** International Trading Supplement -- The Paradigm Shift

When the experts tell you that the metals and minerals markets are facing a paradigm shift, it is as well to be skeptical. A favorite cartoon shows an executive returning to his office after lunch and his secretary informing him: "While you were out, there was a paradigm shift." It is not quite like that. Paradigm shifts are rare and can often only be identified with certainty after the event.

The last year has seen a strong recovery of metals prices following several years of decline. This is obviously in large part cyclical. Low prices have discouraged investment in the mining industry and a pick-up in the pace of global demand in the second half of 2003 found an industry with insufficient production capacity. Inventories have fallen and prices have risen.

However, the recovery has been accompanied by claims that this time, things are different and that the upturn in prices presages a fundamental shift in the economics of metals markets. There has been talk of being on the threshold of a commodity "super-cycle," and speculation that the decline in real prices, which has been a feature of metals markets for the past 30 or so years, may be about to reverse.

EASTERN PROMISE. Behind this speculation lie developments in Asia, especially in China. The industrialization of Asia has brought with it a rapid expansion in the demand for mineral commodities. Some of this has come at the expense of demand elsewhere in the world, as Asia has taken on the role of the world’s factory.

However, much has come from the construction of local infrastructure and the development of local product markets. Since 1990, the consumption of primary aluminum in Asia has grown at an average rate of more than 6 percent per year, taking the region’s share of total global use from 27 percent to 41 percent.

The expectation is that demand from Asia will continue to grow for a long while to come. This is not just because Asia contains more than 60 percent of the world’s population (China and India alone account for almost 40 percent), but also is because rapidly increasing numbers of those living in the region are reaching income levels where they are lifted out of subsistence lifestyles.

Supporting this trend are two other factors: A growing proportion of the Asian population during the next 20 years is going to fall into the 15-to-65 age group, the primary consuming age group; and Asia is only now beginning to see the development of a market for consumer credit.

In effect, the proposition is that economic growth in Asia could produce a sustained surge in demand for mineral commodities similar to that which occurred in developed countries in the 1950s and 1960s during the period of post-war reconstruction. During this period, mineral supply persistently struggled to keep pace with demand, and real prices of most metals either held their own or else trended upwards.

Some statistical evidence shows that this might be so. Certainly, Australia’s terms of trade stopped declining in the mid 1990s and have been rising since 2000. Given the widespread perception in development circles that international trade is inherently biased against commodity producers and that the movement in terms of trade against commodity producers is tantamount to being a law of economics, this would indeed represent a paradigm shift, were it to occur.

So what grounds are there for being dubious about such arguments? As a matter of principle, it is as well to think deeply before jettisoning 30 years of history. Although some of the factors that have driven the real prices and costs of mineral commodities downwards during the past 30 years are unlikely to be repeated—for example, the major industrial relations changes in the industry during the 1980s and the general downward trend in energy costs since the 1970s—other factors continue to apply.

Historical decline. Part of the decline in costs and prices during this period appears to have derived from productivity gains associated with economies of scale, improvements in management and developments in technology, none of which can be assumed to have fully run their course. Similarly, that part of the decline in costs which is derived from a decline in the input costs of equipment and components—effectively representing the productivity gains of other producing sectors—can reasonably be presumed to continue into the future.

Those observers who believe that cost reductions in the industry may be coming to an end must explain the sharp drop in the industry cost curves for many mineral commodities that occurred in the late 1990s to early 2000s. While a case can reasonably be made that the rate of real price decline might slow in the future, or even halt entirely, to assert that the direction of the trend will reverse because the industry has exhausted its scope for cost savings looks like a major leap of faith on their behalf.

The case that strong growth will force the industry to access more and more marginal resources and that this will force costs and prices to rise is also beguiling, except for the fact that the mining industry has been facing this predicament for much of its history and it doesn’t appear to have prevented costs from falling. Average head grades (yields) at western copper mines have dropped from around 1 percent at the beginning of the 1970s to around 0.75 percent today. For many other commodities, including iron ore, coal, nickel and bauxite, it is not at all obvious that they face any immediate resource constraints.

Certainly, it can take a while for growth in supply to catch up with demand during periods when demand is accelerating. The mining industry has long lead times and it takes time for the necessary investment to be mobilized after prices have signaled the need for such investment. It took pretty much a decade of above-trend prices following 1987 to bring copper supply and demand back into alignment. However, having done so, real prices did revert to their earlier declining trend, underlining the risk of confusing normal cyclical swings in the market with something of longer-lasting significance.

The analogy with the 1960s may also be flawed. In responding to the growth in demand in the 1960s, mining companies arguably faced much greater challenges in identifying suitable investment opportunities in countries offering acceptable investment conditions, mobilizing the resources to develop them and winning the necessary financing.

In today’s more globalized economy, information flows much more freely, markets are better informed, legal and fiscal regimes are generally more transparent, and supplies of equipment and technology are more readily available.

Far from being a constraint on resource development, the financial community at times seems almost to be tripping over itself in its enthusiasm to fund mineral investment.

Indeed this susceptibility to over-exuberance has been at the root of many an overoptimistic and unprofitable mining investment in the past. In addition, this time around it could be the case that China emerges as an active investor in offshore minerals and for reasons that have more to do with ensuring the security of supply of raw materials to its burgeoning industrial machine than the high quality of the resource opportunity itself.

However, there is a catch. What matters to producers and investors in the mining and metals industry are not prices alone, but margins. The same forces that would propel U.S. dollar prices upwards would, in many countries, drive their dollar costs in a similar direction.

The author is the chief economist for Rio Tinto plc, London, www.riotinto.com.  This article originally appeared in The Ringsider, a periodical produced for the London Metal Exchange.