Commodity Production

Primary versus secondary

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The production of commodities can be a risky enterprise at times. The success or failure of commodity producers often depends on price economics. When total production costs are lower than market prices producers are profitable. However, when market price drops below production cost it becomes a losing proposition. Commodity prices are cyclical therefore; producers must adjust their strategy according to the position in the price cycle.

As an example, when commodity prices rise producers will mine for lower grade ores, those with higher production cost. Additionally, when prices are high producers will hedge in order to lock cash flow for profitable mining operations for the future. No one, even the most experienced mining companies, knows what the future may hold. A strategy during times of high prices helps miners to secure the future viability of mining projects during inevitable downturns. When prices fall and the commodity cycle turns bearish, the producers will often mine for higher-grade ores looking to lower total production costs as a strategy to combat lower prices and survive for better times. In the case of dominant commodity producers with healthy reserves of both cash and commodities, lower prices can present an opportunity. These players may use lower prices to their advantage. Lower prices often cause high cost producers to go out of business as their enterprises become uneconomic.

This affords the opportunity for the dominant producers to sell more at lower prices in order to secure increased market share. As prices are cyclical, increasing market share during difficult times may yield rewards once prices rebound.

There are two types of commodity production. Primary production is where the producer is in the business of producing a specific commodity.

Secondary production occurs when a producer extracts another commodity as a byproduct of the primary production of another. A great example of primary and secondary production lies within the metals sector. Often, gold mining is primary production. Companies in this business expend huge sums to explore for and develop gold mining projects. Once a deposit of gold is located, the miner will extract gold if the market price exceeds the cost of production. During periods when gold prices appreciate, more companies enter into this business. When the price of gold decreases we often see a great deal of consolidation in the industry. The bigger, stronger and better-capitalized mining companies swallow up the weaker unprofitable companies creating economies of scale. While mining for gold or other metals is a complicated business with many risks, the economics are simple. Those who produce profitably survive those who do not perish. The vast majority of these companies are in the business of producing specific commodities where they have specific expertise.

The silver mining business is a bit different. While there are producers engaged directly in the business of exploration and extraction of silver a large percentage of silver production is byproduct production.

This means that extraction of silver is almost an afterthought, it exists in ores and producers attain the precious metal as a bonus to the specific metal they produce. Silver is a byproduct of gold, copper, zinc and lead metal mining. The ores and concentrates of these metals are never pure rather they contain a variety of other elements. A tremendous amount of silver occurs because of mining for other metals.

Another example of byproduct production is natural gas. During the process of drilling for crude oil, natural gas can be a byproduct of oil production. Platinum and palladium can be a byproduct of nickel production. Some of the largest platinum and palladium deposits in the world are in Siberia at the Norilsk Nickel mines.

Commodity producers tend to focus their activities on specific commodities.

When conducting fundamental analysis in commodity markets it is relatively easy to get a handle on primary production. Secondary production is often another issue.

Update on Commodity Production

One of the biggest issues affecting commodity production as the bear market in raw material prices enters its fifth year is the price action of one very influential commodity sector. The price of active month NYMEX crude oil has dropped from over $107 per barrel in June 2014 to under $36 in early January 2016. The decline of over 66% has had huge ramifications for the prices of many commodities. The prices of other energy commodities like natural gas, coal and electricity have also moved lower over recent months.

The fact is that energy is a key cost of goods sold input in the production of almost all commodities. The production of metals, minerals and even agricultural commodities depend on energy inputs in the production process. Therefore, when the price of oil and other energy commodities decline so does the production cost for other commodities. In a bear market for commodity prices, producer margins decline. The difference between production cost and market price narrows. However, as the energy input costs drop, the bar lowers for producers as it makes it possible for them to continue selling as prices drop. The current bear market in many commodity prices is the result of huge inventories and stagnant demand. A lower energy price allows producers to sell at lower prices and still make a profit.

Production cost for commodities has moved lower since June 2014 thanks to declining energy prices and this has created a vicious cycle of selling across many commodity markets.