"Supply Destruction" to boost Commodity Prices ?

wombat42_2

We have heard of Demand Destruction see http://en.wikipedia.org/wiki/Demand_destruction

But there is also Supply Destruction. The costs of extracting commodities is forever getting higher so the cost of the commodity must go up for the company to make a profit.

See for example:
http://www.fool.com/investing/international/2008/09/26/fool-interview-fronteer-ceo-mark-odea.aspx

wombat42_2

Bump Bump Bump

1echidna

Supply destruction may be a factor were commodity prices to fall a great deal indeed. Normally however in extractive industries the major consideration is the capital cost upfront. It is too late once the investment has been made to look back, and production will normally continue because in itself this is profitable, even at lower prices, although the capital may not be recovered as quickly as was envisaged when the investment was made. Also, taking an example from the petroleum industry where, even when oil prices where above $140 a barrel capital investments (with at least one major company I know of) were only being made where satisfactory returns would be made based on an oil price of $70 per barrel. In the light of volatile prices I expect this behaviour may have been typical in other extractive industries.

Reaper

If you believe the article then it follows gold itself is a good thing to have and gold mining stocks are a bad thing to own.

However one thing struck me as odd. He says:

I think we'll see $1,200 gold easily. I think that's a long-term, sustainable price. I think it's going to be linked to cost of production, which is fundamentally linked to the cost of oil...

...but the oil price has been dropping rapidly which suggests the cost of production is dropping too. In the long term the oil price will rise again, but not until the end of the recession is in sight.

1echidna

It rather struck me that the article was aimed at talking up the prospects of high gold prices. I can't help feel that the cost of production of gold is more peripheral to price than supply and demand and of course there is a substantial reservoir of gold already in circulation. The cost of production (discounting capital repayments) of petroleum (which is consumed almost as soon as it is produced) is typically a few dollars a barrel and bears little relationship to the market price. In the case of gold also I feel it is demand not cost of production that will govern the price. Quite likely that there will be strong demand though in a recession, particularly if it is severe, and people see the value of money being eroded.

Blah99

Reaper wrote: »

...but the oil price has been dropping rapidly which suggests the cost of production is dropping too.

I don't believe that's correct. Oil price is dropping because demand is dropping. The price steadily increased due to increased demand, which has been curtailed because of the economic crisis. It also increased due to market speculators, who kept driving the price higher on the back of the demand-driven rises.

The cost of oil production is actually increasing, because companies are having to find more efficient ways to exploit existing reserves and the oil in hard-to-get places.

1echidna

An interesting extract from Wikepedia on gold as an investment:

"Given the huge quantity of hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production"

http://en.wikipedia.org/wiki/Gold_as_an_investment

It is interesting to me that the price of gold is not higher than it is today but I suppose the general mood may be that inflation is (for the moment at least) lower than in previous crises and that the crisis is not going to be long and deep.

tradetime

Personally I think gold is likely to move higher over the long term, but in the short to medium term it may well drop first. If we are, as many believe, entering a period of deflation such an environment does not support higher gold prices, neither does it increase the cost of production, nor the demand.
Much of the run up in both crude and gold (and other commodities for that matter) was pure speculation, as hedge funds experience more and more redemptions they are being forced to liquidate these position, this along with a deteriorating demand will force prices lower in the short to medium term.
However as price falls and demand falls gradually production will be reigned in, probably just in time for the current hyper-inflation of the worlds economies to kick in.
The dude in the article has a vested interest in talking gold up, much like Boon Pickens and Jim Rodgers were featured all over Bloomberg nearly everyday telling us Oil was going to $200 before it would ever see $100, being heavily invested in something will do that for you.
Though as I say, I suspect gold will go higher further down the road, along with the rest of the commodities market

wombat42_2

Blah99 wrote: »

I don't believe that's correct. Oil price is dropping because demand is dropping. The price steadily increased due to increased demand, which has been curtailed because of the economic crisis. It also increased due to market speculators, who kept driving the price higher on the back of the demand-driven rises.

The cost of oil production is actually increasing, because companies are having to find more efficient ways to exploit existing reserves and the oil in hard-to-get places.

Thats right. Extraction costs are continually on the increase as more dificult sources are used. For gold, extracting currently costs around $600 per ounce and oil is around $55 per barrell.

tradetime

1echidna wrote: »

It is interesting to me that the price of gold is not higher than it is today but I suppose the general mood may be that inflation is (for the moment at least) lower than in previous crises and that the crisis is not going to be long and deep.

Both inflation expectations, and the strength of the US$ have considerable effect on the price of gold, and other commodities.

tradetime

wombat42 wrote: »

Thats right. Extraction costs are continually on the increase as more dificult sources are used. For gold, extracting currently costs around $600 per ounce and oil is around $55 per barrell.

Hi Wombat, do you have a link to that figure for all in cost relating to $55 oil? The current spot price for Nymex Crude is around $71 p/bl