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July 1, 2008

BUBBLE UP OR UNDER?

The metals industry, riding high on the current wave of strong prices and demand, can't help but hope the good times never end. But they will end—won't they?

Illustrations by David Plunkert

Let’s pause for a moment, in the hurly-burly of continually rising metals prices, to consider what we know about the economic phenomenon known as “the bubble.”

In May, at the joint annual meetings of the American Iron and Steel Institute (AISI) and Metals Service Center Institute (MSCI), a panel of solemn CEOs agreed that last year’s huge advance in steel prices was certainly “structural.” By this, they meant the supply-and-demand equation has so immensely changed that it is, in reality (fingers crossed, now) “permanent,” insofar as anything of man or woman can be permanent.

“The surge in global demand is profound and unprecedented, but we believe it is here to stay. It’s a fundamental change,” said Michael Rippey, executive vice president and CEO of ArcelorMittal USA, voicing the consensus view.

Referring to China and India, Steven F. Leer, chairman and CEO of Arch Coal Inc., said that “never has the world witnessed 2 billion people going through an industrial revolution like this. All inputs [to the steel industry] will be challenged for some years to come.”

There are a number of ways to think about those statements. First, if you own or operate a metals producer or metals service center, you were no doubt reassured and cheered by the CEOs’ calm confidence. It used to be difficult to earn your cost of capital across the business cycle. Now, only the most unfortunate, debt-burdened or mismanaged companies are less than comfortably profitable.

But second, and with all due respect to the speakers, whose points of view are valid, learned and reasonable, they are almost certainly wrong.

Whether you’re an economist who would call an environment of rapidly rising prices for all commodities “inflation,” a U.S. Treasury policy expert who attributes much of the movement to the steadily weakening dollar or a markets speculator who views this as both an opportunity and a “bubble,” no economy— global, regional or national—will support long periods of rapidly rising prices for essential goods. Adjustments happen.

Matter of Perspective

Some years ago, the Chicago-based CEO of a then major futures trading organization—global, powerful, always influential—spoke by telephone with his London office manager about efforts by parties unknown to corner the market in silver. Not only were substantial silver stockpiles suddenly held by relatively few owners, but silver futures contracts would soon come due, forcing anonymous holders of the metal either to deliver it to honor their obligations or default. Prices were skyrocketing, and had been for months. A classic squeeze, in other words.

As a financial reporter sat mesmerized in the CEO’s office, he heard from London the report that signaled the end of that particular bubble. “People are standing in long lines at silversmiths with the family flatware,” reported the London manager. Prices were so good that heirlooms were being melted for conversion into cash.

In just a few days, the supply-and-demand equation was transformed. Amazing and unanticipated amounts of silver flooded the market from all the hidey-holes in the world. Prices, inexorably rising, plunged. Anyone long in silver, betting on an ever-expanding bubble, was crushed.

Of course, the silver squeeze of the 1980s was illegal and, according to some observers, doomed to failure. Large markets always respond to imbalances, speculative or otherwise. But that’s the point. Rapidly rising prices lead, in any marketplace, to predictable responses. Consumption declines. Alternative commodities suddenly become more popular. Production of the scarce commodity increases. Projects are postponed or cancelled. Governments intervene with policy changes, sometimes with war. People change their buying habits or learn to do without.

Economists may never reach conclusions, as George Bernard Shaw suggests. But it’s worth remembering that natural economic laws aren’t ever repealed for one commodity or another, or for all commodities at the same time. Although Forward magazine and its owner, MSCI, never predict prices, our purpose is to stimulate thought and raise ideas that sometimes, in all the euphoria and group think, seem to have been forgotten. For every boom in China and every cartel of oil producers, there’s a response among competitors for commodities and customers for suddenly dear products.

The question is, when will the metals bubble burst? When will production of iron ore, coke, coal, ore ships, affordable energy and all the other inputs to industrial metals catch up with and surpass the intense market factors that today look, to some, like structural change? Old collapses offer clues to the outlook for our bubbles today (See “Parsing Smoke Signals”).

The bad, old dot-com days showed what a fullblown bubble is really like: breathtaking prices and stock market valuations for companies that no one understood, that had no earnings and, in some cases, no product. It was a “new economy,” financial analysts, brokers and business writers said. You may not understand it, but there are new fundamentals driving it, and you’d better get on board or get left behind.

Lots of folks got on board—and got left behind. Big time.

More recently, we watched as the subprime lending market exploded in a blizzard of finger pointing, foreclosed housing and a federal bailout of former Wall Street icon Bear Stearns, a central subprime dealmaker and hedge fund giant.

The quite reasonable worry among many in the metals industry is that now it may be their turn. Prices are so high, demand is so strong and predictions for at least the next two to five years are so aggressive, there is growing anxiety that the bubble must be ready to burst. Some of this is based on the very real understanding that since trees do not grow to the sky, as they say on Wall Street, all booms end. Some of it is a suspicion that apart from real market fundamentals, hedge funds and other commodities speculators are behind the boom.

Another concern is that financial analysts, economists and even the savviest investors get it wrong all the time, riding waves of economic optimism and encouraging others by their rhetoric and actions to do the same. Profits for Warren Buffet’s famed Berkshire Hathaway were down nearly 64% in the first quarter of this year because of his bad bets on Moody’s Investors Service and American Express, among others. Bill Miller, who runs Legg Mason’s Value Trust Fund and whose name is always preceded with “legendary,” got hit as well. Until 2006, his fund had beaten the Standard & Poor’s 500 index for 15 consecutive years. Problems began when his plays into Countrywide Financial and major homebuilders went upside down.

Bad News All Around

There seems no end to troubling and conflicting news these days that is unsettling Wall Street and Main Street. Analysts can’t agree whether oil is going to $200 a barrel or will collapse to $75 a barrel, and food prices are feeding an inflationary cycle that must end at some point. In the next 40 years, the planet will add more than 2 billion people who will need to eat—and live—somewhere. China, with its already seemingly insatiable hunger for raw materials, energy and metals, suffered a catastrophic earthquake that destroyed entire cities that will need to be rebuilt using tougher construction standards. That will only further increase that country’s demand for materials and metals. Add to that the conflicting information about global warming and what should be done to lessen its impact, and it’s difficult to ignore the potentially crushing hand of these developments on world economies.

For emerging economies especially, industrial commodities, steel and aluminum are now the feedstock of their development. And they have pushed the United States and EU economies aside as drivers of the present dramatic run-up in prices.

This is all pretty heady, some would say scary, stuff. At the same time, analysts and metals experts at leading banks and commodities companies seem relatively sanguine. Likewise the big traders. Billionaire George Soros and Jim Rogers, both among the most highly regarded commodities traders, say the world is in the sixth or seventh year—depending on who is counting—of what they call a “super cycle” that historically runs 18 years on average. With sometimes jarring ups and downs along the way, they say, overall up-and-down price trends in commodities usually run in these multi-year super cycles.

And with this cycle, despite all the global uncertainty, traders, economists and analysts insist the so-called bubble is not very bubbly. Sure, there is some speculation in many of these markets. But, they say, there are solid economic fundamentals at work, as well. We are not, after all, looking at dot-com, high-tech companies with big stories, uncertain products and faint markets. We are looking at real products with real booming demand and real supply constrictions.

“Fundamentals drive these things,” says William Strauss, senior economist and economic adviser at the Federal Reserve Bank of Chicago. “In this case, it is these developing economies, China and India, and their demands for infrastructure. And with incomes rising, there is an ever-increasing demand for consumer goods. If these economies continue to do well in Asia, the demand will continue.”

These developing economies also use steel and other metals less efficiently than developed countries, says Eric Klenz, director of industrial corporate and investment banking at KeyBanc Capital Markets in Cleveland. That is, they use more of it per infrastructure project than does the United States.

He points also to the Middle East as a strong factor in demand. “The six countries of the [Gulf Cooperative Council]—Saudi Arabia, Kuwait, United Arab Emirates, Oman, Qatar and Bahrain—just announced $2 trillion worth of infrastructure projects,” he says. “And now Russia is planning $1 trillion in infrastructure. The story used to be that Russia was the bridge to Europe and Asia, but now the story is that it is the roadblock because it doesn’t have the roads to support it.”

Steven Anderson, executive director of private wealth management at Morgan Stanley in Chicago, agrees. “We estimate that some $20 trillion worth of emerging market infrastructure spending is planned as of right now,” he says. “China today is one-third of global steel consumption, and the BRIC [Brazil, Russia, India and China] countries are 50% of global steel demand. So we think this is a long-tailed phenomenon and will go on for some time.”

These observers agree, too, that speculation is a minor phenomenon with metals and industrial commodities. “There is some speculation,” says Jonathan Rose, executive director for UBS Investment Bank in New York. “Some fund investors moved into commodities because there’ve been no bright sectors to invest in, not a lot of value propositions out there, and they saw commodities as a safe-haven option.”

Adds James Forbes, global metals leader at Pricewaterhouse Coopers, “There may be some price premiums being paid for [supply] security. But the steel spot market works a bit differently than with other commodities. There is a spot market, but that usually means one- or two-year contracts because the market really works with long-term contracts and market relationships.”

In May, the Commodities Futures Trading Commission’s chief economist, Jeffrey Harris, told Congress that little economic evidence exists to demonstrate speculators systematically pushing commodity prices. He explained that prices have risen sharply for many commodities that do not have developed futures markets, singling out steel, iron ore and coal. “Economic data show that overall commodity price levels, including agriculture commodity and energy futures prices, are being driven by powerful fundamental economic forces and the laws of supply and demand,” Harris said. “These fundamental economic factors include increased demand from emerging markets, decreased supply due to weather or geopolitical events, and a weakened dollar.”

Some also note that competition for materials within the industry provides an inflationary kick to prices. “The more self-sufficient the mills are, the better off they are,” Forbes says. “But look at scrap, which has been going out of sight as well because there’s so much demand. With scrap as an alternative to iron ore, the integrated mills are competing with the electric arc mills. If an integrated mill is looking to offset 5% of its iron ore with scrap, that is a new price driver.”

Sounds very positive, but no one is saying this balloon will go up forever. Denying the laws of physics and markets would be madness. But many bankers and traders say prices and markets can be reasonably expected to keep expanding for another three to seven years.

The China Card

There are, to be fair, some China bears crying out amidst the inflationary euphoria. One of the loudest is William Gamble, principal of consulting company Emerging Market Strategies and author of Freedom: America’s Competitive Advantage in the Global Marketplace. “The real China story is about the collapsing Chinese economy,” he says. “The stock market is off 50%. Real estate in Shanghai is off 10%. In Shenzhen, real estate prices have fallen an average of 28%, and there are reports of falls of up to 50%.

He adds, “Fifteen percent of the GDP in China is real estate, and when that busts, there will be a corresponding bust in demand for iron ore, steel, copper, all of that.” But most troubling, “Really, no one knows the state of the real estate or other markets in China … Ernst & Young in 2006 said China’s bad debt totaled $911 billion. Foreign investors invested $40 billion to prop up Chinese banks, but there’s no way to tell where the money went.” Ernst & Young retracted that report after pressures from the People’s Bank of China.

Gamble doesn’t feel much better about India. “They have labor shortages for the outsourcing industry … and the default rates for auto loans are twice what they are in the U.S.,” he says.

While some analysts and economists might argue with those assessments, most agree it is China’s lack of transparency that makes it difficult to make accurate predictions.

“We are expecting China’s GDP growth at 7% to 10% a year continuing for the near future,” says Robert Wujtowicz, managing director at InterOcean Securities in Chicago. “I question the reliability of their numbers, and there are problems in China with the level of disclosure on economic figures.”

“I think the China weakness is mainly a stock market problem,” says KeyBanc’s Klenz. “The lack of transparency makes it a hell of a risky place to invest in stocks.”

Weakness and uncertainty in China and the other BRIC countries? You bet. But real doubts that this weakness will crash metals and commodities prices soon? Hard to find, which probably means that it’s time to be wary. Anytime too many people are too certain about anything, chances are they’re not paying attention.

Nevertheless, from George Soros (“We are still in a growth phase.”) to the International Iron and Steel Institute (IISI) and big players in aluminum such as Alcoa, predictions are strong. Traders and bankers may not agree on whether the United States is in or emerging from a recession, but they do agree that as far as this roaring global demand for steel and aluminum is concerned, the United States is a minor factor compared to the BRIC countries.

“China is really pulling this train,” says Forbes. IISI sees steel demand in the BRIC countries rising more than 11% this year and more than 10% next year, with demand in China alone up by about those same amounts. And recall that Alcoa is seeing a 6% year-over-year demand escalation for the next 10.

What Next?

More specifically, most see continuing good times for U.S. steel and aluminum makers, especially those that are integrated and those that can export and take advantage of the weak dollar, exactly because of this strong global demand. “For the first time, the U.S. firms are actually exporting significant amounts of steel,” says Strauss. “Just a few years ago, we may have had $400 million in exports—really nothing—and now it has almost quadrupled to $1.5 billion, which is very good for our trade deficit.”

Still, some traders are not exuberant. “I am not married to a multi-year, long position in these commodities,” says Kevin Kerr, a resource trader for 19 years and editor of Resource Trader Alert. “I recognize a business cycle here. It’s just that I don’t think this one has run its course. We are three to five years into a run-up, and Soros and others think commodities run in 18- to 22-year cycles. I think this one will run its course faster. We may be two-thirds into this one or maybe halfway through, I don’t really know. They say a light that burns twice as bright lasts half as long.”