By Drew Hasselback -- Violent swings in commodity prices aren’t good for anyone The pendulum will come back with unpleasant force

Commodity prices have enjoyed a nice rally since the beginning of the year, and part of this has been due to a resurgence of demand from China. Indeed, the World Bank has said that the pace of global economic recovery depends on China. I hear similar sentiments from miners and commodities’ traders. China was the driving force behind the last commodities boom, so it stands to reason that a rise in Chinese demand for minerals is a necessary precondition for a revival of the mining business.

So it’s all good news, right? Not necessarily. I’m worried about another factor that could flow from a massive spike in commodity prices. The severity of the downturn has so spooked the mining world that exploration for new mines has stopped. This is exactly what happened during the last downturn. That last exploration shortfall resulted in a scarcity of mines, which in turn helped engineer the record prices that emerged during the boom. The logic is simple: If people stop looking for potential mines now, there won’t be any new sources of supply when existing mines are exhausted.

A report by the global accounting firm Ernst & Young raises this prospect. “What we’re seeing now... is an overall unwillingness to take on additional risk,” said the firm’s mining specialist, Tom Whelan. “This makes immediate sense, of course, but there’s another side to the story, which is the predicted and inevitable scramble for scarce resources when the global economy recovers.”

The potential of price spikes is no doubt welcome news for a mining industry that has been bleeding a lot of red ink in recent months. But it’s a doubleedged sword: The recent cutback in exploration spending will have immediate and longer-term effects, neither pretty. We saw price spikes during the last boom. While producers thought it was great to bank up all that cash from massive profits, the spikes caused numerous problems. Demand was threatened as prices grew out of reach for buyers. The cost of building new mines grew prohibitive as miners competed for access to a limited pool of skilled construction workers and dwindling building materials. Profits were no sure thing, either. Output was threatened as some important items fell into short supply: Truck tires spring to mind. It grew difficult for some mines to operate at full capacity because operators were finding it tough to secure supplies of the massive tires used on mining trucks.

Exploration spending has indeed plummeted. As I noted last month, a recent survey by Natural Resources Canada suggests nationwide exploration spending should fall to about $1.5-billion this year, down from $2.8-billion in 2008. That 46 per cent drop is pretty much in line with the last global downturn, when annual global spending fell 45 per cent from the cycle’s peak in 1997 to its bottom in 2000. The results of that last dry spell were sharply obvious as demand started booming around 2006. As existing mines ran low on reserves, only a handful of properties were ready for development in time to enjoy the new cycle.

Whelan sees the cycle repeating itself. “With the recent depletion of existing mines reflected in falling grades, and the extended periods of time required to bring on new projects, there is a likelihood of a severe supply constraint developing in many metals and minerals, potentially causing prices to soar to new heights.”

So what does this mean? My take is that while it might be great news for investors, the situation is less cause for celebration for boots-on-the-ground exploration workers.

Those juniors that have managed to locate intriguing properties must do everything they can to hang on to them. Exploration juniors may seem rather unloved in the current market, but those with quality properties will be in hot demand, and probably quite soon. The major producers will want to buy up the best ones while they’re good and cheap. Investors in such juniors won’t want to see them squandering cash resources.

That is why I think the situation is generally going to be bad news for the contractors who do most of the actual drilling and sample collecting. If a junior is well positioned to benefit from any coming acquisition wave, they’re likely putting the brakes on much of their exploration work in order to preserve cash. You see, a good company in the current scenario is one where the drill results are already in hand and published. There’s no need to poke a few more holes in the ground. If your livelihood depends on just doing that sort of work, you might be in for a couple more lean years.

Things will get better in due course. If the Ernst & Young scenario plays itself out, the scarcity of mining projects will spark a new prospecting rush. Good news for the North, perhaps, but a step removed from the coming acquisitions phase.