COMMODITIES SUPER CYCLE OR BURSTING BUBBLE?

By George Wannabe, MacroWonders

Much has been written on commodities being in a super cycle. I will quote Jim Rogers with catch phrases such as “Either the economy gets better and prices go up or the Fed prints money and prices go up”.

My guess is the reality is not that simple especially when considering commodities as an asset class or a “buy and hold” investment.

For one, as it is well explained by SocGen’s Dylan Grice via FTAlphaville, commodity prices in real terms have gone nowhere thus making it a bad “buy and hold” investment.

Some like GMO’s Jeremy Grantham believe this is about to change as we have reached the point where we are running out of resources but only time will tell if “It is different this time”.

For now though, real prices have gone nowhere and this is especially true for investors as prices have been in contango for much of the past years.

Furthermore, as Grice explains:

“A bushel of wheat, a lump of iron-ore or an ingot of silver today is identical to a bushel of wheat, lump of iron-ore or ingot of silver produced one thousand years ago. The only difference is that they’re generally cheaper to produce because over time, human innovation has lowered the cost of production. When you buy commodities, you’re selling human ingenuity. Why bet against human ingenuity by buying physical commodities when you can bet on it by investing in the enterprises whose task is to remove the bottlenecks and lower commodity prices? So devote cash to the fixers, not the source”

And there I have to agree with him. Super cycle or not, the only way to successfully “invest” as opposed to actively manage commodities is through the producers. The chart below of Exxon and the United States Oil Fund ETF is a great example.

Looking ahead, my guess is the secular demand story is not over.

The industrialization of China, India and Brazil is far from over and is at a commodity intensive stage. While the mass urbanisation stage is well entrenched McKinsey estimates there will be 3x the US current population living in cities in China by 2025 and nearly 600m in India by 2030. This will require the build of mass transit systems.

But more importantly, Chinese and Indian consumers income are reaching levels where consumer demand should rise sharply. This will underpin car demand and lead to further infrastructure needs.

The same is happening in Africa while infrastructure there is still lagging.

However, despite the fact that there is plenty of time left in the cycle I would be very cautious in the short term.

The reason for that is China. Even if Jim Chanos is only half right on the property bubble, the very sticky inflation will make it even harder for the government to engineer a soft landing.

A property crash or financial crisis in China where raw materials such as copper are also heavily used as loan collateral in sometimes dubious manners (more on that here) could cause prices to plummet in even greater proportions than in 2008.

I am not calling the crash but the potential volatility is another reason to stick with cash rich quality producers which could even profit from a downturn by acquiring quality assets on the cheap.

  • KB

    I hate seeing graphs with 100+ year charts. Everyone won’t be alive that long. Complete waste of a post

  • goodfriend

    funny to read that in conjunction with the other post which based its gold price analysis on US real rates…the world has changed since the 1st year displayed on the gold post graphs.

  • Explorer

    While the capital intensive development by China and India might drive commodity prices for a few more years, this will inevitably abate over say a decade or less. That might suggest that the current super cycle could easily turn down.

    In the longer term, and perhaps overlapping with capital/commodity intensive development in Chindia, will be the realisation of increased scarcity.

    This becomes self evident when people learn and apply the exponential function.

    World GDP growth is projected at 4%.

    Under exponential growth (using Rule of 72 for approximation) that gives a doubling time of 18 year. If the 4% is nominal you can use 2% real and a doubling time of 36 years. Let’s use the 2% real and 36 years to be conservative.

    In 36 years at 2% real growth compounded annually we will use more oil, coal, iron, etc than we have used in the whole of recorded history (assuming a constant ratio of these inputs to GDP). The rate of usage per annum will be double that of today at the end of the 36 years. Current known resources will have a life much less than half of what it is today. This is just maths and the exponential function.

    Now look forward a second 36 years. The rate of consumption of resources goes to 4 times what it is today. We again use more resources than ever used in recorded history, but that amount in the second 36 years is twice as much as used in recorded history to today. It also takes the total used after 72 years to 4 times what we have used until today. And the life of resources at the end of the second 36 years is halved again! If we had a resource of 300 years today at current consumption and had used 100 units in recorded history absent new discoveries of resource that 300 years of resource life today will be gone in 72 years at just 2% compound real growth.

    I suggest a few minutes with an Excel spreadsheet. Make some assumptions about how many years current usage the known resource life is. Then apply compound growth to consumption and calculate the remaining resource after each year and the resource life left at the end of each year at the new compounded rate of usage.

    In a review of what has happened since The Limits of Growth was published a CSIRO (Australian Government owned Commonwealth Scientific and Industrial Research Organisation) paper concluded we are on track with the business as normal scenario and that scenario leads to collapse in about mid this century.

    Pragmatic capitalism says get cracking and make as much as you can in the next year and just keep doing that and your children and grandchildren have no present value in investment analysis (paraphrasing an article from Pimco, just so you understand this is not some unknown nutter’s paranoia).

    See Albert Bartlett’s videos and transcript:

    http://www.albartlett.org/presentations/arithmetic_population_energy_video1.html

    http://www.albartlett.org/presentations/arithmetic_population_energy_transcript_english.html

  • jaymaster

    I happen to think this is an excellent post.

    Anyone who considers investing in commodities because of predictions of pending shortages needs to keep in mind charts like this:

    http://mjperry.blogspot.com/2011/05/corn-yields-have-increased-6x-since.html

    That is human innovation in action.