Showing posts with label capacity. Show all posts
Showing posts with label capacity. Show all posts

Monday, February 24, 2014

Why the Resource Supercycle Is Still Intact

By Rick Rule, Chairman and Founder, Sprott Global Resource Investments

Natural resource based industries are very capital intensive, and hence extremely cyclical. It is not unreasonable to say that as a natural resource investor, you are either contrarian or you will be a victim.

These markets are risky and volatile!


Why Cyclicality?

 

Let's talk about cyclicality first. Some of the cyclicality of these industries is a function of their being extraordinarily capital intensive. This lengthens the companies' response times to market cycles.

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Strengthening copper prices, for example, do not immediately result in increased copper production in many market cycles, because the production cycle requires new deposits to be discovered, financed, and constructed......a process that can consume a decade.

Price declines—even declines below the industry's total production costs—do not immediately cause massive production cuts. The "sunk capital" involved in discovery and construction of mining projects and attendant infrastructure (such as smelters, railways, and ports) causes the industry to produce down to, and sometimes below, their cash costs of production.

Producers often engage in a "last man standing" contest, to drive others to mothball productive assets, citing the high cost of shutdown and restart. They fail to mention their conflicts of interest as managers, whose compensation is linked to running operational mines.

Interest-rate cycles can raise or lower the cost and availability of capital, and the accompanying business cycles certainly influence demand. Given the "trapped" nature of the industry's productive assets, local political and fiscal cycles can also influence outcomes in natural-resource investments.

Today, I believe that we are still in a resource "supercycle," a long-term period of increasing commodity prices in both nominal and real terms. The market conditions of the past two years have made many observers doubt this assertion. But I believe the current cyclical decline is a normal and healthy part of the ongoing secular bull market.

Has this happened in the past?

 

The most striking analogy to the current situation occurred in the epic gold bull market in the 1970s. Many of you will recall that in that bull market, gold prices advanced from US$35 per ounce to $850 per ounce over the course of a decade. Fewer of you will recall that in the middle of that bull market, in 1975 and 1976, a cyclical decline saw the price of gold decline by 50%, from about $200 per ounce down to about $100 per ounce. It then rebounded over the next six years to $850 per ounce.

Investors who lacked the conviction to maintain their positions missed an 850% move over six short years. The current gold bull market, since its inception in 2000, has experienced eight declines of 10% or greater, and three declines—including the present one—of more than 20%.

This volatility need not threaten the investor who has the intellectual and financial resources to exploit it.

The natural-resources bull market lives…

 

The supercycle is a direct result of several factors. The most important of these is, ironically, the deep resource bear markets which lasted for almost two decades, commencing in 1982.

This period critically constrained investment in a capital-intensive industry where assets are depleted over time.

Productive capacity declined in every category; very little exploration took place; few new mines or oilfields replenished reserves; infrastructure and processing assets deteriorated. Critical human-resource capabilities suffered as well; as workers retired or got laid off, replacements were neither trained nor hired.

National oil companies (NOCs) exacerbated this decline in many nations by milking their oil and gas industries to subsidize domestic spending programs for political gain. This was done at the expense of sustaining capital investments. The worst examples are Mexico, Venezuela, Ecuador, Peru, Indonesia, and Iran. I believe 25% of world export crude capacity may be at risk from failure of NOCs to maintain and expand their productive assets.

Demands for social contributions in the form of taxes, royalties, carried equity interests, social or infrastructure contributions, and the like have increased. Voters are not concerned that producers need real returns to recover from two decades of underinvestment or to fund capital investments to offset depletion. Today this is actively constraining investment, and hence supply.

Poor people getting richer…

 

The supercycle is also driven by globalization and the social and political liberalization of emerging and frontier markets. As people become freer, they tend to become richer.

As poor countries become less poor, their purchases tend to be very commodity centric, especially compared to Western consumers. For the 3.5 billion people at the bottom of the economic pyramid, the goods that provide the most utility are material goods and consumables, rather than the information services or "high value-added" goods.

A poor or very poor household is likely to increase its aggregate calorie consumption—both by eating more food and more energy-dense food like meat. They will likely consume more electrical power and motor fuel and upgrade their home from adobe or thatch to higher-quality building materials. As people's incomes increase in developing and frontier markets, the goods they buy are commodity-intensive, which drives up demand per capita. And we are talking billions of "capitas."

Rising incomes and savings among certain cultures in the Middle East, South Asia, and East Asia—places with a strong cultural affinity for bullion—have increased the demand for gold, silver, platinum, and palladium bullion. Bullion has been a store of value in these regions for generations, and rising incomes have generated physical bullion demand that has surprised many Western-centric analysts.

Competitive devaluation

 

The third important driver in this cycle has been the depreciation of currencies and the impact that has had on nominal pricing for resources and precious metals.

Most developed economies have consumed and borrowed at worrying levels. The United States federal government has on-balance-sheet liabilities of over $16 trillion, and off-balance-sheet liabilities estimated at around $70 trillion.

These numbers do not include state and local government liabilities, nor the likely liabilities from underfunded private pensions. Not to mention increased costs associated with more comprehensive health care and an aging population!

Many analysts are even more concerned about the debts and liabilities of other developed economies—Europe and Japan. In both places, debt-to-GDP ratios are greater than in the US. Europe and Japan are financing themselves through a combination of artificially low interest rates and more borrowing and money printing. This drives down the value of their currencies, helping their exports.

But which nations' leaders will stand firm and allow their export industries to wither as their domestic producers suffer from cheap competing foreign goods? If Japan's Abe is successful at increasing his country's exports at the expense of its competitors like Taiwan, Korea, or China, then his policies could lead to competitive devaluation. And how will the European community react, for that matter?

Loss of purchasing power in fiat currencies increases the nominal pricing of commodities and drives demand for bullion as a preferred savings vehicle.

The factors that have driven this resource supercycle have not changed. Demand is increasing. Supplies are constrained. Currencies are weakening. Thus I believe we remain in a secular bull market for natural resources and precious metals.

With that in mind, I would call the current market for bullion and resource equities a sale.

Where to invest?

 

Let's talk about a type of company most of us follow: mineral exploration companies, or "juniors." We often confuse the minerals exploration business with an asset-based business. I would argue that is a mistake.

Entities that explore for minerals are actually more similar to "the research and development" space of the mining industry. They are knowledge based businesses.

When I was in university, I learned that one in 3,000 "mineralized anomalies" (exploration targets) ended up becoming a mine. I doubt those odds have improved much in 40 years. So investors take a 1-in-3,000 chance in order to receive a 10-to-1 return.

These are not good odds. But understanding the industry improves them substantially.

Exploration companies are similar to outsourcing companies. Major mining companies today conduct relatively little exploration. Their competitive advantage lies in scale, financial stability, and engineering and construction expertise. Similar to how big companies in other sectors outsource certain tasks to smaller, more specialized shops, the big miners let the juniors take on exploration risk and reward the successful ones via acquisitions.

Major companies are punished rather than rewarded for exploration activities in the short term. Majors therefore tend to focus on the acquisition of successful juniors as a growth strategy.

Today, the junior model is broken. Many public exploration companies spend a majority of their capital on general and administrative expenses, including fundraising. Overlay a hefty administrative load on an activity with a slim probability of success, and these challenges become even more severe.

One response from the exploration and financial community has been to put less emphasis on exploration success and focus instead on "market success." In this model, rather than "turning rocks into money," the process becomes "turning rocks into paper, and paper into money."

One manifestation of that is the juniors' habit of recycling exploration targets that have failed repeatedly in the past but can be counted on to yield decent confirmation holes, and the tendency to acquire hyper-marginal deposits and promote the value of resources underground without mentioning the cost of actually extracting them.

The industry has been quite successful, during bull markets, at causing "sophisticated" investors to focus on exciting but meaningless criteria.

Being successful in natural resource investing requires you to make choices. If your broker convinces you to buy the sector as a whole, they will have lived up to their moniker—you will become "broker" and "broker."
We have already said that exploration is a knowledge-based business. The truth is that a small number of people involved in the sector generate the overwhelming majority of the successes. This realization is key to improving our odds of success.

"Pareto's law" is the social scientists' term for the so-called "80-20 rule," which holds that 80% of the work is accomplished by 20% of the participants.

A substantial body of evidence exists that it is roughly true across a variety of disciplines. In a large enough sample, this remains true within that top 20%—meaning 20% of the top 20%, or 4% of the population, contributes in excess of 60% of the utility.

The key as investors is to judge management teams by their past success. I believe this is usually much more relevant than their current exploration project.

It is important as well that their past successes are directly relevant to the task at hand. A mining entrepreneur might have past success operating a gold mine in French speaking Quebec. Very impressive, except that this same promoter now proposes to explore for copper, in young volcanic rocks, in Peru!

In my experience, more than half of the management teams you interview will have no history of success that shows that they are apt at executing their current project.

Management must be able to identify the most important unanswered question that can make or break the project. They must be able to say how that question or thesis was identified, explain the process by which the question will be answered, the time required to answer the question, how much money it will take. They also need to know how to recognize when they have answered the question. Many of the management teams you interview will be unable to address this sequence of questions, and therefore will have a very difficult time adding value.

The resource sector is capital intensive and highly cyclical, and we expect that the current pullback is a cyclical decline from an overheated bull market. The fundamental reasons to own natural resource and precious metals have not changed. Warren Buffett says, "Be brave when others are afraid, be afraid when others are brave." We are still "gold bugs." And even "gold bulls."

Rick Rule is the chairman and founder of Sprott Global Resource Investments Ltd., a full-service brokerage firm located in Carlsbad, CA. He has dedicated his entire adult life to different aspects of natural-resource investing and has a worldwide network of contacts in the natural-resource and finance worlds.

Watch Rick and an all-star cast of natural-resource and investment experts—including Frank Giustra, Doug Casey, John Mauldin, and Ross Beaty—in the must-see video "Upturn Millionaires," and discover how to play the turning tides in junior mining stocks, for potentially life changing gains. Click here to watch.

The article Why the Resource Supercycle Is Still Intact was originally published at Casey Research.com.


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Friday, July 6, 2012

Crude Oil Distillation and the Definition of Refinery Capacity

A crude oil refinery is a group of industrial facilities that turns crude oil and other inputs into finished petroleum products. A refinery's capacity refers to the maximum amount of crude oil designed to flow into the distillation unit of a refinery, also known as the crude unit.

The diagram below presents a stylized version of the distillation process. Crude oil is made up of a mixture of hydrocarbons, and the distillation process aims to separate this crude oil into broad categories of its component hydrocarbons, or "fractions." Crude oil is first heated and then put into a distillation column, also known as a still, where different products boil off and are recovered at different temperatures.

diagram of Crude oil distillation unit and products, as described in the article text
Source: U.S. Energy Information Administration.  

Lighter products, such as butane and other liquid petroleum gases (LPG), gasoline blending components, and naphtha, are recovered at the lowest temperatures. Mid-range products include jet fuel, kerosene, and distillates (such as home heating oil and diesel fuel). The heaviest products such as residual fuel oil are recovered at temperatures sometimes over 1,000 degrees Fahrenheit.

The simplest refineries stop at this point. Although not shown in the simplified diagram above, most refineries in the United States reprocess the heavier fractions into lighter products to maximize the output of the most desirable products using more sophisticated refining equipment such as catalytic crackers, reformers, and cokers.

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Monday, June 18, 2012

Working Crude Oil Storage Capacity at Cushing, Oklahoma Rises

As of March 31, 2012 working crude oil storage capacity at the Cushing, Oklahoma storage and trading hub was 61.9 million barrels, an increase of 6.9 million barrels (13%) from September 30, 2011 and 13.9 million barrels (29%) from a year earlier, as reported in EIA's recently released report on Working and Net Available Shell Storage Capacity.

Utilization of working storage capacity on March 31, 2012 was 64%, an increase from the 53% observed in September 2011, but lower than the 86% observed on March 31, 2011. The report also noted that operating shell storage capacity increased 8.1 million barrels (12%) from September 30, 2011 to reach 74.6 million barrels.

Both storage capacity and the level of inventories held at Cushing are closely watched market indicators, as Cushing is the market hub for West Texas Intermediate (WTI) crude oil that is the basis for crude oil futures contracts traded on the New York Mercantile Exchange. High inventory levels at Cushing have been a symptom of transportation constraints that have resulted in WTI trading at a discount relative to comparable grades of crude oil since early 2011.

graph of Crude oil storage capacity and inventories at Cushing, Oklahoma




Growing volumes of U.S. crude oil production, along with a higher level of imports from Canada, have helped contributed to the record levels of inventories at Cushing. Increased flows of crude oil from these two sources, along with expectations for future increases, have consequently created the need for additional storage at the hub.

Weekly data show that as of June 1, 2012, crude oil inventories held at Cushing were 47.8 million barrels, the highest level on record and very close to total working storage capacity as of March 2011. However, due to the growth in storage capacity between March 2011 and March 2012, the utilization rate for working storage capacity at Cushing has actually declined over the past 14 months.

Thursday, May 31, 2012

OPEC Spare Capacity in the First Quarter of 2012 at Lowest Level Since 2008

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The U.S. Energy Information Administration (EIA) estimates that global spare crude oil production capacity averaged about 2.4 million barrels per day (bbl/d) during the first quarter of 2012, down about 1.3 million bbl/d from the same period in 2011 (see chart below). The world's spare crude oil production capacity is held by member countries of the Organization of the Petroleum Exporting Countries (OPEC). Spare capacity can serve as a buffer against oil market disruptions, and it gives OPEC additional political and economic influence in world markets. There is little or no spare capacity outside of the OPEC member countries.

graph of Quarterly OPEC spare crude oil capacity and WTI spot prices, as described in the article text

Spare crude oil production capacity is now less than 3% of total world crude oil consumption—the lowest proportion since the fourth quarter of 2008—based on EIA estimates.

Spare crude oil production capacity is an important indicator of producers' ability to respond to potential disruptions; consequently, low spare oil production capacity tends to be associated with high oil prices and high oil price volatility. Similarly, rising spare capacity tends to be associated with falling oil prices and reduced volatility. However, spare capacity must also be considered in the context of a number of other market factors that can drive crude oil prices, such as global supply, demand, and inventory levels.

EIA defines spare crude oil production capacity as potential oil production that could be brought online within 30 days and sustained for at least 90 days, consistent with sound business practices. This does not include oil production increases that could not be sustained without degrading the future production capacity of a field.


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Tuesday, February 14, 2012

EIA: Natural Gas and Renewable Shares of Electricity Generation to Grow

Over the next 25 years, natural gas and renewable fuels gain a larger share of the United States generating mix of electricity, according to the Annual Energy Outlook 2012 (AEO2012) early release reference case. Coal remains the dominant source of electricity, but its share drops from 45% in 2010 to 39% in 2035.

graph of U.S. electricity net generation by fuel, 1990-2035, as described in the article text


These results are from the AEO2012 Reference case, which assumes no changes in current laws and regulations. The full report will include additional cases measuring the impacts of alternative policies and different paths for prices and technologies on the electric power sector.
  • Annual generation from natural gas increases by 39% from 2010 to 2035. Eighty-five gigawatts of new gas capacity is added through 2035, as stable capital costs and low fuel prices make it the most attractive source of new capacity.
  • Renewable energy generation grows 33% from 2010 to 2035. Non-hydro renewables account for a majority of this growth, with wind, solar, biomass, and geothermal generation all significantly larger at the end of the projection horizon.
  • Coal's share of the electricity generation mix drops from 45% to 39% between 2010 and 2035. Thirty-three gigawatts of coal capacity are retired and only 14 gigawatts of new coal capacity already under construction are completed. A few factors disadvantage the relative economics of coal-fired capacity: projected low natural gas prices, the continued rise of new coal-fired plants' construction costs, and concerns over potential greenhouse gas emissions policies.
  • Annual generation from nuclear power plants grows by 11% from 2010 to 2035, but its share of the generation mix declines. A total of 10 gigawatts of new nuclear capacity are projected through 2035, as well as an increase of 7 gigawatts achieved from uprates to existing nuclear units. About 6 gigawatts of existing nuclear capacity are retired, primarily in the last few years of the projection.

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Wednesday, January 6, 2010

Crude Oil Stockpiles Unexpectingly Climb by 1.3 Million Barrels


Crude inventories and gasoline supplies rose last week, the government said Wednesday. Crude inventories rose by 1.3 million barrels, or 0.4 percent, to 327.3 million barrels, which is half a percent above year ago levels, the Energy Department's Energy Information Administration said in its weekly report. Analysts had expected a drop of 1.6 million barrels for the week ended Jan. 1, according to a survey by Platts, the energy information arm of McGraw-Hill Cos.

Gasoline inventories increased by 3.7 million barrels, or 1.7 percent, to 219.7 million barrels. That was above analyst expectations and 2.9 percent above year ago levels. Demand for gasoline over the four weeks ended Jan. 1 was 0.3 percent higher than a year earlier, averaging nearly 9 million barrels a day. At the same time, U.S. refineries ran at 79.9 percent of total capacity on average, a drop of 0.4 percentage point from the prior week. Analysts expected capacity to build to 81.05 percent.

Inventories of distillate fuel, which include diesel and heating oil, fell by 300,000 barrels to 159 million barrels for the week ended Jan. 1. Analysts expected distillate stocks to drop by 1.8 million barrels. Crude prices fell 72 cents to $81.05 per barrel on the New York Mercantile Exchange.....Read the entire article.

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Wednesday, December 30, 2009

OPEC Has Way Too Much Oil For 2010


According the Energy Information Administration's (EIA) latest energy outlook, while world energy consumption is expected to grow in 2010, it will only be adding 1.1 million barrels of consumption and will remain below its past peak consumption.
This tepid demand growth will butt against production increases for many non OPEC oil producers, which means that OPEC will be under substantial pressure to limit its output, and obviously will.

Yet this will require massive discipline for the member nations given that OPEC's surplus crude oil production capacity will actually rise in 2010, after a huge increase is surplus capacity during 2009. 2010 will see the worst OPEC overcapacity situation since 2002.....Let's go to the charts!.

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