Investors in natural resources who are either under 30 years old or have only been investing in natural resources for less than five years typically have a serious perspective problem: Based on their experience they may well believe, reasonably, it seems to them, due to the short duration of their time perspective, that mining and (mined) commodities have always been go-go investments that just keep rising in value. They are unaware of the fact that prior to the 21st century the mining industry had overall one of the lowest rates of return on investment of any industry. Mining startups were of little interest to banking and other financial institutions.

The first 7 years of the 21 century, taken as an isolated period of time, have so far certainly been topsy-turvy with regard to the historical attitude of bankers to mining. I haven't done detailed quantitative research on the total amounts of money involved in the many and various commodity "rushes" of the 19 and 20 centuries, but my knowledge of economic history makes me confident that it is unlikely that there has ever before been so much money being made in, or chasing opportunities in, mining or in commodity metals as in the past seven years.

There are two components to the selling price of a natural resource:

1. The cost set by the fundamentals of supply and demand, and;
2. The speculative or technical cost.

Fundamental costs are usually set by end-users and producers, while technical costs are set by the contrasting agendas of short-term speculators and long-term investors and have become much more volatile.

As readers of this website know, a critical failing of U.S. owned and operated heavy industry has been the failure of the finance staffs of companies, which depend upon, and critically require, specific metals and minerals to become long term investors in those metals and minerals. When an end user or producer does make long-term investments designed to ensure access to a supply of a metal or mineral the processes are known as risk management and strategic planning.

As a specific instance of the impact of the consequences of the failure to manage these risks we only need to listen to the American "turn around" and restructuring specialists operating in Detroit, who are each day becoming more convinced that the failure of the supply base of the OEM automotive industry to take into account the rapid rise of, or even consider the possibility of such a rapid rise in, metals and minerals is the leading cause of their bankruptcies! A corollary of this is that the purchasing and finance departments of the American OEM automotive companies by adopting the Lopez method of forcing supplier prices down without understanding themselves how to manage the risk of raw material price volatility have contributed substantially to their own business failures.

The purchasing and finance staffs of the American OEM automotive industry have learned so little from their failure to manage or even foresee the risk of raw material price volatility that they have blindly adapted the Lopez principle to outsourcing. Once again they are driving themselves into the breech. They have all gone to (for the moment) low labor cost countries for components and services and have required their hapless supply base to blindly follow them without any long term strategy in place to exit such countries and relocate sourcing when currency values, labour rates, and controlled streams of raw materials edge up in price. They seem to have learned nothing from their repeated failures that have been in fact due to the free fall upward movement of prices of labour, services (healthcare and pensions) and the cutoff of supply of domestic raw materials, and finished goods made from them, due more to political activism than free market economics.

Most American heavy industrial companies had successful foreign exchange risk management, and most of them thought that this was the only risk to be worthy of managing. They all came late to the in-house hedging of commodity metals, which they depended upon critically, such as copper, aluminium, tin and nickel. The complete reversal of fortune of the mining and related commodity industries helped to severely damage the competitive advantage formerly held by American OEM automotive, and the loss of revenues, margins, profits and retained earnings has put commodity metal risk management programs and strategies beyond the capabilities and capacities, today, of most of them and certainly of essentially all of their suppliers.

Even today most American heavy industrial companies that recognize the problem still outsource the hedging even of exchange traded commodity metals to the same banks and financial institutions, which failed in the recent past to advise them on managing the risk of price volatility in critical materials.

In fact while few American heavy industrial companies have even yet comprehended the need for in-house management of the risk of commodity metal and mineral volatility we have now reached phase two of the current commodity and mining boom. Speculators and long-term investors are looking for plays in metals and minerals that are not exchange traded.

The old economy can now be defined as consisting of those entities that do not manage the risk of raw material price volatility. The new economy is going to be made up of those companies that not only manage the risk of price volatility of the commodity metals and materials traded on exchanges but also have created or accepted the rationale of virtual hedges to manage the risk of price volatility of those materials they critically need that are not traded on exchanges.

This is where the hedge funds come in. They are going to try to create virtual hedges. But post modernism has already set in and is the mantra of hedge funds. It is not globalization that the funds are following but the 'cosmopolitanization' of capital: Wherever you can make money, by whatever locally legal means is a good place to operate.

First some history. In the mid-1990s, as the official story was told, a 'rogue' trader named Hamanaka, working for the very large, $100 billion per annum, Japanese trading company, Sumitomo, attempted to "corner" and control the global copper market. He used Sumitomo's cash and credit lines to buy up all of the copper contracts on the exchanges that traded such contracts. Even though it was actually his transactions that were driving the market up he paid whatever he had to in order to acquire the rights to as much of the world's copper for future delivery as he could.

Copper prices climbed, but the trader had not looked into the inventories and off-takes held by end users. He didn't have any exit strategy for his "physical squeeze" other than to hold out for the highest price as supply dwindled and demand continued. The plan unravelled as it became obvious that demand would not increase fast enough for Sumitomo to stave off margin calls and debt repayments. Sumitomo said that they then became suspicious of Hamanaka's activity, and when his strategy was exposed, Sumitomo was forced to sell its positions and incur a loss of more than $2 billion. Hamanaka was tried in Japan for embezzlement and sent to prison.

The next big squeeze was an ominous portent of things to come. In the late 1990s several European based hedge funds decided that it would be possible to squeeze the global palladium market. They decided that they had learned enough and had sufficient insight and information to avoid Hamanaka's mistakes such as his ignorance of inventory levels, other large hedge holders, and substitution of copper by aluminium or other cheaper materials. Palladium they decided could not be substituted. Moreover its demand was growing and supply was lagging. There were by contrast to copper only 6 million ounces per year of new palladium produced. For copper, in 2000, this figure was 15 million tonnes.

Palladium was suddenly on the move. Stories of shortages and mining accidents and expanded use in automotive emission control catalyst, electronics and jewellery were put into the air as fast as possible. The very unsophisticated purchasing department of the Ford Motor Company, for example, panicked under pressure from a famous American "investment" bank, CEOs of which had already been and would be again U.S. Secretaries of the Treasury, and signed a take-or-pay contract with a struggling mining company at a range of prices that topped out at $1,000 per ounce, a price that would thereafter be the all time high for palladium as it quickly settled back to between $200 and $300 per ounce when substitutions and thrifting took the projections for its demand sharply down.

Ford ultimately took a write-off of $1 billion to cover its losses from having to take palladium and use it for several years at above market prices. It is not generally known who else took a palladium bath, but Ford accounted for only a small, yet very significant to Ford, portion of the total metal involved. This take-or-pay contract was, in fact, a type of virtual hedge against the risk of price and availability, but it was poorly thought out, both by the bank involved and by Ford, so it cost more than it saved.

Since the days of Hamanaka's copper squeeze and the palladium squeeze of 2000-2001, there has come into prominence a new and vast source of liquidity, private equity group financed hedge funds. Today none of these funds wants to go to their subscribers and talk about exchange traded commodities such as copper and palladium. The funds have been investing in these commodities and probably causing the majority of the technical component of the copper price run up of the last few years, but such investments have become commonplace. Investors may bring up the failures of the recent past and waste hours asking questions about exit strategies.

Fund managers are thus now looking into new strategies, which now include investing in non-exchange traded metals and minerals. I predict that the funds will soon discover, if they haven't already, a much more sophisticated financial strategy that operates as a virtual hedge, the off-take agreement between a producer of a metal and an end user.

Off takes once included take-or-pay agreements such as Ford entered into but were and still are in fact common in the oil industry long before that. Basically an off-take says that the buyer will guarantee to take the total output at a floor price and that any increase in prices will only be allowed in specific circumstances where both sides benefit.

Off takes are traditionally insurance policies, not get rich quick schemes. The purpose of an off take agreement in the mining industry is to make proven ore in the ground into good collateral for bank financing. The setting of a price and a guarantee of payment by a solvent high credit rating buyer allows a bank to use the credit of the buyer as collateral for a working capital loan to the miner. This is an excellent strategy for a junior miner, and an off-take can be limited so that, for example, it applies to only a specific ore body giving both parties incentive for further exploration and further deals.

The problem is that with soaring prices off-take agreements require a lot of capital to be tied up. Now enter hedge funds. They have the capital and can get the expertise to propose and negotiate off take agreements to mining ventures. The problem is that they are not end users. They can however become insurers of risk.

A hedge fund can propose an off take agreement to, for example, a tungsten mining project in Brazil. This agreement ties up the fund's capital only if the miner uses the agreement as collateral for a working capital loan. However the fund does not want long term ownership of the tungsten, so it can market the material it controls, for example, to end users at a floor price of what it paid but with an indexed price to give the fund additional revenue in return for a guarantee of supply.

The new 'owner' of the off take can guarantee to assume the liability of the agreement thus freeing up the fund's original investment. There are many, many end users in the world who do not have the capital or the expertise to find or create such an off-take opportunity. The funds can distribute their risk to enough of them to free up the fund's original capital.

As has been said on this website before, a hedge fund could, for example, buy up, through a series of off takes all of the world's existing new lithium production for the next 5 years for less than $200 million. Then when every existing supply contract has ended, say within a year, the fund could sell its off take agreements at an auction to financially qualified bidders. These transactions would probably not be legal in many countries, the U.S. in particular, as a restraint of trade, but that would not stop a cosmopolitan hedge fund from multiplying its investment many times by transacting its business in friendlier countries.

If hedge funds begin doing this kind of virtual hedge creation outside of the current metal markets then prices of non-exchange traded metals will soar as supplies virtually, no pun intended, dry up.

Watch out for this kind of activity in lithium, germanium, indium, gallium, selenium and tellurium, and the rare earth metals as these are the critical raw materials for manufacturing electronic devices and displays, the stuff of the current information revolution sweeping the world.

The U.S. could be self-sufficient in any and all of these materials if only environmental activism would get its collective head out of the sand, and U.S. law would not allow anyone to corner or squeeze these materials. The mindless activists could not have done more harm to America's economy than they have done by driving the extraction and refining of these materials off shore. Now it will be up to the fund managers to complete the job of degrading America's quality of life in search of quick returns. – ResourceInvestor.com