Sunday, January 31, 2016

Theory of the Mine

From an economic standpoint, mining presents some special challenges.

In economics class, we learn about the theory of the mine.  Mining, it turns out, is somewhat different from other economic activities, such as manufacturing or retailing, in that there is a finite amount of product to be sold, and thus whether or not to sell product becomes an interesting economic proposition.

And today, we are seeing this happen as metals prices drop and mining stocks drop.   And among the "minerals" dropping rapidly in price is oil.   Yes, oil is a mineral, in a manner of speaking, and the theory of the mine applied to oil wells, too.

If you own an oil well, or a gold mine, or a bauxite mine, or - as one friend of mine has - a helium farm (no really, they exist), you have to make a decision on a daily basis whether you keep the stuff in the ground and wait for better prices in the future, or dig or pump the stuff out and sell it.   This is a complex decision based on what you perceive future prices to be, versus current prices, as well as the current cost of extraction versus market price.   If it costs you $50 a barrel to extract low-grade oil, then it is best to leave it in the ground.    And we are seeing this right now in North Dakota, where certain low grades of oil have negative prices - they are basically waste products that you have to pay someone to take away.

But of course, the equation is far more complicated than that.   In these kinds of businesses, the owner may have incurred a lot of debt - for leases or mineral rights, equipment to extract the minerals, as well as overhead, salaries, and the like.   And this debt has to be serviced, regardless of the market price of the mineral.

So, the last person to get into the business (who is often drawn in after hearing tales of wild profits to be made) is often the most highly leveraged, in terms of debt and overhead.  And when mineral prices fall, this is the first guy to go under.

But it gets worse.   Since minerals follow a supply/demand curve (yes, even oil, even gold) it is possible to manipulate prices in the market if you are a larger producer, by flooding the market with product, much as Saudi Arabia is doing now, or as John D. Rockefeller did in the past.   If you can flood the market and drive down prices, and at the same time drive up your competitor's costs (for example, by working a deal for shipping rebates with the railroads) then you can drive the smaller producer bankrupt - or nearly so - and then offer to buy him out.   And that is how Rockefeller assembled Standard Oil.

What the Saudis are trying to gain is anyone's guess, other than they have a mountain of debt to service, and keeping the lid on the simmering pot of Wahhabi Islam in their country requires a lot of expensive social services.

Of course, over time, these low mineral prices (oil, metals) will go back up.  That is a given.   Demand will keep going up as the population increases.  The temporary lull in prices won't last forever.   But in the meantime, the more solvent producers can either decide to keep product in the ground, or sell at market prices and live with lower profits.   The more marginal producers will go out of business and their assets will be acquired by the more solvent ones - if their assets are worth anything at all.

There is a lot of pain going on right now, up in the Bakken formation, as folks who thought they'd get in on the rush are finding themselves squeezed out.  And folks who re-opened old gold mines in the Carolina's are probably thinking about closing them again.

The only people who are making out, of course, are the folks who supply tools and materials to the miners.  Whether it is Levi Strauss and his blue jeans, or Howard Hughes, Sr. and his drill bits, it seems the real money is in the support businesses, not in actual mining itself.