1.  Trends and Cycles in Metal and Energy Prices – with a Quick Look at Industrial Sand* John T Cuddington William Jesse Coulter Professor of Mineral Economics Colorado School of Mines 94 th Annual Conference – May 20-22, 2012 Casting Industry Suppliers Association - CISA Bonita Springs, Florida * Motivated by Chuck Fowler’s presentation late on Day 1 of the conference

2. Overview  Why do metal and energy prices matter to the casting industry?  How can economic analysis help us organize our thinking about trends, cycles and volatility in prices?  What does the empirical evidence on metal and energy prices show?  What are the implications of metal/energy price dynamics for the casting industry? 2

3. The Importance of Metals and Energy Prices to the Casting Industry  Prices are important to casting industry  Metal and energy prices are key inputs into the casting process  Casting is energy intensive  Metal and energy prices have significant impacts on:  Profitability  Competitiveness vis-à-vis other forms of casting  Prices provide key information in decision-making:  Capacity expansion and upgrades  Strategic planning  Input substitution 3

4. Economic Analysis of Price Behavior  Standard economic research methodology  Develop/refine theories  Study empirical evidence, ‘stylized facts’  Repeat  Supply and Demand -- starting point for most analyses of prices  Nonrenewable resources – are they different? Exhaustible?  How can anything involving nonrenewable resources be sustainable?! 4

5. Nonrenewable Resource Markets: Supply-Side Considerations  Metals and Energy - multi-step, multi-product production process  Reserves of nonrenewable resources are intermediate inputs into mining and milling  Exploration produces ‘inventories’ of reserves of varying quality (ore grade, multi-ore content, accessibility)  Bulk metals are intermediate inputs in production of either final consumption goods and/or capital equipment (often involving foundries)  Reserves of nonrenewable primary products change over time  Discovery and depletion (via mining activity)  Economic value changes as prices and technology change  Reserve/production ratios have not dropped in spite of large increases in global production  “Fixed stock” view of nonrenewable resources is not particularly useful. 5

6. Supply-Side Considerations - Continued  Mining is very energy and capital intensive  Short-run supply is often (capital) capacity constrained (i.e. vertical SR supply curves); input substitution is limited  Long-run supply is very price elastic (i.e. horizontal LR supply curves)  Implication: Long-run price analysis focuses on primarily on supply 6

7. Technological Change – ‘Drilling for Ideas’  Technological change occurs at each step of the multi-step production process  Increasing globalization due to falling transport costs and improvements in communication  Globalization spread multi-step production process across several countries 7

8. Drilling for Ideas vs. Reserves  The production process to generate new productivity-enhancing ideas is similar to the exploration for reserves  Production process is highly uncertain  Quality of output varies  Incentives and property rights are important for stimulating production  There are often free-rider problems and first-mover advantages  Secrecy sometimes helps in gaining a competitive advantage – at least for a while  To be successful, you can’t rest of your laurels. 8

9. Nonrenewable Resource Markets: Demand-Side Considerations  Long-Run minerals demand depends on:  Population growth  Growth in per capita income  Structural transformation that accompanies economic development  Shifts in the composition of demand (agricultural goods, manufactures, and services)  Shifts in composition of global supply affects the derived demands for metals and energy  Technological change; input substitution Structural transformation is a key component of ‘super cycle’ hypothesis  Short-run metals/energy demands are strongly pro-cyclical (global biz cycles matter) 9

10. Role of Formal Exchange Markets  Some mineral product prices are so-called producer prices that change gradually over time in response to supply-demand imbalances  Others are ‘flex price’ goods traded on formal exchanges, often with both spot and forward pricing  The latter are ‘hybrid assets’ – part real asset, part financial asset  Forward-looking expectations and ‘news’ drive pricing of financial assets  Introduction of formal markets facilitates price discovery and transparency, but also raises (apparent) price volatility 10

11. Simple Mineral Supply-Demand Model P $/unit Q units/period S SR capacity SR D0D0 MC S LR D1D1 11

12. What Does the Empirical Evidence on Metal/Energy Prices Show?  Looking at longest available data spans:  Average growth rates in real metal and energy prices are small  Year to year variability is huge  Little evidence that world is running out of nonrenewable resources  Over 20-70 year periods:  Prices may drift up or down – reflecting the tug-of-war between depletion and technological change  Some evidence of ‘super cycles’ especially in the post WWII period 12

13. ‣ Nominal vs. real crude oil prices using two different price deflators: CPI and PPI Nominal and Real Oil Prices

14. Trend and Cycle Decomposition

15. ‣ Trend increased by roughly 125% over the past 65 years (real terms)  ~2%/year ‣ Comparison to Metals, correlation coefficient: pre-WWII 0.71, post-WWII 0.88 Super Cycles in Oil Prices

16. Trend and Super Cycles in Coal Prices ‣ Downward trend of about -1.3% annually from the Great Depression to 1972 and -0.5% afterwards

17. Super Cycles in Energy and Metals Prices After WWII ‣ Especially after WWII

18. Huge variation in medium-term trends; Huge Volatility  Slides that follow show monthly data on nominal U.S. dollar prices from IMF 18

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21. …More on Empirical Evidence  Metal and energy prices are strongly pro cyclical  Rise sharply in biz cycle upturns  Fall fall sharply during recessions  Metals and energy products traded on formal exchanges are ‘hybrid assets’  Part financial asset where expectations about future conditions are key drivers  Part real asset where supply, demand and inventories are fundamental determinants of prices 21

22. A More Granular Analysis: Real Price of Industrial Sand with LT Trend – 1902-2010 (USGS) 22

23. A Super Cycle in Real Sand Prices – 1902- 2010 (USGS) 23

24. Implications for the Casting Industry  Long-term contracts to supply casted products are risky when long- term trends (20-25 years) in key input prices are difficult to predict  Long-term investments in capacity and/or new technologies are risky  ‘Real options’ to adjust production mix, capacity, input supply sourcing, etc. are valuable  Link between nominal mineral price movements and general inflation is surprisingly weak  Some input price risk can be passed on to consumers of your products  Short-term price risks can be addressed with financial hedging strategies  Exchange rate effects on dollar metal and energy prices can be large. 24

25. Thank You!  Your hospitality in this beautiful setting  Opportunity to learn more about foundries, the casting industry, and its suppliers  Please explore collaborations with faculty and graduate students in our Mineral and Energy Economics Program  My e-mail: jcudding@mines.edu 25