Amid all the talk about falling crude oil and iron ore prices, investors need to stand back and take a much longer-term perspective. If they do so, they might avoid being too optimistic about world prices recovering back to recent elevated levels.
Recently, visiting American fund manager Richard Pzena (Pzena Investment Management), presented graphs of the long-term, real trend in crude oil and iron ore prices – two of the key commodities for Australian miners and our export revenue.
History does repeat
Particularly with iron ore, they show a clear period of more than a century of prices running at an average of around $US60 to $US70 a tonne (2014 dollars and showing the trend in real terms).
It is not until the early 2000s that the graph spikes upwards, as the unprecedented Chinese boom pushes prices as high as $US150 a tonne before re-adjusting down. The most recent fall (now to almost $50 a tonne) has merely brought the current prices down again to around the long-term average.
The graph is virtually a text book example of reversion to the mean – the almost universal tendency for prices to move back to their long-term average level after significant rises or falls. Reversion to the mean is the rule, which underwrites most of the strategy of value investors like Richard Pzena.
The historical picture from the iron ore graph shows a persistent price pattern, which suggests that the 2000s spike is an abnormality that has corrected. If so, it suggests Fortescue’s Andrew Forrest’s forlorn idea of the major producers colluding to restrict supply and regain boom levels of $100 a tonne or more was as likely to succeed as King Canute’s attempt to reverse the sea tides.
The oil tide shifts
While iron ore prices have more significance for Australian investors (and governments), Richard Pzena has been looking mainly at shares in the big oil majors – as a value investor and also as someone with extensive experience in the oil industry with major group Amoco.
His valuation models use a range of measures and suggest that major oil stocks are at their cheapest since 1968 – relative to independent oil groups, service providers or refiners. He reasons that the big integrated oil majors are in better shape to survive the falling oil price than other players.
The oil price also shows a tendency to mean reversion – except it has two major spikes instead of one like iron ore. The first was the massive late 1970s move when OPEC restricted production in an attempt to hold price levels in the face of new supplies from the North Seas discoveries. (This followed the first oil shock at the start of the graph when OPEC first decided to lift prices by restricting supply.)
Historical trend Indicates $US70/bbl Normal Oil Price
The second oil spike followed the upsurge in demand by China. This sparked a boom in spending as the industry rushed to find new supplies to cash in on the record prices. Within a few years, the so-called “fracking” boom (and Canadian tar sands) resulted in 85% of non-OPEC oil supplies coming from North America.
Now, says Richard Pzena, producers from fracking wells require something like $80 a barrel to stay in business; deep offshore wells need about the same price. The tar sands in Canada are even worse off, probably needing $100 a barrel.
Clearly, producers of oil and iron ore needed to read the warnings from the long-term price trends. Mean-reverting prices will wreak their own unrelenting, supply/demand pressure on the highest cost producers.
Once again, investors should look at the long-term trend. Above all, they need to remember the old boom-time rule: Beware – especially when everyone says “this time it’s different.”
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.