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 20% in dollar terms.
But what if one thinks of gold as money? To such an investor, a 20% 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 one is increasingly drawn toward base metals and base-metal producers. Unlike their shinier neighbours on the periodic table of 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 have declined by as much as 50%, depending on the commodity.
Floating a lead balloon
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 by a current price that’s well below historic averages and a very attractive longer-term supply and demand picture.
Lead traded hands recently at a price of $2,500 per tonne. In terms of gold, it now takes about 1.9 gold ounces to buy a tonne of lead. As recently as 2006 that ratio was between four and five 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 versus gold, then its price per tonne ought to be about $6,000, an increase of 140% from today’s levels.
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’s not true. In unit terms, global automobile sales are expected to hit new records in 2010, driven by a combined 55% growth in India, China and South America compared with 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 $2,500 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 to $90.
In contrast with strong demand fundamentals, the supply picture for lead is much less robust. Of the eight million tonnes of annual demand for lead, only 3.8 million tonnes is met by 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 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 known as deep cyclicals for good reason. Beyond economic exposure, certain environmental challenges exist, which for a commodity like lead have significant potential ramifications for 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.