Customer Service 1 (888) 261-2693

Mastering the Resource Market’s Cyclicality

If you plan to invest one dime in natural resources like gold, oil, and uranium, this interview is a must read.
We sat down with legendary resource investor Rick Rule to discuss how one can master the giant cycles in natural resources. Catch one of these big cycles early, and you may never have to work again. Catch one at the wrong time, and you'll lose a fortune...
Rick has spent decades in the resource markets, making himself and his clients many millions of dollars in the process. He has also financed several of the most important resource companies in the world. He's a brilliant trader, a genius investor, and a walking encyclopedia of business knowledge.
If you're looking to make life-changing profits from commodities or resource stocks, read on...
Stansberry Research: Rick, most readers are aware of how profitable investing in commodities and natural resource stocks can be. The gains on individual positions can run into the thousands, even tens of thousands of percent. But many people are unaware of the cyclical nature of resources... and how to use this aspect to efficiently invest or speculate in them. Could you explain how a resource cycle works?
Rick Rule: Sure. Resource markets are cyclical for two primary reasons... They are extremely capital intensive, and they are extremely time intensive. In other words, resources tend to take a great deal of time and money to produce, mine, or extract.
So when supply and demand imbalances occur, the resource sector isn't able to react as quickly as other markets. This long lag time creates huge price swings... extreme highs and extreme lows you don't see in most other markets.
When demand exceeds supply in most markets, you see a relatively quick reaction from producers to meet the new demand. Compare this to resources like copper or gold... Before you can produce it, you have to go find it and build a mine. The exploration cycle – the pre-development cycle – can take up to 10 years. In the meantime, prices can soar, while the market waits for that increased supply.
On the other side, after supplies come onto the market, prices peak and start to fall. What happens is that the industry comes to regard their sunk costs as just that... sunk costs. So they're hesitant to slow production, in spite of high supplies and falling prices. They'll continue to produce even when prices fall below the level at which they would be profitable. In fact, they'll often produce even below the marginal cost of production for a while in a contest known in the resource industry as "the last man standing."
The reasoning here is that it might cost them more to shut down a project and restart it than it would to continue operating at a loss. And each producer wants to be the first in the game when the cycle turns back around. This drives prices even lower than they otherwise would go.
So you have this extraordinary cyclicality as a consequence of the capital and time intensive nature of the business.
Stansberry Research: Can you give us a couple examples of resource cycles in action?
Rule: Sure... To give your readers a feel for the extremes of commodity cycles, let's look at uranium.
In the 1970s, uranium prices kept pace with other energy sources, escalating tenfold. And uranium share prices exceeded those commodity price escalations.
But the decline in energy prices that accompanied the worldwide economic slowdown in the early 1980s – along with the "Three Mile Island" mishap – delivered a staggering blow to uranium markets. Then the Chernobyl disaster finished them off.
The uranium bear market – beginning in 1992 and ending in 2002 – saw the uranium price decline from $35 per pound to $7 per pound. At the bottom of the market, the industry was selling the stuff for $7-$9 per pound and producing it for $18 per pound. They were losing $10 per pound and trying to make it up on volume!
Worldwide however, we were producing 90 million pounds and consuming 150 million pounds, with the consumed surplus coming from prior excess utility inventories, and conversion of weapons grade stocks. So the price had to rebound, and it did.
In the period from 2002-2006, the spot price soared from $7 to $130. Meanwhile, production costs approximately doubled to $40 per pound. Since then, the price of uranium has continued to fluctuate dramatically.
The reaction of investors to these cycles is amusing, if tragic.
At the periodic highs, investors were crowding frantically into uranium equities, although the stage was set – through price induced increases in supply and reductions in demand – for a price collapse. And of course, investors sold in disgust at market lows, when inverse conditions argued for dramatic increases in the uranium price.
Stansberry Research: Are there any tricks for distinguishing where we are in a particular commodity's cycle?
Rule: Yes... In any resource, when the industry's median production cost exceeds the commodity's selling price – in other words when it costs companies more to produce that commodity than the commodity is worth on the market – that industry is in liquidation. This is the situation I just mentioned in uranium.
There are two potential outcomes at that point... either the price has to rise, or that commodity will no longer be for sale on the market. That is a strong sign that you're approaching or have arrived at the bottom of a cycle.
Conversely, when commodity producers as a whole enjoy 50% or better pre-tax margins and returns on capital employed exceed the S&P 500's returns on employed capital by 50% or more, you should be looking for the exits. The stage is set for a serious decline in the price on that commodity.
In other words, markets work. The cure for low prices is low prices, and the cure for high prices is high prices.
Stansberry Research: You've made a career of profiting from resource cyclicality. What advice do you have for readers to do the same?
Rule: Well, technically it's as simple as following the old Wall Street adage of "buy low and sell high." You want to buy when supply exceeds demand and prices are low, and sell when demand exceeds supply and prices are high. It sounds easy. But in practice, it's very difficult to follow.
Most people don't have the courage to buy something that is dirt-cheap and has gone nowhere for years... But that's what it takes to "buy low" in the resource sector. Similarly, most people don't have the discipline to sell something that has soared hundreds or thousands of percent... But that's what it takes to "sell high."
So the first thing that one must do is learn to master him or herself before attempting to master cyclicality.
Warren Buffett famously said you shouldn't buy a share of stock unless you know it well enough that you would be delighted to see it fall 25% in price, so you could buy more at a 25% discount.
That is also how you must approach the resource sector. Even when you buy low, it is certain many of your investments will go lower before they go higher. You absolutely will buy shares of XYZ exploration for $1 a share and see it fall to $0.70 a share. If you did your research, the stock will be a substantially better buy at $0.70 a share than it was at $1 a share, and you need to buy it.
When you buy resources stocks, you need to recognize that they're not merely trading vehicles. They represent fractional ownership of a business.
And to profit from them, I think you have to go through the type of analysis your colleague Dan Ferris goes through.
What's the company worth? If the company is worth $1 billion and there are 10 million shares outstanding, what is the value per share of the business?
That's a simple example, but many people don't go even that far.
If you have a good sense of what something is worth, and it declines in price... you may have the courage and the sense to buy more. If it escalates fairly rapidly in price to the point where its price exceeds your estimate of its value, you might make a rational sell decision.
But without that sort of grounding in value and understanding, most people have no business in resource stocks.
Stansberry Research: Thanks for the insight, Rick.
Rule: You're welcome. Thanks for having me.
Summary: To profit from resource cyclicality, you want to buy when supply exceeds demand and prices are low, and sell when demand exceeds supply and prices are high. Since resource stocks represent fractional ownership of a business, you must determine what the company is worth before buying the shares.

More on This Topic

Beginners guide
Investment Glossary
How to Buy Rare Coins, Art, and Collectibles More on this topic Why You Should Hold Gold