Trends and Cycles in Metal and Energy Prices – with a Quick Look at Industrial Sand*

1. Trends and Cycles in Metal and Energy Prices – with a Quick Look at Industrial Sand* John T Cuddington William Jesse Coulter Professor of Mineral Economics Colorado School of Mines 94th Annual Conference – May 20-22, 2012 Casting Industry Suppliers Association - CISA Bonita Springs,  Florida * Motivated by Chuck Fowler’s presentation late on Day 1 of the conference

2. Overview • Why do metal and energy prices matter to the casting industry? • How can economic analysis help us organize our thinking about trends, cycles and volatility in prices? • What does the empirical evidence on metal and energy prices show? • What are the implications of metal/energy price dynamics for the casting industry?

3. The Importance of Metals and Energy Prices to the Casting Industry • Prices are important to casting industry • Metal and energy prices are key inputs into the casting process • Casting is energy intensive • Metal and energy prices have significant impacts on: • Profitability • Competitiveness vis-à-vis other forms of casting • Prices provide key information in decision-making: • Capacity expansion and upgrades • Strategic planning • Input substitution

4. Economic Analysis of Price Behavior • Standard economic research methodology • Develop/refine theories • Study empirical evidence, ‘stylized facts’ • Repeat • Supply and Demand -- starting point for most analyses of prices • Nonrenewable resources – are they different? Exhaustible? • How can anything involving nonrenewable resources be sustainable?!

5. Nonrenewable Resource Markets: Supply-Side Considerations • Metals and Energy - multi-step, multi-product production process • Reserves of nonrenewable resources are intermediate inputs into mining and milling • Exploration produces ‘inventories’ of reserves of varying quality (ore grade, multi-ore content, accessibility) • Bulk metals are intermediate inputs in production of either final consumption goods and/or capital equipment (often involving foundries) • Reserves of nonrenewable primary products change over time • Discovery and depletion (via mining activity) • Economic value changes as prices and technology change • Reserve/production ratios have not dropped in spite of large increases in global production • “Fixed stock” view of nonrenewable resources is not particularly useful.

6. Supply-Side Considerations - Continued • Mining is very energy and capital intensive • Short-run supply is often (capital) capacity constrained (i.e. vertical SR supply curves); input substitution is limited • Long-run supply is very price elastic (i.e. horizontal LR supply curves) • Implication: Long-run price analysis focuses on primarily on supply

7. Technological Change –‘Drilling for Ideas’ • Technological change occurs at each step of the multi-step production process • Increasing globalization due to falling transport costs and improvements in communication • Globalization spread multi-step production process across several countries

8. Drilling for Ideas vs. Reserves • The production process to generate new productivity-enhancing ideas is similar to the exploration for reserves • Production process is highly uncertain • Quality of output varies • Incentives and property rights are important for stimulating production • There are often free-rider problems and first-mover advantages • Secrecy sometimes helps in gaining a competitive advantage – at least for a while • To be successful, you can’t rest of your laurels.

9. Nonrenewable Resource Markets: Demand-Side Considerations • Long-Run minerals demand depends on: • Population growth • Growth in per capita income • Structural transformation that accompanies economic development • Shifts in the composition of demand (agricultural goods, manufactures, and services) • Shifts in composition of global supply affects the derived demands for metals and energy • Technological change; input substitution Structural transformation is a key component of ‘super cycle’ hypothesis • Short-run metals/energy demands are strongly pro-cyclical (global biz cycles matter)

10. Role of Formal Exchange Markets • Some mineral product prices are so-called producer prices that change gradually over time in response to supply-demand imbalances • Others are ‘flex price’ goods traded on formal exchanges, often with both spot and forward pricing • The latter are ‘hybrid assets’ – part real asset, part financial asset • Forward-looking expectations and ‘news’ drive pricing of financial assets • Introduction of formal markets facilitates price discovery and transparency, but also raises (apparent) price volatility

11. Simple Mineral Supply-Demand Model D0 D1 SSR P $/unit SLR MC capacitySR Q units/period

12. What Does the Empirical Evidence on Metal/Energy Prices Show? • Looking at longest available data spans: • Average growth rates in real metal and energy prices are small • Year to year variability is huge • Little evidence that world is running out of nonrenewable resources • Over 20-70 year periods: • Prices may drift up or down – reflecting the tug-of-war between depletion and technological change • Some evidence of ‘super cycles’ especially in the post WWII period

13. Nominal and Real Oil Prices • Nominal vs. real crude oil prices using two different price deflators: CPI and PPI

14. Trend and Cycle Decomposition

15. Super Cycles in Oil Prices • Trend increased by roughly 125% over the past 65 years (real terms)  ~2%/year • Comparison to Metals, correlation coefficient: pre-WWII 0.71, post-WWII 0.88

16. Trend and Super Cycles in Coal Prices • Downward trend of about -1.3% annually from the Great Depression to 1972 and -0.5% afterwards

17. Super Cycles in Energy and Metals Prices After WWII • Especially after WWII

18. Huge variation in medium-term trends; Huge Volatility • Slides that follow show monthly data on nominal U.S. dollar prices from IMF

21. …More on Empirical Evidence • Metal and energy prices are strongly pro cyclical • Rise sharply in biz cycle upturns • Fall fall sharply during recessions • Metals and energy products traded on formal exchanges are ‘hybrid assets’ • Part financial asset where expectations about future conditions are key drivers • Part real asset where supply, demand and inventories are fundamental determinants of prices

22. A More Granular Analysis: Real Price of Industrial Sand with LT Trend – 1902-2010 (USGS)

23. A Super Cycle in Real Sand Prices – 1902-2010 (USGS)

24. Implications for the Casting Industry • Long-term contracts to supply casted products are risky when long-term trends (20-25 years) in key input prices are difficult to predict • Long-term investments in capacity and/or new technologies are risky • ‘Real options’ to adjust production mix, capacity, input supply sourcing, etc. are valuable • Link between nominal mineral price movements and general inflation is surprisingly weak • Some input price risk can be passed on to consumers of your products • Short-term price risks can be addressed with financial hedging strategies • Exchange rate effects on dollar metal and energy prices can be large.

25. Thank You! • Your hospitality in this beautiful setting • Opportunity to learn more about foundries, the casting industry, and its suppliers • Please explore collaborations with faculty and graduate students in our Mineral and Energy Economics Program • My e-mail: jcudding@mines.edu