It has been a good year for making money. Investors who simply allocated their capital at the outset of 2010 into gold bullion are up about twenty percent in dollar terms.
But what if one thinks of gold as money? To such an investor, a twenty percent year-to-date cash return is just treading water. One hundred ounces in January is still one hundred ounces in November. Making money is all right, but in these days of printing presses and helicopters, the real aim is to make gold.
So where in this market are the best opportunities to make gold? Scanning the local investing universe for opportunity, one is increasingly drawn towards base metals and base metal producers. Unlike their shinier neighbours on the periodic table of the elements, most base metals are still significantly below the high prices established in the heady days of 2006 and 2007. Since 2006, gold and silver prices have doubled, while base metals prices have declined by as much as 50%, depending on the commodity.
Digging into this market, I focus on lead, whose market dynamics are generally aligned with other under-appreciated base metals. Lead’s investment thesis is supported both a current price that is well below historic averages and also a very attractive longer-term supply and demand picture.
Lead traded hands recently at a price of $2,500 per metric tonne. In terms of gold ounces, it now takes about 1.9 gold ounces to buy a tonne of lead. As recently as 2006 that ratio was between 4 and 5 ounces per tonne which is in line with the past 60 year average price ratio. (Incidentally, the ratio was as high as 11:1 oz/tonne back in 1951). If lead were merely to revert to its historic average value vs gold, then its price per tonne ought to be about $6000, an increase of 140% from today’s levels.
Figure 1: Historic Lead to Gold Ratios (Ctrl +Click for larger image)
Backing the case for upward mean reversion on lead prices are developments in supply and demand. On the demand side, lead is used principally in lead-acid automotive batteries which accounts for 70% of consumption. Although the North American automobile industry still appears depressed, elsewhere that is not true. In unit terms, global automobile sales are expected to hit new record sales in 2010, driven by a combined 55% growth in India, China and South America compared to 2008. With automobile penetration in these countries still far below Western levels, there is ample room for growth. In Canada, for instance, there are 562 cars per 1,000 people. In India there are less than 20.
Substitution is not a major risk in the case of lead-acid batteries. The cars sold in the growth markets are generally cheaper (including for instance, India’s $2500 Tata Nano). These are not markets experimenting with expensive hybrid technologies. Cars in India include a standard lead-acid battery at an input cost of $60-90.
In contrast with strong demand fundamentals, the supply picture for lead is much less robust. Of the 8 million tonnes of annual demand for lead, only 3.8 million tonnes is met by actual mine production. The rest comes from recycling, mostly related to automobile batteries. Due to this reliance on recycled stock, a 20% increase in global lead demand, would actually require a 40% increase in mine output to stay in equilibrium. Given the strong dynamics described above, a demand-driven squeeze in the lead market seems highly possible, in my view.
Risks and Opportunities
There are numerous investment risks associated with base metal producers, which are not known as deep cyclicals without reason. Beyond economic exposure, certain environmental challenges exist, which for a commodity like lead have significant potential ramifications for both supply and demand.
However, even though I can easily imagine a scenario where this trade gets worse before it gets better, I find the base metals group to be one of the most attractively positioned sectors for the long-term. From a stock selection point of view, there are worse places to start than Vancouver’s Teck Resources (TSX: TCK) for diversified exposure.