The Commodity Investor Q&A
With Matt Badiali
August 13, 2008
Q: I've noticed some base metals, like zinc and nickel, have been clobbered recently. I know you're a believer in the commodity bull market long term, so do you see this base-metal decline as a buying opportunity? – T.B.
A: I don't think it's time to buy base metals yet, but we're getting closer. For new readers, base metals are basic industrial metals like zinc, lead, and nickel.
Nickel peaked in May 2007 around $24.58 per pound. It's down 67% since then. Zinc peaked in December 2006 at $2.07 per pound. It's down 63% since then. Lead peaked in October 2007 at $1.81 per pound. It's down 51% since then. The one exception is copper.
Copper hit a recent peak of $3.99 in June 2008. However, the metal is down 15% from that high. If the other base metals are any indication, copper could be on the verge of a big leg down. A 60% decline would put the copper price at $2.39 per pound.
We don't want to stand in the way of that train.
We can get a better idea of where these prices are going by seeing where they were. Take a look at the current prices versus the 20-year average prices.
|
Lead (Lb) |
Nickel (Lb) |
Zinc (Lb) |
Copper (Lb) |
Current Price |
89¢ |
$8.15 |
76¢ |
$3.39 |
20-Year Average |
39¢ |
$4.60 |
62¢ |
$1.38 |
% Above Average |
129% |
77% |
22% |
145% |
|
This table tells us zinc is the lone base metal that appears to be near a bottom. Clearly, lead and copper have a long way to fall to reach the mean value.
Patience is the rule right now. Big declines like we've seen often produce big opportunities. I'm seeing some great values out there now, but the trend in the base metals is down.
However, if you must speculate on base-metal companies, choose companies that are zinc-rich (that usually includes silver and lead). I think zinc is the closest to bottoming.
Q: How deep is the oil correction going to go? In other words, what do you think a barrel of oil is worth? – C.B.
A: This question has "pulled down the pants" of many smart analysts on national television. I don't know how far down it could go, but I can do a back-of-the-envelope calculation to figure out the rational value of a barrel of oil.
I'm going to base the calculation on data from Exxon, Chevron, and ConocoPhillips. These companies are the most efficient and transparent oil companies in the world. They use economies of scale and legacy fields to produce oil at the lowest prices in the industry. No other oil company can produce oil this cheaply (with the exception of Saudi Aramco).
If you start with the most efficient companies, then we'll get a base price.
According to Bloomberg, those three majors sold oil for $65 per barrel and made $43 per barrel on average in 2007. That means it cost those companies around $22 per barrel to produce the oil. So the most efficient producers in the world need at least $22 per barrel just to pump it out of the ground.
If the most efficient oil companies in the world need $22 to produce a barrel of oil, then inefficient National Oil Companies like Venezuela's PDVSA and Mexico's Pemex need twice that price, at least. Their operations are a mess. That puts the fundamental cost of oil – without profits – around $45 per barrel. Below that price, most companies are producing at a significant loss.
Now that we know the production cost, what is the actual value of a barrel of oil?
Our three majors average about a 10% profit margin at the end of the day. That means they reinvested about $36.50 per barrel on capital projects – what we call sustaining capital. That's money spent on new wells, land acquisition, and other capital projects.
That reflects the cost of the modern oil company. Exploration is getting more expensive, drilling is getting more expensive, construction is getting more expensive – there isn't any way to avoid it. In order to sustain the current level of exploration and development, companies probably need to make about $40 per barrel.
In real terms, that puts oil at $85 per barrel ($45 in production cost plus $40 in sustaining capital). Less than that will probably slash exploration budgets. Low exploration means higher prices eventually.
Good investing,
Matt Badiali
Editor's Note: If you'd like to submit a question to the Commodity Investor Q&A, e-mail me here. Please keep in mind... I cannot give personalized investment advice.
