1. Why are mineral markets cyclical?
Mineral price cycles mean that mining companies’ expenditure on exploration and investment can vary considerably from year to year. They also have dramatic effects on fiscal revenues, exchange rates and employment levels of mining countries.
For countries with large mining sectors it is important to manage both the short-term impact of commodity price swings and to develop structural defences to manage mineral price volatility over the long-term.
Key issues for Policymakers
Ideally, the major part of such investment should be directed towards improving the long-term structural capabilities of the economy, for example through investment in infrastructure and training as well as the promotion of economic diversification
Consideration should be given to investing a high proportion of state revenues derived from mining.
For some countries, it may make sense to direct a proportion of investment into overseas assets during times of high mineral prices, so that a fund can be built up which can be used in harder times to help mitigate damaging swings in exchange rates.
To build consensus around policies for development and restrict the scope for corruption, it is advisable that there is transparency about the source and distribution of revenue.
Why mineral markets are cyclical – demand side
The mineral price boom which ran between 2004 and 2011 was the most powerful cyclical upswing seen in recent times. Driven by the rapid industrialisation of China, it gave rise to the notion that the world was undergoing a mineral commodity ‘super cycle’. In fact, the cycle was much like any other, only longer and stronger.
The cyclical downswing which set in after the price peak of 2011 has also displayed many of the same characteristics as previous cycles, including slower demand growth, squeezed producer margins, reduced exploration and investment and disillusion with the development potential of the resource sector.
The reasons for price cycles lie in the high volatility of demand for mineral commodities and the low responsiveness of mine supply. Two factors largely drive demand volatility:
Firstly, demand for mineral commodities is highly sensitive to changes in the rate of economic growth. This is in part because of the economic sectors in which these commodities are used. There is a high concentration of mineral commodity use in construction and in the production of capital goods (like heavy machinery) and consumer durables (like fridges and cars). These sectors have a large investment component and tend to be more volatile than economic activity more generally (as measured, for example, by GDP).
A second reason for demand volatility is the stock-holding behaviour of manufacturers. As economies accelerate, so manufacturers build up their stocks of raw materials in anticipation of increased levels of production, adding to the demand for mineral commodities. When economies slow, manufacturers reduce their stocks of raw materials, suppressing demand for mineral commodities.
Why mineral markets are cyclical – supply side
Supply of mineral commodities is typically inflexible and producers find it hard to respond to fluctuations in demand. This inflexibility arises from the fact that mineral commodities are commonly produced at large-scale, capital-intensive operations. For reasons of cost-effectiveness, producers like to run their operations at close to full capacity. Even in the face of weakening demand and prices, the internal economics of their operations may result in producers continuing to produce flat out, weakening prices further.
The capital-intensive nature of mineral production explains another facet of supply inflexibility – the difficulty in expanding production once all the existing capacity is used up. Large, capital-intensive projects take a long time to develop, finance and construct. It is common for a major new mine to take ten years from conception to production. Accordingly, supply is often slow to respond to surges in the demand for mineral commodities and associated shortages. Prices are the mechanism by which the demand and supply of commodities are brought into balance. When markets are oversupplied and prices are low, producers are forced to cut costs. When they can no longer produce minerals economically, operations are sold or closed.
When markets are undersupplied and consumers are experiencing shortages, prices rise. This helps ration the available supply to consumers in line with their ability to pay. It also provides an incentive to producers to squeeze out as much production from their existing plants as they can and to invest in new production capacity. However, supply adjustments, both in cyclical downswings and upswings, can be slow and take several years to complete. It may not be an exaggeration to say that the normal condition of commodity markets is imbalance, with prices most of the time either trending cyclically upwards or downwards.