I think people struggle to understand how cycles work.A simple...

I think people struggle to understand how cycles work.

A simple example is - there are 9 farmers who each produce 1 potato (thermal coal) and there are 10 families, who each need 1 potato to feed their family. Even though there's only a small supply/demand imbalance, when they all meet together at the market, the families are desperate to pay whatever it takes to get a potato because they know one will miss out and it will be catastrophic. So the price goes up very quicky.

Since the price of potatoes is so high, the cow farmer (met coal) decides to produce potatoes (thermal coal), and an office worker from the city (AHQ) decides to start a potato farm too.

Next year, there are 11 farmers with 11 potatoes and still 10 families needing 10 potatoes. They all get together and this year the farmers understand one of them will be left holding their potato, so they all undercut each other to secure a sale. The price goes down very quickly.

There are complexities to this, such as stockpiles on either side which dampen the volatility and changes in demand but essentially this is how it works. Over cycles, the price of a commodity should equal the cost of production plus a reasonable margin based on the cost of capital.

With commodities, when there is a big boom, there is usually a big bust. This is because balance sheets of these farmers have become very strong, so even when there is an oversupply and prices are below their cost of production, they are able to sustain production for long periods of time. The best capitalised and lowest cost producers manage to survive and the crappy 2nd tier miners disappear.

Prices may go up from here but I think it's more likely we are in the oversupply part of this cycle and because miners are so well capitalised (most are heavy net cash), this down cycle will go on a lot longer and deeper than people think is possible.