Investing is a complicated business. Even when you have a well-thought-out investment thesis, there is always something that you just can't know.
When investing in the natural resource sector, one unknown that is always present and has the capability to turn everything on its head is the ability of human beings to innovate.
Innovation can create incredible opportunities for investors both on the long and short side of the ledger.
Case in point, the nickel industry.
At the turn of this century, quite a few people could see that it was going to be a very wise idea to get exposure to the price of nickel. Nickel was then trading for less than $10,000 per metric ton and production was closely controlled by a few large Western companies.
Meanwhile, demand for nickel was surging, driven by China, where a construction boom was consuming vast amounts of steel (in which nickel is used).
It didn't take a Nobel Prize in economics to figure out that soaring demand for and static supply of a commodity will result in an escalating price.
And that is exactly what happened to nickel.
Investors who had the vision back in 2000 to get exposure to rising nickel prices made out like bandits as the price rose from as low as $5,000 per metric ton in 2002 to $50,000 per metric ton in 2007.
But then the party stopped for nickel bulls. And it stopped rather abruptly.
The 2008 financial crisis certainly played a part in this initially by curbing demand for nickel. But this isn't like oil, which also collapsed in 2008 and then quickly rebounded.
Nickel prices dropped and have stayed down.
What happened?
Surging nickel prices lit the fire of innovation.
There is nothing like extreme financial pain or burning desire for wealth to bring innovation to the front and center.
For nickel, the country most hurt by soaring nickel prices was China. China is (by far) the biggest user of the commodity and was left at the mercy of the Western companies that controlled most of the nickel supply.
It makes perfect sense that as the country most impacted by rising nickel prices that China would be the most motivated to do something about it.
That is precisely what happened.
Chinese steel manufacturers devised a way to refine a substance found mainly in Indonesia called laterite ore into nickel pig iron. This nickel pig iron could then be substituted for pure nickel and used to make steel.
With nickel prices under $10,000 per metric ton, turning laterite ore into nickel pig iron would not have been an economic proposition. With higher nickel prices it is.
Nickel pig iron uses 15% of the nickel that 'conventional' steel does. What that meant for the nickel market was that much of China's demand for steel could now be met by steel produced using only a fraction of the nickel.
This decrease in demand for nickel from China is what collapsed the bull run in nickel prices.
Is There An Opportunity In Nickel Today?
The short answer, I believe, is 'yes'. But the opportunity isn't what you might think it is.
Western nickel producers continue to be slow to admit to this new reality of reduced demand for their commodity.
Despite weak nickel prices, few nickel miners have yet to make significant cuts in output levels. This stubbornness toward reducing production continues to create an inventory glut of the commodity.
According to industry estimates, almost half of the nickel sector is running at a loss. That is a state of affairs that can't continue indefinitely.
Yes, there is opportunity in the nickel miner sector all right, but that opportunity is on the 'short' side of these companies.
Going 'short' a stock means that you are effectively placing a bet that the share price of a company is going to decrease.
In order to do that, an investor borrows shares from her broker and sells them without ever owning them. At some point in the future, the investor will then have to buy shares in the same company so that they can be returned to the broker.
If the share price has decreased since the original shares were borrowed the investor has made money. If the share price has increased, the trade was a loser.
With nickel prices where they are, nickel producers are going to be forced to shut higher cost facilities. When that happens the value of these facilities will have to be written down in the company financial statements.
Those writedowns will not be well received by the stock market.
Barring a dramatic move by Indonesia to restrict exports of laterite ore to China (in an effort to encourage China to construct refineries in Indonesia) there is no reason to believe nickel prices are going much higher.
The way to get direct exposure on the short side to continued nickel price weakness is the world's largest nickel producer, Norilsk Nickel ADR.
Norilsk Nickel's ADR trades on the OTC market under the symbol NILSY and will be directly impacted as long as nickel prices stay low.
Risks to Consider: Shorting can be dangerous business. When you go 'long' a stock, the most you can lose is 100% of your investment. When you go 'short,' the potential for loss is unlimited as stock prices can double, triple or more. Also, if Indonesia aggressively acts to restrict laterite ore exports, it could drive nickel prices higher.
Action to Take--> Short shares of a pure play nickel producer such as Norilsk Nickel and wait for the inevitable asset write-downs and disappointing profits to drive shares lower before covering.
