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A Fourth Implication
Part II showed that the prices and values of lower-order (producers’) goods such as minerals and petroleum are derived from the satisfaction consumers derive from their associated consumers’ goods. The structure of production thus consists in a process of continuous enhancement of value as it proceeds from goods of higher order (and less value) to goods of lower order (and higher value).
Clearly, however, the demand for particular consumers’ goods (and hence the prices consumers are willing to pay for them) constantly changes; similarly, entrepreneurial errors of greater or lesser degrees of magnitude are ever-present at all stages of the structure of production. It is plausible to assume that the further entrepreneurs’ distance from consumers, the more prone to error (relative to final consumers’ demand) their interpretations of the price signals sent and received at “their” stage of the structure of production.
Menger’s premises thus imply greater price volatility at higher stages of production and lower volatility at lower stages of production. The prices of higher-order goods, in other words, will tend to fluctuate more than the prices of lower-order goods. The price of crude oil, for example, will tend to ebb and flow more than the price of petrol at the local service station. More elaborately but similarly, the price of iron ore will tend to be more volatile than that of steel; the price of steel, in turn, will tend to oscillate more than those of automotive components; and the prices of auto parts will tend to be more erratic than the price of a Holden Vectra at the local dealership.
A Fifth Implication
It also follows from Menger’s two premises that the revenues and earnings of companies which produce higher-order goods (which depend upon the volatile market price of a commodity or group of commodities) will tend to be more volatile than the revenues and earnings of firms which produce lower-order goods (which depend upon the relatively stable prices paid by consumers for goods which, to some extent, have brand status in consumers’ eyes). Over time, then, the revenues and earnings of an oil producer will be more volatile than the revenues and earnings of a petrol retailer. Similarly, the results of an iron ore miner will fluctuate more than those of a steel company; the steel maker’s results will be less predictable than those of a white goods manufacturer; and the manufacturer’s revenues and earnings will oscillate more than those of the white goods retailer. In Mark Skousen’s words, “the further away a company is from final consumer use, the more volatile its profits, earnings and prices will be.”
Austin Donnelly, doyen of Australian financial advisers and long-term observer of Australian financial markets, seems to concur. In his words, “mining stocks give good opportunities for profit for vigilant investors and traders who are prepared to take their profits and sell a major part of their holding before the inevitable slump. We must remember that they are extremely volatile, and the risk of loss is great. Indeed, what are called speculative or mineral or exploration stocks experienced a decline of well over 90 per cent in the 1974 slump.” Donnelly adds “it is worth noting that there is a considerable element of speculation in mining stocks, even among the largest, most highly-regarded and well-established stocks, to the extent that most share buyers are hoping to obtain significant capital gain on their stocks to compensate for the high risk.” He concludes “even if share markets were a good deal less speculative than they are, the value of mining shares would move considerably more than industrial shares. The reason is that their profits are very significantly affected by changes in world commodity markets, which are notoriously volatile.”
A Sixth Implication
Markets for minerals and energy commodities are thus characterised by large and rather quickly-growing supply; large but less-quickly growing demand; downward pressure on commodity prices and producers’ margins – and therefore a never-ending contest between profit margins and advances in technology (which temporarily improve margins but eventually depress prices and thus erode margins). In Stephen Wyatt’s words (AFR 22 February 1999), “ironically, commodities are cursed with the secret of eternal youth because technology-driven productivity growth lifts supply more quickly, while income growth augments demand more slowly, than in manufacturing or services.” Minerals and energy thus epitomise Menger’s central insight that the prices of goods and services are determined by the extent of consumers’ subjective willingness to pay for those goods and services. Prices thus do not depend – as Adam Smith, David Ricardo and others had contended for a century – upon suppliers’ cost of production or any “labour theory of value.”
Mark Skousen provides an example. Within several months during the early 1980s (when analysts estimated that the opportunity cost of producing copper was approximately $US0.80 per pound) the price of copper dropped from $US1.40 to $US0.60. Since copper was selling below its cost of production, it was widely predicted that its price would subsequently rise. Although they seldom make their reasoning explicit, it is likely that analysts reasoned that copper producers could not maintain then-prevailing levels of production at unremunerative prices; that some would cease production, exit the industry, etc.; that this rationalisation of the industry would tend to curtail production; and that this restriction of supply would place upward pressure on prices. Hence many analysts’ advice that copper futures contracts be purchased.
The recognition that prices are subjective (in Menger’s sense of the term) draws to our attention the reality that costs are prices – which, accordingly, are subjective and subject to change. There is nothing fixed, and even less sacrosanct, about the opportunity cost of producing a pound of copper. Indeed, when the price of a mineral or energy commodity sinks below remunerative levels, producers have a strong incentive to reduce sharply their costs of production. In practice they often attempt to do so by negotiating on more favourable terms their arrangements with trade unions and suppliers. Not infrequently they are able to reduce their costs so much that they restore their profit margin – which gives them an incentive in the short term to increase production and which in the longer term places additional downward pressure on prices.
Exactly these developments occurred in the copper market in the early- and mid-1980s. More generally, developments such as these have occurred throughout recorded history in the mining and energy industries. For this reason it is no accident that Australia’s most bitter and protracted labour disputes have occurred disproportionately in these industries.
A General Conclusion
From Menger’s two premises we have reasoned towards a range of conclusions about resource companies and their valuation. Mineral and energy resources are essential preconditions of civilisation and a consumer society. They are valued (and are therefore best defined) not as stocks of raw materials but rather in terms of the consumers’ goods and services they help to produce. Hence these resources are not ‘natural’ resources; quite the contrary, human action conceives and creates them. Nor is their supply finite: assuming that human action will continue in the future to be as ingenious as it has proved in the past, their supply, for all practical purposes, is limitless.
It is therefore reasonable to expect that in coming decades the prices of minerals and energy will continue to fall both in real (i.e., inflation-adjusted) terms and relative to consumers’ goods. Net of this trend and over shorter periods their prices – and hence the revenues and earnings of resource companies – will not only fluctuate, they will do so in a manner which is very difficult if not impossible to predict accurately. And at all times technology will advance and replace labour, industrial disputes will flare and the importance of resource industries relative to manufacturing and services will decline further.
These implications should not lead us to conclude that resource companies necessarily are poor investments. From the standpoint of a Graham-Buffett value investor, however, they are very (and perhaps insuperably) difficult enterprises to value. In this context it is no co-incidence that Mssrs Graham and Buffett have emphasised the rough stability of earnings as a basis of valuation. The less stable previous years’ earnings the more arbitrary the estimation of future earnings and the resultant valuation of the business. Indeed, although at first glance they could not be more dissimilar (indeed, the conventional wisdom places them at opposite poles of a fictitious “Old Economy-New Economy” continuum), in one fundamental respect resource and technology companies closely resemble one another: the estimation of their value is inherently difficult and perhaps impossible. It is perhaps for this reason that resource and technology companies (much more than, say, banks or retailers) tend to be playthings of speculators – and have been primary objects of the dizzying booms and nauseating busts occurring periodically in Australia.
 
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