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Spec Haters

David Forest
July 22nd, 2009

Do you have to be a power-plant owner to really understand the natural gas market? Should makers of aluminum siding being the only ones allowed to buy aluminum? These are the kinds of questions being raised in many commodities markets today. The issue is speculators versus users of fuels, metals and agricultural products. Both of these groups are big investors in commodities. Users buy these goods to consume them. Speculators buy without any intention of ever using them. A speculator looks purely to make a profit by buying and selling the rights to a pound of copper or a barrel of oil.

But there is a growing movement to reduce speculation in commodities. The anti-speculation lobby believes that allowing "non-professional" investors to drive the price of commodities with their buying and selling distorts these markets, sending incorrect price signals to everyone involved.

This week we wade into this contentious debate. While I don't consider speculation to be a particularly insidious force in commodities, its effect on prices is undeniable. And as investors it's crucial that we don't get fooled by "false" price signals created by mass psychology rather than supply and demand fundamentals. As we've learned over the past year, just because oil rises to $150 doesn't necessarily mean the world is running out of crude.

And investors aren't the only ones who get fooled by prices. We'll look at the huge effect that price fluctuations can have on commodities producers. Literally, a year of high and rising prices (such as we've had in many commodities of late) can drastically alter an industry's supply and demand balance for decades to come. Leading to boom and bust cycles that cost producers (and investors) billions. I'll offer some "big picture" musings on what recent price swings will mean for the investment landscape in the coming years. It should be a thought-provoking discussion.

Spec Haters

Commodity prices have been extremely volatile the past year. Last summer we saw new highs in price for many of the metals, fuels and agricultural products. Followed quickly by multi-year low prices in early 2009. And today, many commodities have recovered to historically-high levels once again.

A lot of people don't like these price swings. The transport industry was up in arms last summer when oil neared $150. Human rights groups were outraged when agricultural products doubled or tripled in price, making food prohibitively expensive in some parts of the world. The government of China was so unsettled by last year's rise in the price of iron ore that this appears to have been a major factor prompting this month's arrest of Rio Tinto iron ore executives in the country on charges of price manipulation.

And prices have cut the other way recently. Oil prices today are half what they were a year ago. Natural gas is down 70%. Most base metals prices have been cut in half over the last nine months. Problematic for producers of these commodities.

Everyone has been looking for someone to blame for these price swings. Is it OPEC's fault that oil ran to $150? Couldn't they release more supply to the market? Is it Rio Tinto's fault that iron ore prices rose 85% in 2008? The jury is out. But one group is drawing ire across the board for its role in influencing prices of all commodities: speculators. Speculators are undoubtedly a huge part of commodities markets. Only 1% of oil futures traded on the NYMEX are ever delivered for use. The other 99% are bought and sold by buyers hedging prices or investors using futures as a way of making money betting on oil prices. This sort of buying has the potential to drive pricing. And some observers think that's harmful. They believe that supply and demand should mostly determine prices. Not the ideas of investors about what the future holds for a certain commodity.

Because of this, we've had several investigations of the effect of speculators on commodities markets. Perhaps the most high-profile was the recently-released investigation of the U.S. Commodity Futures Trading Commission on the effects of speculation on oil and gas prices. The CFTC found that although there was some evidence of speculators moving the markets, the change in prices they caused was not significant.

The Big, Bad Gas Fund

But not everyone is convinced. There have been numerous pushes to ban speculation in agricultural commodities. Oil is also a hot topic, as this is seen as a "basic need" for most people in driving and heating their homes. And this month, natural gas has come to forefront of the debate. That's because of the United States Natural Gas Fund. The Fund is an exchange-traded fund (ETF). Investors buy shares in the fund, and management then uses the money to buy natural gas futures and swaps on the NYMEX and ICE commodities exchanges. Basically, providing investors with an easy way to bet that natural gas prices will rise.

The problem with the Fund is that a lot of people seem to want to bet on gas prices these days. Over the last six months, the Fund has raised so much money from investors that it has been able to increase its purchases of natural gas derivatives by ten times. The Fund has grown 1000% in six months! The total value of its holdings is now near $4 billion. Here's the big issue. That amounts to 85% of the open interest outstanding on the NYMEX natural gas market. This is a massive holding. And it creates a very real possibility that the actions of the Fund could materially affect the gas price.

The biggest concern is that the Fund must "roll" its position each month. Most of the futures that the Fund holds are "front-month". These futures require the buyer to take delivery of the contracted gas in one month's time. If the fund were to hold these futures until their expiry date (usually in the last week of each month), they would be contractually obligated to take ownership of a huge amount of gas at the Henry Hub in Louisiana. Obviously, management has no interest in this. The solution is to sell the front month contracts before they expire. Management then uses the money from the sale to buy futures for the next month out. So the Fund's investment position is maintained.

This rolling of contracts has a couple of effects. Firstly, the selling of front-month contracts at the end of each month, depresses the price of this contract. Imagine a stock where one shareholder dumps 50% or 60% or 70% of the outstanding shares all at once. This is a lot of selling for the market to absorb. The opposite happens when the Fund buys a new position in the next future. The massive amount of buying can drive prices up. This decrease in the near future price coupled with an increase in the further-out future price reinforces contango in the market. The Fund tries to lessen its effect on prices by buying and selling over a period of days. But still, because of the Fund's huge holdings, there is potential for price movement.

The Invisible Hand

Most criticism of vehicles like the Natural Gas Fund centers around the impact on gas users. If speculators are driving prices, how can buyers get an accurate idea of the state of the market? When oil soared to record highs last summer, there was a chorus of peak oil advocates pointing to the price rise as evidence that the world was running out of crude. Buyers should scramble to secure supplies while they last! But as it turns out, the rise may have had more to do with mass psychology than geology. Very confusing for crude users.

But there's a less-discussed side of price manipulation. The effect on producers. Just like users, producers of most commodities rely on prices to gauge the state of the market. Particularly when it comes to planning capital spending. Producing companies constantly need to make capital decisions on where to invest their money. Build new mines or expanding old ones? Drill new wells? Build pipelines to tie-in producing wells? Construct gas processing facilities? All of these projects require a large "up front" investment. Take liquefied natural gas (LNG), for example. Building an LNG facility can cost several billion dollars. Deciding whether to make such a large investment obviously requires a lot of analysis. The most important question being, can we make back the billions we spent building the facility? Plus a decent profit, to make the investment worthwhile?

Answering these questions means making some educated guesses about cash flows from the proposed facility. Often for decades into the future. And commodity prices are one of the major factors affecting cash flow. At $10 natural gas, our LNG project might make back the billions of up-front investment quickly, and then make billions in profit on top. If we use this as our forecast price, we'd definitely decide to build the plant. But at $4 gas, the facility might never pay back our initial investment. If we're using $4 in our analysis, we'd take a pass on the project.

Billions of dollars in petroleum and mining investment around the world are made each year based on managers' ideas about future commodity prices. And managers' ideas about future commodity prices are heavily influenced by current commodity prices. When oil traded at $135, there was a legion of analysts who felt it would go to $200. When it fell to $30, there was a chorus of forecasts for $20. All of the psychological research done on investing shows that the human brain is hardwired to extrapolate the present into the future. When prices are on the way up, we think they'll stay high and rising. When prices fall, most of us get chicken little about the future.

Which means that big price swings can dramatically alter the landscape of most natural resources sectors. When prices are high, a lot of projects show strong cash flows and returns on investment. So a lot of projects get approved. And construction begins. The above-mentioned LNG business is a prime example. With spot LNG prices soaring to $20 last year, managers used very optimistic price projections in analyzing new projects. Globally, trillions of cubic feet of new LNG capacity was approved. Most of these projects are now under construction. Price becomes an "invisible hand" controlling capacity expansion for the industry.

But spot LNG prices have now fallen to $4 in many parts of the world. This is a price that many analysts thought we would never see again. And it obviously makes project economics look a lot skinnier than did the record-high prices of last year. If we get low LNG prices for a few years to come (which it appears we might), many projects currently under construction will never turn a profit. (Commodity prices in the first few years of a facility's operation are particularly important. In economic analysis, cash flow is discounted, meaning that cash flow several years in the future is worth significantly less than cash flow in the first few years. So even if commodity prices rise down the road, project economics might be irreparably damaged by low prices in the first few years of business.)

Intense Capital

A sector like LNG is particularly affected by mis-guesses about commodity prices. That's because of the "capital intensity" of the business. As mentioned above, building an LNG facility generally costs a few billion dollars. And there is little "scalability" to an LNG plant. You can't build a smaller plant for $100 million. Either you sink billions or you don't build. Go big or go home.

That means when you start building an LNG facility, there's no turning back. Let's take a quick example. Suppose Pierce LNG approved a $3 billion LNG facility in 2006, when gas prices were running hot. After all the permits are applied for, and the contractors are hired, Pierce begins building in 2008. After one year, the company has spent $2 billion building part of the plant. But suddenly, in early 2009, gas prices fall 80% (that's about the drop in spot LNG prices over the past year). Now the economics of the plant don't look so good. In fact, the world LNG market looks highly oversupplied, with gas demand dropping in most countries around the world. The economic analysis Pierce did in 2006, the whole basis for the decision to build the plant, is now completely invalid. All of the assumptions have changed: demand, supply (other LNG facilities have been built in the last few years), and gas prices. The project just doesn't make business sense anymore. Does Pierce cancel it?

Probably not. The company has already sunk $2 billion into the development. If Pierce walks away from the project now, the company will have to take a large write-down on the facility. The harsh truth is a half-built LNG plant is not an asset. This looks bad for the company's financials. At this point it makes more sense to spend the $1 billion to finish the project (reducing the company's balance sheet by only $1 billion) rather than write the project off (which would reduce the company's asset value by $2 billion). No matter how poor the economics might be.

This is why highly capital intensive industries like LNG are prone to oversupply. During times of high gas prices, a lot of projects get approved. And when prices drop, there is a "lag" in the supply response because most of the big projects that have already been started will be completed despite the poor state of the market. And in LNG, these few big projects can add a large amount of new supply. Further depressing prices. To curb production in a down LNG market is like turning an ocean liner. It takes time.

Compare this to a less capital-intensive industry like onshore oil and gas. Unlike LNG, where a developer has to spend a billion to get in the game, domestic petroleum production can be had at a wide spectrum of costs. Yes, there are expensive, deep wells drilled on exploration plays onshore. But a large number of onshore wells come at relatively low cost. Some shallow gas wells in North America cost as little as $200,000 to drill. The catch is that these cheaper wells deliver less gas. A $2 million deep well might produce at 2 million cubic feet per day. While the $200,000 shallow gas well only comes on at 200,000 cubic feet daily. One-tenth the capital cost gets you one-tenth the production. This is scalability.

Because of scalability, it's quicker and easier to curb supply in the onshore gas industry during times of depressed gas prices. If turning the LNG market around is like steering an ocean liner, domestic production is like a speed-boat. It responds quickly. Consider a small domestic gas producing company that owns a well that cost $200,000 to drill. If gas prices drop to the point where that well is no longer making money the company will likely shut it in. Even if they have to write-off the well's value, this is a relatively small loss compared with the billions that an LNG developer loses if they cancel a project. This is part of the reason why a less capital-intensive industry like domestic gas usually "self-corrects" to supply imbalances quicker than more capital-intensive businesses.

The other problem with capital-intensive projects like LNG is they tend to be long-lived. If a company is spending billions on a project, that project is going to produce for decades to come. Meaning that once the project is built, the market is going to be stuck with this added production for many years. So in times of high commodity prices, markets like LNG that are dominated by big, capital-intense projects usually get a build-out in capacity that can overshadow demand for years. One brief burst of investment can tide these markets over for decades.

By contrast, less capital-intense industries require sustained investment to keep up supply. Take the above example of the domestic gas industry. The average reserve life of an onshore gas well in North America is 8 years. And production rates decline quickly. The average Canadian gas well falls to 50% of its initial production rate in just one and a half years. Because new wells decline so fast, the industry must constantly drill new wells to keep up overall production. In industry jargon, operators are "on the treadmill". This makes the production response to gas prices much quicker. If prices fall, drilling slows (there are a few caveats to this rule, but generally it holds true). With fewer new wells, production drops off quickly. Reducing supply and eventually raising prices. The speedboat turns much quicker than the ocean liner of long-life LNG production.

Capital intensity is also important for the mining industry. As with LNG, it takes a large up-front investment to build a mine (often in the billions of dollars). And mines usually aren't very scalable. It takes a certain threshold output rate to achieve economies of scale for a mining operation and turn a profit. A smaller operation just won't cut it. You spend a lot or nothing at all. And if a major project like a mine is started, it will likely get finished. Even if metals prices fall during construction (as long as prices are still above the mine's operating cost). And a few large mines can add significantly to global metal production. Making the industry prone to overbuilding capacity during times of high prices. And leading to depressed prices afterward.

David Forest
July 22nd, 2009

Note: The information provided in this newsletter is based on the independent research of Dave Forest and Notela Resource Advisors Ltd. and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade any securities or commodities named herein. Information contained in this newsletter is obtained from sources believed to be reliable, but is in no way assured. All materials and related graphics provided in this newsletter and any other materials which are referenced herein are provided "as is" without warranty of any kind, either express or implied. No assurance of any kind is implied or possible where projections of future conditions are attempted. Readers using the information contained herein are solely responsible for verifying the accuracy thereof and for their own actions and investment decisions. Neither Dave Forest nor Notela Resource Advisors Ltd., make any representations about the suitability of the information delivered in this newsletter or any other materials that are referenced herein for any purpose whatsoever. The information contained in this newsletter does not constitute investment advice and neither Dave Forest nor Notela Resource Advisors Ltd. are registered with any securities regulatory authority to provide investment advice. Readers are cautioned to consult with a qualified registered securities adviser prior to making any investment decisions.The information contained in this newsletter has not been reviewed or authorized by any of the companies mentioned herein.

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