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Economic Moats in Basic Materials
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Economic moats in the basic materials industries tend to be very few and far between. The main reason is that many of these companies produce commodities; thus, they would create a sustainable competitive advantage only by becoming the low-cost producer.

Some commodity-producing companies achieve the low-cost position by increasing their size and attaining economies of scale. Consequently, their production cost per unit is less than the competition's. In the aluminum industry, Alcoa has this economic moat; in steel, it's mini-mill producer Nucor. In the low-cost position, a company can charge less than its competitors and still remain profitable. Ideally, this should drive inefficient producers from the market and strengthen the industry over the long term.

The reality is, however, much more complicated on several fronts. In many industries, such as steel, domestic firms have come under increasing pressure from foreign producers with much lower cost structures. Their cost advantage usually comes from some combination of three sources: the sheer benefit of geography, government subsidies and tariffs, or low labor costs.

After a long decline, culminating in the 1990s, America's steel industry experienced strong competition from foreign firms with much lower costs that churned out more steel than demand warranted, thus driving U.S. steel prices to bargain-basement levels. In recent years, more than 30 domestic producers, with relatively costly labor contracts and crushing pension and retirement obligations, could not operate profitably with steel prices at such low levels and filed for bankruptcy protection. Though the specifics and intensity of these problems vary from industry to industry, other commodity industries are dealing with similar issues.

Although basic materials industries do have significant barriers to entry— the cost of constructing a new steel, aluminum, or paper processing plant is steep—stiff price competition makes for mediocre profits at best. As mentioned previously, basic materials producers are highly susceptible to performance swings tied to the overall economic environment. The high cost of equipment and low profit margins mean these industries typically have poor returns on capital, so there's little to attract investment capital and even less to attract investors.

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