Why Metals Stocks Haven't Peaked

Jim Jubak

Is it too late to buy into the boom in metals stocks -- everything from gold to silver to copper to iron to zinc? After all, flashy gold stock Goldcorp(GG Quote) is up 130% or so in the last 52 weeks, and plodding copper stock Phelps Dodge(PD Quote) isn't far behind, with a 90% return.

Or does the current boom in metals have longer to run, making this a good time to buy despite gains like these?

Investors looking to answer such questions should take a clue from the boom in oil prices, particularly from a theory called Peak Oil. The analogy isn't perfect -- the commodity markets for metals are much smaller and much more speculative than the market for crude oil.

But applying a theory that I'm calling "Peak Metal" argues that while short-run risks have risen recently, the boom in the prices of metals and metal stocks is a long, long way from over. Over the long term, the only thing likely to derail it, in fact, is a big slowdown in the global economy -- and therefore in global demand. And that doesn't look likely in either 2006 or 2007.

Supply Squeeze at Work

Peak Oil is a controversial theory that argues that, sometime soon, global oil production is due to hit a peak. After that point, no matter how much money oil companies spend on exploring for new oil and developing new reserves, global oil production won't go up. After a period of stagnant production, global production will indeed start to decline.

Most of the controversy about Peak Oil involves shouting matches about when -- if ever -- this peak will occur. Estimates range from now to 2008 to 2020 to never.

To me, predicting the date for peak production is an interesting parlor game. Given the immense ignorance we have about the true levels of production and reserves in major oil producers such as Saudi Arabia and Russia, I simply don't think it's possible to come up with a specific year.

But I find the mechanisms that Peak Oil theory has developed to explain the direction of oil prices and the operation of the oil market immediately applicable to the metals sector.

Here's how those mechanisms work for oil: As oil production moves toward the peak, oil also becomes harder to find. Discoveries are smaller and in less-accessible regions or geologic formations. And it costs more to produce the crude from these discoveries.

Producing oil from existing fields also gets more expensive: It's never possible to recover 100% of all the oil in a field, and recovering the last barrel of oil also requires more technology, more equipment and more dollars than recovering the first barrel. Peak Oil theory also notes that extracting oil from a field damages the field by allowing water to infiltrate the oil pools, by leading to the collapse of rock or sand formations and the like. That happens even if the oil producer has put adequate capital into the infrastructure of the field, which most oil producers haven't done over the last decade or two.

The price of oil rises as the peak approaches for both reasons.

It's at this stage that opponents of Peak Oil theory often object that Peak Oil doesn't take into account the effect of those higher prices on oil production. As oil prices go up, it becomes profitable to exploit oil deposits, such as Canada's huge oil sands reserves. And it becomes profitable to find substitutes for oil -- such as ethanol or biodiesel. This postpones the day of Peak Oil, perhaps indefinitely.

But this counterargument, ironically, actually validates the key insight of Peak Oil. As the production peak approaches, the price of oil rises -- even as unconventional sources of oil and substitutions come to market -- because these new sources and substitutes are more expensive to produce than oil used to be. If they weren't, they would have been put into production during the days of cheap oil. In effect, the rise of oil prices in Peak Oil theory creates a price floor for these new sources. As the floor moves up -- to $40 oil from $30 oil, for example, and then to $60 oil -- new sources and substitutes become profitable. That slows the price rise predicted by Peak Oil. But it doesn't reverse it.

Twin Peaks?

Now look at the three similarities between Peak Oil and Peak Metal:

• It's becoming harder and harder to find significant new deposits of everything from gold to copper. Gold production in South Africa, historically the world's biggest gold producer, is now just one-third of its peak, because the country's deep underground mines are exhausted, and mining companies haven't been able to find enough new gold deposits to make up the difference. Global gold production has actually tumbled as gold prices have spiked. After peaking in 2001 at 2,621 metric tons when gold sold for less than $260 an ounce, gold production fell in 2005 to under 2,500 tons.
• When new deposits are discovered, they are in politically riskier countries. In gold and copper, that has meant replacing production from South Africa and the U.S. with production from Peru and Indonesia, for example.
• Production costs are higher in newly discovered deposits. Part of that is a result of location: It's more expensive to produce copper if you have to build roads, railroads and ports from scratch in remote Indonesia than it is to produce copper from Arizona. And part of that is a result of the poorer quality of newly discovered deposits. Costs are rising at many gold-mining companies because the grade of ore -- the amount of gold per ton of rock -- is lower in newly discovered deposits than in older mines.

To those, I'd add these factors that could produce even sharper and more sustained price increases for Peak Metal than for Peak Oil.

• Mining companies are even more conservative about adding new production than oil companies. Oil companies, initially hesitant to invest when oil hit $30 because they were worried that oil prices would fall back to $20 or less, have started to factor $30- or even $40-a-barrel oil into their long-term capital-spending plans. Mining companies, scarred by the boom-and-bust cycle of an industry that is even more cyclical than oil, are so far sticking by their pre-boom projections for the prices of their commodities.

  Freeport-McMoRan Copper and Gold(FCX Quote), for example, recently reaffirmed its intention to use projected copper prices of 80 cents to 90 cents a pound in making its decisions on capital spending to increase production. "Metal prices, like all commodities ... are cyclical," CEO Richard Adkerson told the Financial Times this month, "and I don't see any reason to change the long-term planning price because prices are higher." Copper now trades at $2.70 a pound.

• Oil producers have been able to exploit new technology to drill deeper, to force oil and gas out of stubborn geologic formations, and then bring vast new types of reserves -- oil sands and oil shale, for example -- into production. Nothing comparable has occurred in the metals sector. The last big technology shift -- from deep, underground shaft mining to vast, open-air pit mining -- is decades old. (The next big things -- genetically engineered bacteria and viruses that excrete metals from even the lowest-grade deposits -- are now just smears on laboratory Petri dishes.)

All these Peak Metal factors make me want to rush out and add more metals stocks to my portfolio.

But one difference between the markets for oil and metals gives me pause: The commodity markets for metals are so much smaller than the commodity market for oil that it is much, much easier for speculative demand to drive up the price of gold, silver, copper, etc., than it is to drive up the price of oil.

Not that the price of oil hasn't moved up and down as speculative cash has flooded in and out of the oil market. The price of a barrel of West Texas Intermediate hit an intraday high of $70.85 on Aug. 30, 2005, as traders bid up the price of oil on speculation that Hurricane Katrina -- which made landfall on Aug. 29 -- would shut down a significant part of oil production and refining in the Gulf of Mexico.

On Nov. 1, the price was down to $58.30, despite Hurricane Rita's landfall on Sept. 24 and the damage it caused, as traders sold the storms. Despite crude inventories at high levels, oil prices have bounced back in the last two months, on speculation that something in Nigeria or Iran or Venezuela would disrupt supply. Crude oil in New York closed at $70.40 a barrel on Monday, its first close ever above $70.

But it took the anticipation of two huge hurricanes -- and then the passing of those storms -- plus the prospects of major geopolitical upheaval to produce a 10% to 15% swing in oil this year and last. In the much smaller gold and silver markets, all it takes is the launching of an ETF or two.

Gold and silver have been driven higher on the projected launch of funds that let retail investors buy the commodities. The launch of gold ETFs pushed gold prices up 12% in the 90 days before the ETFs were actually launched. (Prices fell 10% in the 90 days after trading in the ETFs began.) Silver is now going through the same process. Not surprising since Barclays Global Investors, the backer of the silver ETF, estimates that demand for its ETF will require it to buy 12% -- 130 million ounces -- of global silver demand.

Waiting for the Metals to Cool

So where do I come down?

Yes, in the long term I believe the metals boom will run for the rest of the decade -- or until a downturn in the global economy puts the kibosh on demand for all commodities. So, for the long term (or until the day of economic reckoning), I'd like to own shares of metals producers.

And, yes, in the short term, I believe that flows of speculative cash have pushed the prices of all the metals, but especially silver and copper, to heights where they've become unglued from the positive long-term fundamentals. (Gold, the first choice of investors in any crisis, is, as always, a special case.) In the jargon of Wall Street, they're ahead of themselves. I wouldn't sell positions in this sector that I own -- the froth will get frothier over the next few months in the aftermath of copper strikes in Mexico and the election in Peru -- but I wouldn't add new positions just yet.

For that I'd wait for a sharp little correction. Nothing too big, mind you. But enough to take gold and silver off the front page of The Wall Street Journal for a while.

---