Today, emerging market countries are some of the primary basic materials consumers, and of metals in particular. In 2007, they consumed over 50 percent of global copper and iron ore production.¹ This wasn’t always the case. The developed world was the dominant consumer and growth driver for many years. This changed over time as emerging markets began to industrialize. When the emerging markets’ growth rate and industrialization process rapidly accelerated, its consumption of basic materials also began to dramatically impact global materials demand.

Emerging markets weren’t the only consumption drivers during this period. Another structural change was the rebuild of aging developed market infrastructure. Much of the developed world was industrialized over 100 years ago. Pipes, bridges, roads, dams, and other infrastructures showed increasing deterioration and in some cases began to fail, requiring significant repairs.

The impact of these events on the Materials sector, and Metals & Mining in particular, was notable. The Metals & Mining industry of the MSCI All Country World Index provided a cumulative negative 12 percent return from 1995 through 2002, but a 468 percent return from 2003 through 2007.

The cause of the dramatic stock performance can be seen in Table 6.1. The tremendous increase in basic materials prices led to higher earnings, driving stock prices higher. Of course, demand doesn’t tell the whole story. Prices are always a function of supply and demand. Basic materials prices rose so dramatically because while demand was skyrocketing, supply remained extremely constrained.

By the 1990s, metal producer executives were determined not to be burned again. This attitude, coupled with a period of low metal prices, caused metal producers to slow expansion. The lack of new projects also meant a lack of opportunity for new workers. The combination of the ongoing Internet revolution and introduction of new financial innovations like derivatives made the mining industry a relative backwater. Many talented and skilled workers shunned the industry, preferring to devote their careers to expanding and better-paying industries with greater opportunities.

Against this backdrop, the fall of the Soviet Union demonstrated capitalism was a more sustainable economic model than communism’s controlled economies and led to greater wealth. As capitalism’s tenets were adopted and governments largely avoided past mistakes, the emerging markets began stabilizing and growing. For example, Brazil’s 85 percent interest rates in 1985 had sunk to 11.25 percent by the start of 2008 as monetary and fiscal policy stabilized, while infrastructure investments surged.² Suddenly, global demand for Materials was booming again.

But this time, many metal producers preferred to be “prudent” and shunned new investment, fearing the inevitable bust. Investments in existing mines were delayed and funding for new mines sluggish. This would prove to be a key determinant for higher metal prices since few envisioned the coming strong demand.

Expenditures on infrastructure are investments, not simply expenses. A significant return can be generated on the investment in the form of higher levels of productivity, increased economic growth rates, higher living standards, reduced income inequality, greater social stability, and of course, higher tax revenues. The World Bank’s 2005 Infrastructure Progress Report cited that if Latin America improved its infrastructure to the median level of East Asian countries (or about the level of South Korea), its annual GDP growth rate would increase by 1.4 to 1.8 percent and income inequality would fall by 10 to 20 percent. Such outcomes are obviously appealing.

The World Bank estimates governments provide about 75 percent of infrastructure funding, the private sector provides 20 percent, and international aid and development organizations like the World Bank provide the remaining 5 percent. And although studies vary on the specific degree, they do consistently show that better infrastructure significantly increases productivity. The greatest gains typically come from investments in core infrastructure like transport, power, water, and telecommunications.

The following photo shows two satellite photos of the Middle Eastern city of Dubai, one taken in 1973 and the other in 2006. Flush with oil money, the government invested heavily in infrastructure, transforming Dubai City from a barren desert to a city full of skyscrapers with two man-made islands in the shape of palm trees and the world’s largest man-made port (the Jebel Ali Harbor). It was estimated in mid- 2007 that a quarter of the world’s large construction cranes were operating in Dubai.³ The difference between the two pictures is the difference industrialization has on a society and its consumption of basic materials.

The changes in China were no less dramatic. Examples of its consumption of basic materials include:

The answer is more specific than just the emerging markets. It was China. From 2000 through 2006, China’s finished steel consumption increased by 187 percent to account for 32 percent of global consumption. The US was a distant second at 11 percent.¹⁰

China wasn’t just consuming steel at an impressive pace, it was also producing it at amazing rates. From 2000 through 2006, China’s steel industry grew by an astounding 285 percent to reach 36 percent of global production.¹¹ Japan was the second largest producer at less than 10 percent.¹² In fact, in order to feed its growing steel habit, China accounted for 95 percent of the growth in iron ore trade from 2000 through 2007 and grew to consume 40 percent of the world’s annual iron production.¹³

Due to its massive infrastructure investments, China became the dominant consumer of virtually all major industrial metals. In its 2005 Infrastructure Progress Report, the World Bank estimated the emerging markets as a whole were spending 2 to 4 percent of annual GDP on infrastructure. By comparison, it is estimated China was spending up to 9 percent.

China’s footprint can be seen on almost every metal over the period. By the end of 2007, it was the world’s largest consumer of copper, iron ore, aluminum, nickel, and zinc. Examples of its metal consumption include:

According to the UN’s World Urbanization Prospects report, in 2007 an estimated 49 percent of the world’s population lived in an urban environment, but by 2050, an impressive 70 percent of the world’s population is expected to live in urban settings.¹⁶ Put another way: While the world’s population is expected to increase by almost 40 percent between 2007 and 2050, its urban population will increase by nearly 95 percent. In fact, by 2050 the urban population is expected to reach 6.4 billion and become equivalent to the entire world’s population in 2004.¹⁷ This works out to an additional 3.1 billion people moving into urban environments. Construction in housing, roads, bridges, power plants, canals, dams, and other forms of infrastructure will have to expand to an unprecedented scale to meet the challenge. Asia is expected to be the largest contributor to this urban migration with about 60 percent of the increase attributed to it.¹⁸

To meet these growing needs, tremendous sums are expected to be spent on infrastructure around the world. For example:

Aging infrastructure typically creates little public outcry until it actually fails, but pressure will increase on politicians to rebuild and renew infrastructure in the coming years as deterioration becomes evident. In 2007, a 40-year-old commuter bridge collapsed in Minneapolis, killing 13 people.²⁵ Earlier that year, an 83-year-old steam pipe in New York City blew a gaping hole in the street during rush hour and injured over 30 people.²⁶

Crumbling infrastructure doesn’t just imperil us, it also retards economic growth, slows productivity, and reduces living standards. It’s estimated Americans spend over 3.5 billion hours a year stuck in traffic, largely because one-third of urban roads are congested. It’s also estimated this congestion costs motorists over $60 billion a year in wasted time and fuel.²⁷

Some efforts have been made to repair the aging infrastructure. In 2005, Congress passed the $286 billion Federal Highway Bill to help address the growing needs of our highway system; while in 2006, California voters approved a $42.7 billion bond package to begin addressing the state’s infrastructure needs.²⁸ Table 6.5 outlines the combined growth of public and private spending in the US on the primary infrastructure categories from 2003 through 2007. Total US infrastructure spending increased a significant 37 percent in these categories over the five-year period.

As public awareness of the developed world’s infrastructure needs increases, government funded construction projects are only likely to increase. When combined with the industrialization of emerging markets, the demand for basic materials has placed a strain on the world’s resources we’ve rarely, if ever, seen before.

Growth opportunities will no doubt attract new talent, but developing skills and experience takes time. The skilled labor shortage raised costs and delayed projects in the last decade, which significantly slowed attempts to increase production and catch up with soaring demand.

Equipment was so scarce, firms took what they could get. Deliveries of 60-ton mining trucks without tires were commonplace. Costs also skyrocketed. For example, prices of 12-foot mining tires practically quadrupled, reaching up to $40,000 per tire by 2006. As with the dearth of skilled labor, equipment shortages raised costs and delayed projects.³⁰

Tied to the lack of infrastructure capacity was simply a lack of new mines. The underinvestment in the mining sector during the 1990s also resulted in very limited exploration and new development. Many existing mines had aged, and ore grades (the percentage of metal per ton of rock mined) were declining. After all, the most profitable and highest grade regions are typically mined first. This caused costs to rise (it’s more expensive to mine two tons of rock for one pound of metal than one ton of rock for two pounds of metal) and constrained production.

Many developing regions continued to struggle with corruption, political instability, weak property rights, and labor strife. Limited existing infrastructure in many emerging market countries also posed a challenge. The cost and time to develop a new mine are significantly higher if a firm has to build its own roads, ports, power plants, and rail systems rather than simply renting space on pre-existing infrastructure. The higher risks and costs further delayed development of new mines and constrained production.

High levels of political risk can be a tremendous challenge when trying to justify spending billions of dollars and forecasting an expected rate of return on an investment. In many cases during the 2003-2007 Materials bull market, it delayed or deterred investments altogether and significantly constrained production growth.

In early 2008, South Africa’s utility provider Eskom had a power failure and was forced to temporarily shut down. This was mostly the result of years of underinvestment by the government. It quickly resumed power, but said for the next four years, it would only be able to provide between 90 and 95 percent of what was previously provided.

The significance of such problems to global metal production was visible in platinum prices (80 percent of the world’s platinum is produced in South Africa). Following the power cuts, platinum prices rose nearly 45 percent in the following month and a half.³⁶

Many companies agreed to pay higher wages and one-time bonuses to prevent or settle strikes. This increased the cost of production and in some cases deterred firms from expanding mines in areas with high labor unrest. Strikes also frustrated analysts since the length and severity of such disruptions were difficult to predict.

One of the more prominent cases during the period involved a gold mine in Indonesia owned by Newmont Mining. The tailings (or leftover rock, after it had been processed with toxic chemicals) were deposited in the middle of a nearby bay through an underwater pipe extending half a mile into the water. In 2004, local residents began complaining the toxins were polluting the bay and causing illnesses and skin rashes.

The bay was found to have an unusually high level of mercury and arsenic. Civil and criminal proceedings were brought against the firm and its directors, with some being detained in Indonesia for extended periods of time and threatened with up to three years in prison. Ultimately, the company and directors were found innocent of criminal charges, the civil suit was dropped, and the company agreed to pay $30 million to the Indonesian government to help clean up the area and provide aid to the affected community.³⁷

All of these risks and challenges served to severely stunt production growth in the midst of soaring demand. The result was dramatically higher raw material prices.

This environment of constrained supply growth and rising demand caused firms to purchase existing mines rather than taking on the risk of developing new mines. A favorable credit environment also provided a friendly environment for M&A transactions and deals flourished. Table 6.6 outlines the year-over-year increase in announced deal value and volume for the global Metals & Mining industry. The announced deal value in 2007 of $339 billion was an amazing 3,359 percent higher than in 2002, prior to the start of the Materials bull market. It also wasn’t just a few big deals. In 2007, an impressive 1,010 deals were announced, representing a 3,419 percent increase over 2002.³⁸