As I write the prices of commodities across the spectrum (oil, iron, copper, steel, fertilizer, corn, wheat, etc) are depressed, far beyond the pale of their all-time high a few years ago. Are they depressed because of an overall downdraft in the global market? No.
Is the price of commodities falling, in some sectors below the cost of production, due to lackluster demand? No, demand remains robust in most sectors.
Take the fertilizer industry, for example, where the price of nitrogen, potash and phosphate, the three main ingredients for crop growth and yield, are in high demand with a projected 2016 consumption of 60m to 65m tonnes, yet prices have tumbled over 50 percent in 2015 – 2016 compared to a few years ago.
Are prices sagging because of China’s drop in GDP? Partly, but the primary reason commodities are on the down-low is because of supply side economics. In the last few years, the world has seen an increase in supplies of commodities due to increasing efficiency (fracking for example) in mining, a large appetite from China’s 7 to 10 percent annual growth and an overreaction to demand.
Scenarios like these bring the words of Solomon into shape focus. “There is a time for everything, and a season for every activity under the heavens: a time to plant and a time to uproot… a time to tear down and a time to build… Whatever is has already been, and what will be has been before; and God will call the past to account.” – Ecclesiastes 3.
All things move in seasons and cycles. The Christian investor should utilize the wisdom of old to gauge the direction of the market. Even Buffett alludes to the Bible as a guide.
So when prices fall, how do companies react and adjust to market conditions?
They do three things: consolidate, rationalize and optimize. These three reactions often navigate market prices back to equilibrium, and into the territory where higher profits can be made.
When prices of commodities fall, companies report lower profits, which leads to asymmetric movement in stock price, understandably due to negative reaction from investors towards the companies within the sector.
A lower stock price renders the valuation of companies lower. Thus, they become more attractive to the eye of suitors – larger competitors, hedge funds and private investors who take a long-range horizon to investing, confident that the cycle will eventually turn, as the counsel of Solomon so brilliantly advise.
Opportunistically, when large companies acquire smaller ones in a commodity down cycle, the main reason for the purchase is to reduce the number of players in the market, creating an oligopoly (few companies dominate) environment, amasses more control over the supply of the commodity. Since supply and demand have an inverse effect on price, that control affords the acquirer greater control over the market price of the commodity. If consolidation within the industry becomes widespread, supply is quickly controlled and prices revert to an upward trajectory.
The second strategy or reaction of executives is to rationalize and cut cost where cost is the thickest. The first mines to be short down and left on maintenance mood are those producing commodities at a less effective rate. The second mines to be closed are those operating above the cost of the market price of the commodity. For instance, Potash Corporation, the largest fertilizer company by capacity has recently suspended its higher cost producing mines in New Brunswick, Sussex, and Picadilly.
A good dose of rationalization has occurred in the oil industry, particularly in concerns operating in the fracking sub-sector where the cost of production is currently higher than the price per barrel of oil.
Understandably, companies experiencing a downdraft in their sector will find ways of operating on a more efficient level and implement new programs to cut cost. Unfortunately, staff reduction is usually the first item on the agenda. Suppliers providing items that are not absolutely necessary for production is another.
These unpleasant times can be the best times for companies. It is at those moments of uncertainty that investors catch a glimpse of the true character and ingenuity of management.
What Should the Investor Do
When you as an investor, a prudent investor, see consolidation, rationalization and optimization occurring within an industry, it might be time to take a hard at the best-of-breed as a candidate for sound investing.