Return of the commodity cycle

A study recently presented to the Department of Industry concludes that the energy industry is finding it difficult to raise investment capital, and that there is some danger the industry will cut back on exploration and development.

Fancy that. If nobody invests, there’s no exploration and development.

Perhaps we shouldn’t be quite so arch. The study’s logic is certainly sound, which is not a universal characteristic of the reports that land on the desks of ministers and senior civil servants. If the figures are right, the conclusions are uncomfortable.

The study says that while the energy industry’s cost of capital is between 10% and 12% annually, the average return on capital has been only 5%. The low returns have been scaring away investors who would otherwise have provided capital for exploration and development.

No wonder: rates of return that are only half the cost of capital would scare away any investor — or so we thought until the dot-com bubble. The central causes of low returns might be high operating costs or low commodity prices. Natural gas and crude oil prices have been recovering over the past few years, so the finger probably points at high production costs, at least in the case of the energy business.

The problem that looms in the oil patch is no stranger to anyone working in other resource industries. Producing mining companies have been squeezing exploration budgets ever since 1998, as the Asian economic crisis and subsequent slow growth worldwide brought metal prices to lows that rivaled those of the early 1980s.

As for the junior exploration sector, it’s made up of companies that have no cash flow from production and are forced to live off of what they can raise on the venture-capital markets. For them, the poor commodity prices of the past four years, and an equity market that was first besotted by dot-coms and telecoms and then benumbed by crashing prices, have combined to strangle the flow of capital.

It’s common to say that what we need is a discovery. The fact is, it won’t come without investment.

But the flip side of the resource industries’ difficulty in raising capital is the inevitability of shortages. This is where the problem of low commodity prices may suddenly reverse; and it may stay reversed over a relatively long time.

Gold, for so long the millstone around mining’s neck, has come back to life, but its recovery has not been enough to draw large quantities of capital back into mineral exploration and development. A large gold discovery could help attract investment, but high prices would have to be sustained to keep investors there. On the other hand, if base metal prices recovered, there might be hope for better times.

Oversupply is plaguing most of the base metal markets. More than that, established base metal producers have been inconsistent in their response to it. BHP Billiton, for example, voluntarily cut production at several of its big copper mines, including Escondida. On the other hand, Outokumpu is apparently going ahead with plans to reopen the Tara zinc mine in Ireland, while zinc — or zinc metal, at least — is in tremendous surplus.

All that could evaporate if, over the next few years, the base metal industry doesn’t find significant new reserves. Nickel — which has better supply-demand fundamentals than most of the industrial metals right now — appears to be less threatened by a shortage of new projects. But nickel is not typical; there are comparatively few large copper or zinc projects in the pipeline.

It’s not pleasant to think resource industries need Fate to teach the public another lesson. But if the well dries up, eventually the tap dries up too, no matter how big the reservoir. Investment now might stave that off; but eventually an economy that won’t put capital into exploration and development just won’t have commodities at low prices.