Note: This is part two of a two-part series discussing a recent report from Ernst & Young. Part one offers additional insight and an introduction to the topic.
The Ernst & Young report expresses disdain at the accuracy of metals price predictions, noting the disappointing errors of the past few years. The writers suggest that some metals, like nickel and copper, are hard to predict, but add, This has been, not coincidentally, a time of sustained market strength and rising metal prices over the last three years. Analysts, almost universally, have been predicting a sharp decline in metals prices to return to the average levels of the previous 10 years ¦ It is only when the mining companies are really convinced that future revenue from operations justifies the commitment of significant capital outlay that they will accept the risk, resulting in further capacity ¦ Investing just before prices plummet is a far harder mistake to survive than going along with cautious market sentiment and not making an investment.
The problem with any forecast is that it relies on forecasting tools — typically statistical models that rely on past data. These models may be better than a guess in the air, but they inherently fail to act in a predictive fashion because the utilized information has been gleaned in hindsight. In addition, it is always challenging to incorporate correct estimates of multiple factors, such as supply and demand, supply risk events which affect supply and demand patterns, technological innovation, etc.
Valuation Errors and Market Activity
The paper notes that the forecasts of future metals prices drive valuation, adding that industrial metals prices have almost simultaneously risen with the forecasts of future prices. However, it’s important to realize that metals analysts did not predict price rises would endure for such a long stretch of time, and Downham and Williams add the fact that equity research shows analysts did not predict the past three years of sharp price increases in copper, nickel, steel, and aluminum.
By no means do we consider ourselves expert at price predictions, either. It’s possible that the analysts missed the price run-up because they focused more of their research on the major producers’ and mining company predictions, commentary, and feedback — and less on end-user industry segment predictions.
The undervaluing of metals by analysts affects the economy and investors. The realistic view of mining companies can create a much more positive outcome than the pessimistic views of analysts. The report concludes, With a near impossible task of predicting future prices, it is no wonder that metals analysts are keen not to stray too far from the comfort zone of historic averages ¦ While the size of these transactions have only been increasing, we do not believe that they mark the end of the consolidation era. [We] would expect further strategic acquisitions to occur in the sector, while investment analysts under-price commodities relative to the corporations themselves.
From our point of view, the E&Y authors are spot-on. We have not seen the end of the consolidation era. But let’s remember who is doing the research … often financial analysts and not metals experts or others working in the field.
–Lisa Reisman & Amy Edwards