A Melman Minute — July 5, 2011

Somehow, during the rush of stories about the Greek default crisis, the American budgetary crisis, the coming struggle over the USA debt limit crisis and the other attention-grabbing headlines of the moment, one of the most important underlying influences regarding the prices of both the precious and base metals seems to have been ignored. We are referring to the influence of inflationary expectations.

Of the many component factors which go into the inflationary equation, perhaps the most visible of all is the actual prices for the raw material commodities which go into manufacturing, distribution and retail pricing calculations and along those lines, a recent interview with a respected analyst caught our eye in yesterdays press.

Patricia Mohr, economics and commodity specialist at the Bank of Nova Scotia, is quoted at length in an article in the Toronto Globe and Mail on her predictions regarding future movement in commodity prices. The article caught our attention because Ms. Mohr is that rarest of all bank analysts, one who has a well-deserved reputation for objective thought. The interview was headlined, A commodity bull market ready to charge with the headline providing a clear indication of her prevailing opinion that much brighter days lie ahead for commodity prices in general.

Her first consideration is the all-important nation of China. She believes that it was growing fears that the Chinese economy was going to enter a period of diminishing growth rates or even an actual slowdown that was the biggest single factor in creating the recent weakness in several important commodity markets. However, the article informs us that ...Ms. Mohr says the anxieties are overblown. She expects worldwide and Chinese industrial production to increase during the second half of this year, thereby increasing demand for four metals in particular; copper, aluminum, zinc and nickel.

She paid particular attention to copper price forecasts, given that copper, ...is an essential element in Chinas massive infrastructure program and is used in everything from air conditioners to high-speed railways. She believes that many Chinese industrial users reduced their orders for new copper when prices first reached the $4.40 level, preferring to use their previously-acquired stockpiles and it was this action that was a primary influence in driving the price of Dr. Copper temporarily below the $4.00 level during recent weeks. However, she notes that, ...the liquidation of those inventories is going to come to an end very soon, if it hasnt already. As a result, she is predicting that copper prices will reach at least $4.40 per pound during the fourth Quarter 2011, just 20 cents below the historic high of $4.60 per pound set this past February.

She is particularly bullish on agricultural commodities and while those do not directly affect our world of precious and base metals mining, they can be a strong influence on inflationary expectations, a very important historic indicator of precious metals prices. In her opinion, a combination of adverse worldwide planting conditions combined with her expectation of an improving world economy later this year should combine to drive agricultural commodity prices higher. She is particularly bullish on the corn market, predicting that prices could exceed the historic high of $7.87 per bushel, perhaps reaching the $8.00 per bushel mark before the end of the year.

One other prediction of note involves the lumber market where Ms. Mohr predicts that growing Chinese demand will drive prices higher, upward from the present quotes near $237 per contract to an average range near $270 next year.

Rising prices may be bad news for consumers, but could be the harbinger of new gains in both the precious and base metals prices, should Ms. Mohr be correct in her forecasts. That is what makes it particularly important for us to take her views into consideration at this time.

There is one other factor we would add into our long term positive expectations for metals prices in particular and commodity prices in general. In our travels across five continents, it is becoming impossible to ignore the forces driving life style expectations higher across the previously lesser-developed nations of the world. As many economies such as China, India, Brazil, Russia, Indonesia, Mexico and others affecting billions of people continue to advance, their demand for raw materials will continue to grow apace, and we believe there are growing restraints building on the ability to bring new resources into production faster than present supplies are being depleted, thereby driving the supply-demand equation further in favour of demand, with the accompanying expectation of higher commodity prices down the road.

By one of those strange coincidences, another major article relating to an important commodity appeared in yet another respected financial journal, Barrons Magazine. Their cover story in this weeks edition carries the self-explanatory headline, Get ready for $150 oil. The sub-headline reads, After a decline this summer, crudes price is likely to rise sharply by next spring...

The gist of writer Gene Epsteins case for higher petroleum prices is that the spare capacity of the worlds producers is declining to worrisome levels, a fact which should help drive the price of crude oil to an average of near $150 per barrel, but with spikes to $165 or even $170.

There is a point of unity between the outlooks of Mohr and many petroleum analysts which relates to the growing demand from newly-advancing nations which are entering a period of increasing automobile, industrial and other consumer demands, while the ability of current producers to ramp up production on a sufficient scope to meet those increasing demands is coming into question.

Epstein provides us with two pieces of fundamental data that could bear importantly on the question of future petroleum prices. While worldwide petroleum demand has now reached 90 million barrels per day and is increasing at a rate of 1.1 million barrels per day per year worldwide production is increasing at a rate of only 0.6 million barrels per day.

The implications implied by these two trends is clear: unless some new and reliable petroleum production capacity is quickly added to the mix, the upward pressure on petroleum prices could begin to assert itself in the near future and could become a powerful trend as fears of outright shortages begin to spread.

Epstein suggests that should these higher prices occur, they will likely spur new exploration and development efforts, but even if those were to prove successful, their impact would not become part of the market equation for several years. Therefore, he offers this final caution: ...none of this is likely to help much by spring 2012. Get ready for higher oil prices.

Our chart on the price of oil still looks static to weak for the time being. It is the future which we believe is of much greater concern in terms of inflationary expectations and if Epstein and others are correct, this chart could be turning up in relatively short order to once again threaten and then exceed the high levels set just a couple of years ago..

Commodity markets are trading higher early this morning and as of 7:00 AM PDT, gold and silver are both sharply higher with gold up by about $20 to near $1,510 while silver had added about one dollar to just above $35.00 per ounce. Base metals are slightly improved on balance while mining share indexes have advanced by about 1.5% so far this morning. Financial markets are split with the Dow down some 20 points while Canadas TSX Index is ahead by over 50.

In other markets, petroleum is up by a strong $1.25 per barrel to about $96.00, the US Dollar Index is up by a modest 20 points while long term interest rates have declined a little.

All quotes US$ unless otherwise indicated.

Next Melman Minute scheduled for tomorrow morning.

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