This book’s goal is to help you gain a basic understanding of the Materials sector, its components, drivers, challenges, and history, as well as be a general guide to Materials investing success. Wherever possible, we’ll also help you think critically about the sector to generate your own views, rather than just dictating a bunch of rules. Successfully investing in Materials companies does not require a PhD in chemistry or geology. What is important is a firm grasp of the laws of supply and demand, and understanding what drives the earnings and stock prices of Materials companies.

This chapter covers the basics of the Materials sector, including an overview of common traits across material producers, how materials are priced, and a primer on how basic materials are extracted and processed. At this point, we’re just looking at the firms and their structures. In later chapters, we’ ll translate a firm’s structure into performance (earnings, profitability, productivity, etc.) and detail how to use that to build an appropriate portfolio strategy.

But not all commodities fall in the Materials sector. Most notably oil, by far the largest commodity of all by value, falls in the Energy sector. Most agricultural products—also commodities—are found in the Consumer Staples sector.

The Materials sector is composed largely of metals, chemicals, paper, lumber, cement, crushed rock (called construction aggregate), and packaging. As Chapter 4 will cover, these products are not equally represented in the sector—some are more important than others (i.e., they drive more revenue). But before we get into the specific industries, let’s cover some broad characteristics all Materials firms generally share.

It takes tremendous money to start a new business in these industries, often hundreds of millions or even billions of dollars. The nearby picture shows a large machine sometimes used in coal mining. Notice how small the white cars are in the bottom left. The Materials sector is characterized by huge machines, huge mines, and huge manufacturing plants—not many mom-and-pop shops in these industries. This creates a tremendous barrier to entry for new entrants and provides significant pricing power. As Chapter 4 covers in greater detail, it also creates concentrated industries dominated by a small number of large firms.

Capital investments in Materials firms are not made for next year, but for long time horizons. With the rapid pace of technological innovation and the inherent difficulty in long-term forecasting, today’s business investments are often failures. This creates significant shifts in industry leadership over time with new companies with new technologies overtaking older and once-dominant firms.

Table 1.1 lists the 10 largest domestic Materials firms (including Canada) in 20-year intervals, starting in 1965. The order changes frequently with many once-dominant firms falling off the list or disappearing entirely. Three of the top six 1965 firms no longer exist today (Union Carbide, Bethlehem Steel, and Inco Ltd).

Not all firms that disappeared went bankrupt. Some were acquired by stronger competitors aiming to enhance the targets’ values with updated technology or a new strategy.

Most products coming from the Materials sector have extremely long useful lives. Once installed, it takes years for steel to corrode, cement to break down, or plastic to wear out. When archeologists discovered a copper plumbing system in the Egyptian pyramid of the Pharaoh Khufu, it was still in serviceable condition 5,000 years after construction!² Absent economic growth, particularly in the construction and manufacturing industries, demand can drop considerably and be easily outstripped by existing supply.

Pretend you’ re a factory owner. To increase production, you must build a new factory or expand your existing one. The construction takes metal, concrete, and so on. But if you’re content to maintain production, other than occasional maintenance and steady use of any basic material in your product, you require no additional basic materials to maintain your existing production capacity. With no growth, demand for Materials doesn’t just decline, it often falls precipitously. The combination of economic sensitivity and extremely high fixed-costs makes Materials firms very cyclical with large historic booms and busts. The high fixed cost structure creates significant operating leverage, which fuels tremendous profits during boom times and tremendous losses during busts, since raising or lowering production volumes only modestly changes total costs.

Though economic growth is a vital component of demand, you should be concerned about both supply and demand in your Materials analysis.

In a free market, prices are ultimately set by the interaction of supply and demand. A price is simply the representation of how scarce a good is and how much it’s desired or valued.

Put another way, the global economy works on the same principle as a third-grader trading his potato chips for his friend’s brownie. The value of that brownie depends on how much the third-grader wants it, how many other brownies or close substitutes are readily available, and how many competitors (schoolmates) have similar potato chips on the market. The brownie’s worth or price is dependent on the interaction of the demand and available supply.

Although simple, never underestimate the power of this concept! Supply and demand determine prices for stocks, bonds, commodities, real estate, and virtually any other free market good.

Depending on availability, regional pricing differences may exist due to shipping costs and import or export taxes (tariffs). If regional pricing differs by more than the cost of shipping and taxes, a producer has an incentive to ship goods to the higher-priced region and sell them there. This incentive typically keeps regional prices relatively in line with each other.

The lower the value-to-weight ratio and the smaller the end market, the more likely regional differences exist since shipping costs become a larger percentage of total costs. Table 1.2 outlines the various costs of some common basic materials. It’s very cost effective to ship gold, which was over $800 an ounce at the end of 2007, but often uneconomical to ship construction aggregate, which cost less than $10 a ton. And if only a few tons are needed, economies of scale are lost and the shipping becomes even more uneconomical. Therefore, gold prices have less regional disparity than construction aggregate.

Bulk materials with low value-to-weight ratios like coal, iron ore, lumber, and construction aggregate have the greatest regional disparities. Steel and specialty chemicals, with hundreds if not thousands of product variations and niche markets, can also have significant regional pricing disparity. Most precious and industrial metals, along with commodity chemicals, have relatively small disparities.

Basic materials with relatively small regional pricing differences are typically priced globally on commodity exchanges. Prices for products with greater regional differences are typically priced regionally upon sale by producers.

Iron ore is a notable exception. The majority of its prices are negotiated annually in year-long contracts between steel makers and miners. This helps provide stability for both highly capital intensive and cyclical industries. A spot market with prices set by regional producers does exist, but it’s relatively small. Under the annual pricing system, the largest producers negotiate annual prices and smaller producers have little choice but to follow. In economic terms, this makes the large producers “price setters” and the small producers “price takers.”

While contracts typically originate at set intervals starting at three months and going out as far as five to ten years, once the contract is created it trades on a daily basis until maturity. Figure 1.1 shows a graph of futures prices for copper at various maturities. In this case, investors expect the price to fall over time. They’ll ultimately be proved right or wrong and the price of their contract will equal the going spot price upon maturity.

When the futures curve (also known as a forward curve for non-exchange traded commodities) is inverted and the future price is below the current price, the commodity is in backwardation, reflecting current scarcity relative to future expectations. When the futures curve is positively sloped and the future price is above the current price, prices are in contango, reflecting a surplus relative to future expectations. Because of storage, insurance, and financing costs, it’s normal for non-perishable commodities to be in contango.

Modern futures exchanges originated with the Chicago Board of Trade in 1848. It was created to provide stability to Midwestern farmers’ incomes. Without futures or forward contracts, a farmer’s business is quite risky. A farmer invests substantial money in seeds, fertilizer, weed killers, machinery, and labor to grow and harvest crops, but doesn’t know what the crop will sell for, even months after it’s planted. By pre-selling the crop, the farmer knows exactly what can be spent along the way while still ensuring a profit. The futures market takes the price risk out of the equation. Taking risk out of the equation proved to be very popular and the Chicago Board of Trade quickly grew.

Speculators also engage in futures trading, although they rarely hold a contract to maturity and therefore don’t take physical delivery of the good. Future exchanges like the London Metal Exchange (LME), the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), and the New York Commodities Exchange (COMEX) all provide pricing information and venues for Materials trading.

Different commodity exchanges often specialize in different products. Chicago’s commodity exchanges oversee greater volumes of agricultural-based commodities (tied to their history as an exchange for Midwestern farmers). The London Metal Exchange is historically the global leader in metals because England was first to experience an industrial revolution.

But first, some definitions.

The terms stem from the metaphor of a stream or river. A river’s flow starts upstream at its source and ends downstream. The closer the source, the farther upstream you are. In steel making, an iron ore mining operation is about as far upstream as you can go. By comparison, a steel producer is downstream and a steel distributor is even farther downstream. Upstream and downstream operations usually have very different margins, business models, and benefit from different economic environments. Vertically integrated producers have both upstream and downstream operations complementing each other.

Once a promising search area is discovered, the interested firm meets with the land owner (usually governments) to negotiate broad exploration or mineral rights covering wide territories, often tens of thousands of acres.⁴ Governments typically negotiate contracts as leases with specific exploration and development time frames to ensure firms are actively investing in their country rather than speculatively purchasing rights to sell at a higher price in the future.

Geologists then survey and take samples to assess likely ore veins and identify spots for drilling exploratory holes. They often explore sparsely inhabited areas with no more than their packs, a donkey, and a few local guides. Based on the geologists’ findings, firms drill exploratory holes. And with costs often over $300,000 to drill a 3,000 foot deep hole, the decision isn’t made lightly.⁵

If a viable quantity of ore is discovered, the firm applies for government and environmental permits to construct a mine. Approval usually involves fees, royalty agreements based on a percent of revenue or mine production, taxes, and even mandated social programs for the community. (And sometimes a bit of backroom dealing with government officials.)

Such agreements are permanently binding only in theory. Governments have a funny habit of coming back for more and re-negotiating terms when it suits them. Additional fees and other alterations years later are not uncommon. A recent example is the dramatic changes to South African mining laws in 2004. Called the Black Economic Empowerment program (BEE), it addresses previous racial inequality under apartheid, but also represents a dramatic shift in ownership requirements. Existing mining companies must transfer 15 percent of ownership to individuals designated as historically disadvantaged South Africans by April 2009 and 26 percent of ownership by April 2014. South Africa also reviewed mining royalties and proposed significant changes on each type of metal.⁶

New mining projects are known as “greenfield” projects because the project was started in an unspoiled “green field.” Expansions to an existing mine or drilling at a nearby site is known as a “brownfield” project—a project commenced in a well-traveled area with established roads and infrastructure.

Brownfields typically represent less risk. Mineral rights are generally already established and the terrain is well understood. However, most brownfield regions with potential for significant ore deposits have already been explored, and current brownfield projects are typically smaller expansions. So although greenfield projects are much riskier, they often have the potential for much larger discoveries.

Mines can either be built underground or as open pits, depending on the depth and concentration of ore veins. Collapsing tunnels, toxic fumes, and operating heavy machinery in close quarters make underground mines significantly more dangerous. They typically have a conveyor belt system to transfer out rock and ore. Open pit mines involve blasting rock, loading it into large dump trucks, and hauling it out.

Chemical flotation or leaching is typically used to create concentrate. The process involves a bath of water and a chemical reagent. When air is pumped into the solution, chemicals cause the ore to attach to rising air bubbles forming a surface froth that is skimmed off. This easily allows sorting multiple types of ore from the same batch of rock. Simply by changing the chemical composition of the bath, another ore type rises to the surface. Once skimmed, the material is filtered and dried to remove excess water and reduce shipping weight.

Concentrate is still not pure metal and requires additional refining or smelting. The metal percentage in concentrate (called concentrate grade) depends on the metal type, processing efficiency, and presence of other impurities. Copper concentrate for example typically only holds between 15 and 35 percent actual metal depending on the quality of the ore and efficiency of the leaching process.⁸

Smelters melt concentrate down and mix it with materials like limestone, which absorb impurities and leave a material with a 40 to 60 percent metal ratio called matte. Hot, oxygen-enriched air is blown through the molten matte to purify it over 95 percent and create blister (named for the air bubbles that form on the surface). The blister is then heated in an anode furnace to burn off excess oxygen and form anodes, which are 99 percent pure metal.⁹

While this quality level is usable for many purposes, some uses require 100 percent purity. Copper used in electrical wiring is further refined to maximize its electrical conductivity. To further refine it, the anodes are put through electrolysis. The metal is dissolved in a water and chemical bath and attracted to an electrically charged pole. As it dissolves and attaches to the pole, impurities left behind fall to the bottom of the tank, and the result is metal with 99.99 percent purity, called a cathode. The various stages of the smelting process are summarized in Table 1.3.

Refining differs slightly for each metal. Some metals like gold require little to no refining. Others like copper must undergo the full smelting process. Iron ore doesn’t even use the basic leaching process in its transformation into refined iron (called pig iron) and then steel. There’s also usually more than one way to refine a metal, but this is among the most common processes.

Smelting typically yields lower profit margins than mining. Smelters generally sign annual contracts to provide a stable flow of input materials. When global smelter capacity exceeds the supply of concentrate produced by the miners, negotiating power falls into the hands of miners and smelting fees decline. When the reverse occurs, smelting fees rise.

Smelters buy ore from miners at the daily London Metal Exchange (LME) benchmark rate, minus the amount of the annual pre-negotiated fee. Since annual contracts are long term, smelters typically negotiate what’s known as price participation, allowing smelters to increase fees by a pre-determined level if prices exceed a certain threshold. For example, a smelter may charge $0.25 per pound to refine copper, with the agreement that for any period in which copper exceeds $4 per pound, the charge increases to $0.35 per pound.

In 2008, smelting capacity outpaced copper production from mines by such a large margin that miners eliminated the price participation clause and smelting fees dropped by 25 percent. That year, it cost $0.20 per pound to form anodes, and roughly another $0.05 per pound to further refine it into cathodes. These charges are called treatment (TC) and refining charges (RC), respectively, and often are denominated as TC/RC in shorthand for the total smelting fee.¹⁰

The US isn’t the only energy-conserving country. In 2007 the US exported over 19 million metric tons of scrap metal to foreign countries. Emerging markets rank among the largest scrap importers, with China leading the way. Since most construction is brand-new in developing regions, they are forced to import large quantities to realize the savings.¹²

Chemicals and their products are pervasive—paints, glues, plastics, fabrics, lubricants, cleaners, and many others. Even the binding of this book is held together by a chemical adhesive! So how are they made?

First, a disclaimer: Detailing how thousands of different chemicals are made would require many encyclopedias, so the following description is simply a guide to typical chemical synthesis. But keep in mind the process won’t apply to all chemicals.

A few products in the chemicals industry are mined, like potash and phosphate for fertilizer. But the majority of chemicals start with oil or natural gas. Once petroleum is out of the ground, its next step to becoming a finished chemical is through commodity chemical plants.

End markets are huge, which makes competition fierce. A producer who can gain an edge and undercut its competitors stands to benefit tremendously. As competitors battle to gain efficiencies and drive down marginal costs, the size of the operation typically grows to exploit economies of scale. The commodity chemical industry is characterized by large manufacturing plants producing large volumes of chemicals at a steady rate. In fact, these plants often run 24 hours a day.

The most commonly used feedstock for commodity chemicals are naptha, a by-product of oil refining, and ethane, the second largest component of natural gas behind methane. Once isolated, these products go through a process called “cracking” to break down large hydrocarbons into smaller ones like ethylene and propylene.

Steam cracking is the most common process. Naptha or ethane is heated to over 750 degrees Celsius until a reaction occurs. Depending on the specifics of the input, scientists know the exact temperature the reaction will take place and stop it milliseconds after it starts. That short time, however, is enough to break down hydrocarbons, which are then filtered into ethylene, propylene, and other basic substances.

Ethylene and propylene are two of the most commonly used commodity chemicals because they are among the simplest forms of hydrocarbons in existence, making them extremely versatile for use as building blocks in specialty chemicals.

While commodity chemical plants typically run continuously, specialty chemical plants produce ad hoc batches of chemicals with volume dependent on current customer needs. Since markets for specialty chemicals are smaller, competition is not as fierce. The gains from improving efficiencies and undercutting a competitor on a single chemical are relatively small and not worth large investments of time or capital. Pricing power is therefore strong, and the specialty chemical industry is much less cyclical than the commodity chemical industry.

Concrete is a mix of 80 percent construction aggregate (crushed rock) and 20 percent cement. Once water is added, cement remains malleable for a period before hardening into its final rock-like form.¹⁵

Dry cement furnaces are typically long rotating tubes, up to 12 feet in diameter (wide enough to drive a car through) and 400 feet long, set at a slight incline. The mixture is placed in the top of the furnace and slowly travels down the inclined and rotating tube while being heated to over 2,700 degrees Fahrenheit. Chemical reactions take place along the way and the result is marble-sized pieces of new material called clinker.

Clinker is ground into a fine powder and mixed with various additives, depending on the characteristics of the cement desired. Cement powder is ground so fine it can pass through a sieve capable of holding water.

Cement is primarily manufactured regionally due to its low value-to-weight ratio, but unlike construction aggregate, some global trade does exist. In 2005, the US imported approximately 28 percent of its cement, with most going to coastal regions like California.¹⁸ However, the US is expected to expand its cement production capacity by 27 percent between 2007 and 2012 to replace the higher cost imports.¹⁹

Heating the large cement furnaces to high temperatures is very energy intensive. It takes about a half pound of coal to produce one pound of cement. Over 1.6 billion tons of cement is produced globally each year—that’s a lot of coal.²⁰

Softwoods are primarily used as lumber for construction and to make paper. The largest end market for softwood lumber is the residential housing market. Examples of softwood are pine, Douglas fir, and redwood. Wood used for paper production is called pulpwood and results from diseased or heavily branched softwood trees unusable for making lumber, the scraps from sawmills, and a few trees such as eucalyptus, which are widely grown specifically for pulpwood.

Forest land owners have a variety of harvesting methods, including clear-cutting (where every tree is cut down), diameter limit cuts (where any tree over a specified diameter is cut), and selective harvests (where only designated trees are cut). One of the most commonly used methods is a variation of the selective cut called a “group selection” harvest.

In a group selection harvest, small patches of forest, up to about an acre in size, are cut in scattered fashion throughout the forest. Most forests in highly regulated areas are cut using the selective or group selective method because they are considered the most sustainable practices. To help sustainability, new young trees are planted in place of the removed mature trees to help the forest re-grow.

Most trees planted specifically for lumber or paper are given an 8- to 15-year life cycle prior to harvest, but it varies depending on the tree and climate. Trees can be felled by hand with chainsaws or much more efficiently and safely with tree harvesters. Tree harvesters are somewhat like large tractor capable of grabbing a mature tree, felling it, shearing its limbs, cutting it to the desired length, and stacking it for transport at a rate of about 45 trees per hour.²³

In most cases, the pulp is bleached white and put through a process called “beating,” which mashes the pulp. At this point, fillers like chalk and starch are added, affecting the final opaqueness and paper quality. Then pulp is laid on a fine mesh screen and subjected to rollers, pressing water out through the screen, leaving behind compressed pulp. Despite attempts to recycle its water when possible, the pulp and paper industry is the single largest industrial water consumer in the developed world.²⁴

The pulp sheet is pressed into form and sent over a number of hollow, heated rollers to dry the paper. At this point, pigments or latex finishes may be added for color patterns or a glossy coat depending on its intended use. The final result is a sheet of intertwined cellulose fibers we call paper. No glue is used in the process. Because of all those steps, the paper industry is one of the most capital intensive industries in the world.

Besides reducing landfill size, recycling paper also has the advantage of taking 64 percent less energy to produce than making it from scratch.²⁵ The amount of paper recycled in the US has increased an impressive 87 percent from 1990 to 2007, with 56 percent of the paper consumed in the US in 2007 being recycled. This equates to nearly 360 pounds of paper recycled for every man, woman, and child in the US!

There is a limit, however, to our ability to recycle paper. Paper can only be recycled five to eight times before the fibers become too short and weak to be reused.²⁶ Nonetheless, approximately 36 percent of US paper production (including exports) is now made from recycled paper.²⁷