What goes up… | Fin24
 
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What goes up…

Oct 09 2019 18:46
Simon Brown

Typically, the price of a product will go up over time – whether it is a tin of baked beans, a car or a home to live in.

This is in part driven by inflation as input costs increase, but prices also increase via demand – especially with property where there is, to a degree, a limited supply.

The above is of course true about physical products. But the cost of services also generally increases over time due, again, to input costs.

Even if those input costs are just a salary, the person receiving that salary will experience a higher cost of living, requiring them to charge more for their service.

Here demand also has an impact on the cost, depending on what the service is. For example, a pool cleaning business has a very low barrier to entry, whereas an expert SQL database administrator role has a higher barrier to entry, giving them more pricing power.

So, both product and service prices will increase over time – even if in the shorter term there may be some volatility. But then there are commodities, for which prices seem range-bound. 

I recently wrote about Renergen and the potential for the helium deposit it’s developing. Helium is currently in a global shortage and prices are moving higher as a result.

But we’re seeing a large amount of new production coming onstream in response to this shortage. The Ras Laffan industrial hub in Qatar and helium sources in Skikda, Algeria, will both start production shortly, while another Russian supply will come onstream in a couple of years.

This is how commodity supply and demand works; it adjusts as the dynamics change.When demand and supply are largely in sync, prices will likely be stable. But then something will disrupt this balance. For example, demand could start to increase.

Think of platinum group metals as they start being used in auto catalysts to reduce pollution. This starts sending prices higher due to that increased demand. But then the supply side – the miners – see the prices moving higher, so they start to produce more to benefit from the increased prices.

This could be through either new deposits that they start mining, or even a deposit that wasn’t economical at lower prices, but is profitable at higher prices. This is also the case with frackers in the US. As the price of oil moves higher, they turn on more taps and produce more.

And then, as the price drops, they’ll produce less, producing only where the price makes them a profit.Frackers are in a unique space in that their ability to turn production on and off is very quick. For most miners, new production takes years – even if it is just starting up a mine that has been on care and maintenance.

A new greenfield mine will take many years, if not a decade or more, to get online.So, as the price moves initially, it has scope to run higher, but eventually new supply will come into the market and push prices lower.

Of note is agriculture, which also has the ability to move quickly to better-priced products. If soy prices are weak, then it is moderately easy to grow a different, better-priced, crop.As investors, we need to be very aware of this effective price cap on commodities. But it also creates a floor, because when prices drop, miners will remove production – especially if it is at loss-making levels.

So, when a commodity is booming, the issue is that the boom is seldom going to last forever. Eventually new supply will come online and push the price lower or, alternatively, users will look for a substitute such as we saw with the switch from platinum to palladium that has now seen the latter soar higher. 

We need to remember this and, as such, remember that commodity stocks are never really bottom-drawer stocks. Eventually commodity prices will move lower again and thereby hurt profits.

This article originally appeared in the 10 October edition of finweek magazine. Buy and download the magazine here or subscribe to our newsletter here.  

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