$10,000 per tonne (under US$7.50 per lb.).

One Year nickel price. Credit: tradingeconomics.com

So, what gives? Have the fundamental rules of supply and demand flipped?

Well, in some ways yes. Thanks to a period of record-breaking rate rises, markets have become distorted.

Today’s global economy is one in which many miners are bleeding cash. From rising cost of capital, diesel charges and staff shortages, pulling a tonne of ore out of the ground, processing it, and converting it to profit has never been harder.

As a result, miners are rushing metal onto the market, converting stock into cash. This masks the impact of low inventories.

Buyers can still access metal. But this is not sustainable market.

It’s critical to understand that a tight market makes the system vulnerable to disruption. As it stands, current stockpiles are unlikely to absorb supply shocks or any meaningful increase in demand.

In other words, when supply is tight, a jolt to the system could have a very destabilizing effect.

For example, it could induce a positive feedback loop, where a run of panic buying forces inventories lower still.

A destabilizing event could come from the demand side, from commodity market-moving China. Government stimulus has the effect of pushing more buyers onto the market.

It could also emerge from the supply side, with mine shutdowns, a strike at a major operation, geopolitical tensions or any number of other short-term catalysts that could undermine metal markets.

Take First Quantum Minerals’ (TSX: FM) Cobre Panama mine — an operation supplying around 1.5% of global copper supply.

It was recently ordered to shut down operations, after massive protests across Panama and a court ruling that said its contract with the government was invalid.

According to analysts at Macquarie, permanent closure of this one mine could move the global copper market into deficit as early as next year. That’s why we say the system is vulnerable to disruption.

Watch out for the catalyst event

While supply continues to walk an extremely tight rope investors should be positioning for a possible re-pricing event. We have a clear structural set-up that could move commodity markets higher.

So, what happens when a catalyst sets off disruption in this tight market?

Recall, March 2022, Russia’s invasion of Ukraine. A devastating breakdown in diplomacy that also set-off fireworks on the LME trading floor. In just three days, the price of nickel shot up 270%!

The world’s largest and oldest metals market terminated billions of dollars of nickel trades following chaotic price action and suspended trading for the first time since 1988.

Events like this expose vulnerability.

While investors have stayed clear of resource stocks in 2023, it seems the major miners understand what’s at stake. The last 18 months have seen a high level of mergers and acquisitions.

Yet, M&A activity adds nothing to future supply. It simply changes the ownership structure of an asset. It’s why this problem is set to linger, as timelines to move a deposit from discovery to production are in the range of 15 years.

Explorers and developers are key to meeting future supply and addressing low inventories. But until we see meaningful investment in brownfield development or greenfield discovery, the 15-year time lag continues to push further into the future.

Its why COMMODITIES are still set to become the defining investment theme over the coming decade.