Real dimensions of the Super Cycle

In real inflation adjusted and purchasing power corrected terms, as pointed out by Jeffrey Christian (CPM Group) and others, the 2003-2007 cycle – already weakening or in ‘pause mode’ for the Base Metals – has a long way to go if it is to rival other and previous commodity cycles. By commodity indices growth relative to equities or other financial instruments, or by comparing the weight of commodities spending in average household budgets in OECD countries with spending in previous cycles we come to the same conclusion:  this cycle has far to go before it can truly be called ‘super’.

In addition, extreme devalorization of commodities as an asset class through the equities boom of the 1990s, and apparent ‘secular’ but more likely cyclic slow economic growth of the real economy for an even longer period, of about 1986- 2003, tended to push the baseline role of energies, minerals and metals, and the agricultural commodities ever lower. At the time and as a notable example, oil was proclaimed a Sunset Commodity by rising stars of the New Economy, which through technology changes, it was believed, would entirely relegate dumb commodities to the back seat ‘for the rest of time’. 

This claimed ‘new economy’ breakthrough in economic thought had in fact been proposed, and already disproved in the 1950s, with the first flush of atomic energy, plastics and composite materials, crystallised by the musings of Jean Fourastié and early members of what was later on called the ‘Chicago School’. This unsaintly alliance of old-style monetarists, technology optimists and ‘neoclassic’ economists essentially argued that the economy, going forward, would have its kinks and humps ironed out by the arrival of a near-mystic, service sector-heavy ‘stable state’. The net result, reaching its peak in the slow-growing  real economy of the 1990s, was to push down the baseline for commodities relative to all other asset classes, in some cases to historic lows.

              (Source:‘Don’t Super-Cycle Me’, Jeffrey M Christian, CPM Group, 2006)

Problems comparing Like-with-Like

Economic globalization and ‘vintage’ worldwide economic growth at least until late 2007, extreme growth and increasing complexity of financial instruments sweeping the entire spectrum of asset classes, in turn increasing the fragility of non-commodities instruments conspire to create new, or intensify existing problems of comparability. More basic or ‘technical’ problems of currency, inflation and purchasing power adjustments and comparison add yet more reasonable doubt as to how far the present cycle has come. Not knowing this, how much further it can go is obviously difficult, if intriguing, to forecast and estimate.

Another, distinct and critical problem is the near-fundamental difference between fossil or mineral commodities, specially oil, gas, coal and metals (’energies and metals’) and the theoretically renewable bioresources of the agricultural and soft (‘ags and softs’) commodity class. Depletion and exhaustion necessarily affects the first, but not necessarily the second. With further analysis however, this neat compartmentalization breaks down, for example due to climate change, loss of arable land, water depletion, species extinction and so on, all of which are generated by, or related to peak extraction and utilisation rates for commodities of the non-renewable energies and minerals group or class. Fossil water resources, for example, can be and are ‘mined’, almost exclusively using fossil fuels. These resources are therefore extracted at a vastly more rapid rate than their normal reconstitution by natural processes, and become ‘one-shot’ resources, exactly like fossil energy and mineral commodities.

In the short-term however, the energies and metals commodity class, and the ags and softs show classic lag-and-lead phases or intra-cycles within the broader ‘commodity cycle’. In the current epicycle, or leading phase which we date at 2003-2007, it is the first which lead, with the ags and softs trailing. This, among other things (and ‘other things’ notably include very fast or vintage economic growth at the world level) has resulted in the very low apparent global level of inflation, to date. Again we have to qualify and limit this favorite claim of monetary and financial authorities in the OECD and elsewhere.

Presented as due to ‘currency pegging to the US dollar’, the Gulf Cooperation Council oil and natural gas exporter countries of the Persian Gulf now admit very high rates of CPI inflation, about 12% pa. in the case of Qatar, but only 4.5% pa, as we could anticipate, for Saudi Arabia. In the Eurozone, certainly during the forced introduction of the Euro from end-2001, monetary but not economic inflation ran at double-digit annual percentage rates for several years, though this surely never showed in published and official ECB data. 

In several key industries closely linked to the lead phase of the present commodity cycle – minerals, metals and energy – inflation rates are very high and openly declared and published. In oilfield services and equipment, tarsand oil and bauxite mining and processing, power plant and refinery construction, silicon wafer costs for solar PV, gearbox prices for windmills, and so on, inflation through 2005-2007 is often running at 25% to 40% pa.

Due to delays in pass-through or trickle down this upstream inflation takes a certain time, and show specific rates of dilution, before impacting broad or mass-market prices. In the case of iron and steel, with upstream cost increases to producers for iron ore, transport and energy running at about 30% or 40% pa in 2007-2008, downstream prices will rise about 9%-15% pa in 2008. In late 2007 energy intensive sectors of the US economy, such as trucking and airlines, reported increases of energy costs running to 8% (per month) for FedEx, closely tracking WTI price moves.

Depletion and exhaustion of One-shot Resources

As already noted above, the neat two-part division of commodities into ‘renewable’ and ‘non-renewable’ breaks down under the onslaught of global economic growth running at around 5%pa in a world of about 6600 million consumers and potential consumers, growing at around 65 million persons-per-year. The ‘China and India syndrome’, resumed by the perspective or mirage of Emerging Economy Growth at near double-digit annual percentage rates right through the period 2007-2025, poses essentially impossible challenges for commodities production and supply in the near-term future.

We are already at the pinch-point for world oil supply shown not only by the vintage price performance of WTI, Brent, Bonny, Dubai and other benchmark crudes, and weak or zero oil stock growth in the OECD, and even more so in Indian or China - but also by the forward cost and lead times for developing new supply able to cover both depletion and rising demand. Such is the fragility of world oil supply/demand balances that the perspective of a near-normal winter in the northern hemisphere, La Nina willing, can very easily generate the ‘perfect storm’ and propulse WTI well beyond the current or supposed ceiling of 100-dollars per barrel. At this ‘exotic’ price level US heating oil will move to more than 285 cents/US gallon and gasoline to much the same, these price levels being provisionally set as a Rubicon, or maybe Styx for oil traders - and for the conventional or classic consumer-driven growth economy. 

Oil price explosion and a weak US dollar inevitably generate unstoppable upward pressure for Gold and other PMG metals, but will also and shortly entrain natural gas, coal and electricity prices, sweeping the entire energies sector, either ‘renewable’ or ‘fossil’. As of Q4 2007 these are challenges to filling daily editorial comment on business news and views programs – with of course no fixed conclusion.

Then-and-now comparisons using various inflation and PPP yardsticks for setting a price to traded oil show that the 100-dollar ‘ceiling’, rather surely a glass ceiling, was last breached in 1980. The Wall Street Journal likes to give a suspiciously exact figure for this peak price, at $ 101.30 per barrel in today’s dollars. Other analyses taking a broader sweep of then-and-now yardsticks give results ranging from around $ 85 to $ 135.

This may be attractive to general readerships on a ‘gosh and golly’ basis, but entirely avoids any comparison of real fundamentals. These are shown below:

(Author’s calculation from various sources. Oil defined as ‘all liquids’ including LPG, biofuels, tarsand, CTL, GTL synthetic oil)

Among other things we note that record high oil prices, in 1980, were associated with demand intensity well above today’s. This is easily explained not by any theoretical and rather slow acting ‘price elasticity of demand’, which Teflon Consumers are loathe to exercize, but through high and constant growth of world natural gas supply over the last quarter-century. Since the 1990s this has been joined by fast-expanding world coal supply, now running at about 6%/year growth, effectively substituting oil in the world energy mix far more than so-called ‘price driven elasticity’ of oil demand, considered as theoretically apart or different from other fossil energy. The ‘new renewables’ (wind, solar, biofuels) in all this are of such minor energy significance they can be left aside, except in their capacity to drive inflation, as we note below.

Supply side Limits to Oil

When we come on to the supply and resource side of the equation then-and-now difference are stunning. Taking the entire Middle East and the FSU CSRs or former Soviet Union central southern republics, with names ending in “-stan”, total oil production in Q3 2007 by this ultimate key region for world oil supply, and natural gas supply, was probably running at about 30 Mbd, with internal or domestic oil demand well over 7.5 Mbd and growing fast. The outlook for net export supply growth from this region, totally unlike the outlook in 1980, when greenfields were truly green not dark brown, is for slow or zero expansion followed by long-term decline.

Elsewhere in world oil, despite claims that the Middle East plus FSU CSRs ‘can produce more’ net export supply growth depends on reserve building. In the late 1970s and 1980s world oil had a bountiful perspective of new and big oil provinces coming on-stream, like Alaska, the North Sea and offshore West Africa, with a combined resource base probably more than 75 Billion barrels. Today there is no such perspective, if we make an abstraction of environment crunching, energy intensive and intrinsically high cost tarsand oil mining expansion in Canada – but the global consumer herd of real oil and energy consumers has grown by a little more than 50% or 2200 million since 1980. Put in other terms, this is more than 7 times the USA’s current population, or around 2 times India’s or China’s current population numbers.

Change of Phase in the Cycle

As noted above, intra-cycle phases of growth and decline of relative value for various asset classes, broadly equities versus commodities, and energies and minerals versus ags and softs within the commodities grouping, are driven by different factors. For energies, and also minerals these are now converging, due to to energy supply limits. This specially concerns Peak Oil and Peak Gas, and the impact of these ‘twin peaks’ on evolution of the commodities cycle in the near-term period of 2007-2015.

There are decreasing numbers of ‘firewalls’ between the two theoretically-distinct asset classes inside the commodities sphere, and this trend is self-reinforcing. One proof of this is the impact of the biofuels on price trends in the ags and softs grouping. Since 1999, the date that oil ceased to be a giveaway commodity subsidizing the easy and constant, inflation-free growth of equities right through the 1990s, its correlation with world sugar prices has dramatically increased, from almost null correlation, to almost complete and lockstep correlation (see below).

Similar ‘re-linked’ or new correlation can be observed with almost all other ags and softs, specially the grains and oilseeds. One major supply-side cause of this is the energy intensity of current agroindustrial production techniques, downstream processing and transport of these commodities. For sugar and corn ethanol, and soybean or rapeseed biodiesel production, ‘biofuels linkage’ is now powerful

Although estimated by Dr Nastari as supplying only 13.5% of Brazil’s land transport energy need in 2006 (ca 45% of gasoline-engined road transport needs), Brazil’s sugarcane ethanol program is surely re-linking sugar and petroleum price movements..

Presentation by: Plinio Mario Nastari, Chief economist, Datagro, Brazil, August 2007

Powering the world’s estimated 800-850 million cars, and about 250 million other car-equivalent land transport vehicles, currently about 97% oil and natural gas fuelled and each taking about 9 barrels oil equivalent/year of fuel energy for operating, will be somewhat difficult using‘current generation’ biofuel food crop feedstocks. This volume constraint sets insoluble production challenges for annual tonnages of feedstocks needed, including sugar, as well as grains and oilseeds. 

In brief, the push to head off Peak Oil impacts on the world car fleet – more simply achievable by reducing numbers, weight, and utilisation -  through the mirage of ‘massively expanding’ the biofuels has instead added massive new pressure on the demand side for ags and softs, and this will surely push up food prices. This simple evidence is to be sure ‘controversial’ but rather hard and certain limits on agroproduction infrastructures and the energy cost of rapid and huge increases in biofuels feedstock production – former food only crops – will take their toll on final consumer food prices and impact the sacrosanct CPI.

European rapeseed and rapeseed oil, for example, has a specific production energy intensity of around 600 litres gasoil consumed per hectare cultivated, per year. This easily explains why rapeseed biodiesel fuel able to substitute petroleum diesel fuel has a production cost estimated by the IMF and IBRD at around 85 US cents per litre, equivalent to and competitive with oil at about 135 US dollars-per-barrel. Despite this, for the crop year 2007-2008 European rapeseed biodiesel production is forecast to swallow about 60% of the entire European rapeseed crop. Not surprisingly, current and likely short-term future food price inflation in Europe is a growing concern of the ECB and national governments.

Anybody who says increased food prices is also saying increased inflation and rising chances of economic recession. This is an almost iron rule of economics, whether new, old, or alternative.

Ags and Softs powered by Peak Oil

We find that continued increase of oil prices, due to Peak Oil impacts on the supply side, also levers up the threshold for economic breakeven of the biofuels, due to oil-linked or oil-driven production and processing energy cost inflation inside this asset class. After a relatively short period, this spills over to other asset classes. These, like the base metals which are presently the target of intense profit taking as collateral damage to swooning equities and massive write-downs of value in financials, will at some future but certain stage be lifted back on the upward elevator of the Commodity Super Cycle. Price inflation in ags and softs will provide an essential inter-phase adjustment in this cyclic process.

We must repeat that the ‘global energy limit’ set by Peak Oil and Peak Gas is already and quite powerfully changing ground rules for asset class pricing and world inflation trends. One key example and proof of this is the disappearance of ‘seasonal price decline’ of oil prices, due to Peak Oil limits on supply growth, shown by WTI and Brent pricing in Q3-Q4 2007 against Q3-Q4 2006. In 2007 the ‘seasonal trend’ price is running in the exact opposite direction to one year previous, and is building on the ‘annual price peak’ of late summer. Much the same applies to certain key ags and softs, such as wheat, and because of the same fundamentals – strong demand, limited supply, and eroding stocks.

WTI crude oil November 2006 versus December 2007

Catch up for Ags and Softs

To date in OECD countries there has been slow pass-through and large dilution of energy and minerals price rises at the final consumer level. Energy and minerals price rises have typically been swamped or amortized by the wealth effect of increasing real revenues and spending power, in large part based on access to cheap credit derived from inflated housing equity - until recently in the US, UK and other OECD countries. This is less likely for coming food and fiber, or ags and softs price rises. This class of consumer basics is more important even than energy spending, and much more important than metals and minerals in average household final budgets. 

Household spending on narrowly-defined energy and minerals or metals rarely exceeds 9% by country in 2007, while food and fiber spending can exceed 12% to 15% of typical household budgets in OECD countries, and much more outside the OECD. As prevously noted however, the ‘firewalls’ are coming down in the interstices between energies and metals, on one hand, and ags and softs on the other, setting the stage for accelerated catch-up by the ags and softs.

To be sure there is considerable resistance, both on the part of economic and political deciders, and within the pricing system to pass-through of upstream and absolute price rises for ags and softs. In other words this means there is a ‘pent up’ or ‘dam breaker’ aspect of coming food and fiber price prises at the consumer level, both in OECD and in other countries. When this occurs, it will likely be rapid, and by stepwise upward change. Previous cycle phase-coupling lessons from the early 1980s serve to show that, by country, price movement for ags and softs against energies and metals is never simultaneous but through variable time-lagged phases.

In turn and by conclusion, we have the makings of a classic economic recession in OECD USA, Europe and Japan, the daily concern of troubled base metals traders today. One definition, and driver of this recessionary phase is a period in which food prices rise relative to all other prices, squeezing so-called discretionary spending on manufactured products and services. The opposite corollary is also set as the succeeding phase: inflationary expansion.

So-called discretionary manufactured products and services spending, in the developed economies, typically accounts for 80% to 90% of total spending and is very vulnerable to increased basic food-and-fuel costs of average consumers. During the recession “V” we can anticipate that ags and softs show significant price gains, at least matching recent oil and petroleum product price gains, in turn shifting the Commodty Super Cycle into higher gear. Due to Peak Oil and Peak Gas the other designated victim of the recession “V”, energies, will very likely show ‘surprising robustness’ despite the traditional concerns of Cheikh Yamani and today’s oil minister of Saudi Arabia.

COPYRIGHT Andrew McKillop Nov 2007

© 2008 Andrew McKillop
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