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Common Commodity Misconceptions
Commodities are the most basic economic goods, providing essential inputs into progressively more complex goods at advanced stages of production. Yet the economic mainstream generally fails to understand commodities, treating them as distinct from the processes whereby they are created and the processes they subsequently enable, when in fact they are an integral part of a dynamic, complex, adaptive economic system. A correct understanding of commodities is essential if we are to understand what their price signals are telling us about supply, demand, and economic activity generally. In this report, I offer some thoughts on longer-term commodity price trends, including the so-called ‘supercycle’. Is it over? Or has it a long way to run? The truth, in fact, is neither: There never was a ‘supercycle’ in the first place! I conclude with some thoughts on commodities investing and trading strategy, in particular how to take advantage of ‘overshooting’.
Malthus and the Myth of Scarcity
Common sense is a good place to start when thinking about the role that commodities play in an economy. As with all goods, they are limited in supply: there is not enough available to satisfy the potentially infinite needs and wants of consumers. Sure, some are more plentiful than others, but even those once thought essentially unlimited, say fresh water (or even fresh air!), might not be as unlimited as they once were.
The Reverend Thomas Malthus (1766-1834), a prominent classical economist, explored this concept of scarcity in some detail, in particular with respect to food production and consumption. He noted that farm production tended to grow linearly over time, yet populations tended to grow non-linearly. Eventually this would lead to demand outstripping supply, rising real food prices, and the impoverishment of the masses. A similar phenomenon is observed when bacteria are isolated inside a test tube with a limited food source: The bacteria grow exponentially until the food source becomes limited and access becomes restricted, at which time there will begin a precipitous decline and, in the end, a complete wipe-out of the entire population as the food source is depleted.
Malthus was entirely correct in his view, given his assumptions, as the test-tube example above demonstrates. In practice, however, his assumptions have been completely wrong. Indeed, the technological advances of the industrial revolution were already in full swing during his lifetime, but he failed to understand the role of technology and the associated division of labor and capital that was enabling, already during his own lifetime, a multifold increase in agricultural productivity.
Modern, neo-Malthusians sometimes retort that global population growth has now caught up with agricultural productivity to the point where food scarcity is again becoming an issue. There is some evidence for this claim. Food price inflation has been picking up in most parts of the world of late. But is this really due to scarcity? Or is it due to something else entirely?
Understanding Price Inflation
When thinking about commodity price inflation, we naturally tend to think of this in terms of the dominant medium of exchange. In the US, this would be US dollars, although dollars are used around much of the world. In Japan, people think in yen terms; in the euro-area, in euro terms, etc. But while this is certainly conventional and convenient, when considering whether scarcity might be causing food price inflation, it can be horribly misleading. For example, food price inflation in Japan has soared over the past year. But is this due to scarcity? Or to the sharp devaluation of the yen that began in late 2012? Back in 2010-11, UK food price inflation was also unusually high. But was this due to scarcity, or to the sharp devaluation of sterling in 2008-9?
It should be obvious that currencies that experience sharp swings in their purchasing power serve as poor measures for benchmarking food price inflation and thus obscure its true cause. So which currency should we use?
The answer is… wait for it… None! NO currency can serve as a perfect measure of true food price inflation because all currencies are subject to swings in their purchasing power. These swings occur naturally, as currency supply and demand fluctuate, although most central banks purport to keep such swings to a minimum. (As we know, central banks in fact fail miserably to keep such swings to a minimum, but that dead horse has been flogged in many an Amphora Report.)
Here at Amphora, our entire investment philosophy and associated processes are based on the idea that the best way to understand commodity prices is to think of them in relative terms, that is, relative to each other, rather than to denominate their prices in currency terms. So if we want to find an answer to the question of what is behind food price inflation we should first get a sense of to what extent there has been relative food price inflation.
Let’s start by comparing the price of food to that of one of the key inputs in production: crude oil. Mechanized agriculture is powered primarily by petroleum products. Have food prices been rising relative to crude? No. How about metals? No. In fact, food prices have been sharply lagging the general price rise in commodities since the early 2000s.
The False ‘Supercycle’ Supposition
Having declined in relative terms in recent years, to the extent that food prices have been rising of late, this would appear to be food prices merely playing catch-up with the more general commodity price inflation that began back in the early 2000s. And what can account for that general rise in global commodity prices? Why, the decline in the purchasing power of the US dollar and associated acceleration in global money supply growth that began back in 2002 when the Fed slashed interest rates and ignited the global housing and credit bubble.
In this context, it is easy to dismiss the so-called commodities ‘supercycle’ as a scarcity-driven phenomenon. Yes, commodity demand has risen along with global economic growth. But real supply has risen to meet real demand. Scarcity has had little if anything to do with rising prices. Consider the evidence: You can purchase today as much or more oil, industrial metals or food with an ounce of either gold or silver as you could a generation ago under the Bretton Woods system. What ‘supercycle’?!
Crude Oil Priced in Gold*
(*This and subsequent charts are provided courtesy of ‘Sir’ Charles Vollum who maintains the handy website pricedingold.com)
All that is happening here is that the dollar and other currencies are losing their purchasing power, normally slowly, occasionally more quickly. But the trend is clear and no doubt highly expansionary monetary policies across most of the developed world continue to support this trend, notwithstanding the modest commodity price declines that took place from 2011 through 2013.
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Supportive evidence for this view is provided by a much-discussed 2013 study of long-term commodity prices by professor David Jacks.¹ He observes that commodity price volatility, including that associated with so-called ‘supercycles’, has increased dramatically since the global economy moved away from the gold-backed fixed exchange rate regime of Bretton Woods. That is strong evidence that large commodity price swings over long periods of time are not primarily scarcity-driven phenomena but rather macroeconomic and monetary (although Mr Jacks does not explicitly make this connection. In any case it would be beyond the scope of his paper.)²
The Malthusian Reflex
There is, however, something else requiring explanation here. Commodity prices may have risen substantially since the early 2000s and food prices may have caught up somewhat of late, but as Mr Jacks notes in his 2013 study, looking back longer term through many decades it is clear that food prices have chronically lagged those for commodities that are pulled out of the ground, such as crude oil or metals. Now why should this be?
A popular neo-Malthusian explanation is that this is due to the growing scarcity of ‘underground’ relative to ‘above-ground’ commodities. Farmland remains plentiful and it is easy to expand food output to meet rising demand, so the thinking goes, but this has not remained the case with metals or fossil fuels. The following chart showing this phenomenon was featured last year in The Economist:
Under vs. Above-Ground Price Inflation
As we have seen in our previous discussion of Malthusian thinking, scarcity-based theories for commodity price movements don’t have a great track record and I am highly skeptical of this particular explanation for the sustained divergence between above- and under-ground commodity prices.
Why? Because it is a woefully incomplete argument, failing to take into account the changing sources of demand for commodities and how these evolve over time with technology and the composition of the capital stock of an economy. Consider: Is a bushel of wheat somehow more economically productive today than it was ten, twenty or fifty years ago? Not at all. It contains the same amount of calories and makes the same amount of bread or other staple foods. But what about crude oil, for example? With power plants and engines of all kinds far more efficient, a barrel of oil can add much more economic value today than it could twenty or fifty years ago. For example, it can sow and harvest far more wheat. If it can add more value, it is entirely reasonable that people will be willing to pay relatively more for it. Moreover, innovation in petroleum products has created a huge and growing range of specialty petrochemicals, some of which enable highly advanced industrial processes that simply didn’t exist in any form a generation ago. With technological advancement creating entirely new sources of demand in a highly complex entrepreneurial dynamic, other factors equal, oil prices will rise to reflect that shift. Thus this is not a scarcity-driven price development but an efficiency-driven one, facilitated by technological advancement.
Expanding this thinking to other industrial commodities, metals are, due to technological advancement, able to provide for far more economic value added today than a generation or more ago. Electronic components are more advanced and efficient but still need copper. Silver has found new applications as an anti-microbial agent. Platinum, palladium and rhodium’s catallactic properties make these metals enormously useful in a growing range of applications beyond autocatalysts. Rare earth metals can provide essential input into some of the most advanced tech components. And on and on.
The fact is, wheat, corn and soybeans may be essential staples but their economic properties do not change with industrial innovation the way that energy and metals’ properties do. (What use would a primitive society have for crude oil? Palladium? No doubt rice would be far more ‘expensive’.) With tremendous advances in technology through the decades, the substances that we pull out of the ground and then process, refine, etc, are able to add substantially more economic value and naturally we are willing to pay relatively more for them as a result. I’m amazed that many prominent economists overlook this rather obvious point. But then I suppose the scarcity myth and associated Malthusian reflex can overwhelm rational thought, even in those with a PhD or Nobel prize to their credit.
Commodities Investment Strategy
Having seen that historical commodity price movements are not meaningfully determined by some abstract concept of ‘scarcity’ but rather primarily by general macroeconomic and monetary factors, technological innovation and associated changes in the economic capital stock, it remains to draw some practical conclusions for commodities investment strategy.
First, as should be obvious, if a general, sustained rise (or decline) in the price of commodities is primarily a macro-monetary phenomenon, then it is important to keep an eye on these developments. For example, signs that, even in the face of rising price inflation, major central banks are loath to materially reduce stimulus, should be regarded as bullish for commodities prices, even in the face of weak final demand. Therefore, the recent statement by the Bank of Japan that it is in no hurry to tighten policy even as inflation rises toward 2% should be considered potentially bullish. Similarly, signs that the US Fed is concerned about weak final demand, notwithstanding the sharp rise in consumer price inflation in recent months—to a nearly 4% annualized rate—should also be considered bullish. Unlike equity prices, those for commodities remain near their lowest levels since 2011, indicating good relative value and substantial outperformance potential.
Second, consider that certain types of environments are particularly supportive of commodity price outperformance, in particular the dreaded ‘stagflation’ in which productivity and profit growth are weak and price inflation is elevated notwithstanding weak economic growth. Recent data showing poor, even negative productivity growth suggest that the recent mix of weak growth yet rising inflation may continue. As we know, this was the case in the 1970s, a decade in which commodities sharply outperformed equities.
Third, note that industrial commodity prices tend to have a strong correlation to the business cycle and provide far less diversification vis-à-vis equities than soft commodities or precious metals. Investors seeking diversification through commodities investing should take care to structure holdings and select funds accordingly.
Fourth, rather than worry about growing scarcity restricting supply, it is more important to remain abreast of technological developments that could result in entirely new uses or sources of demand for certain commodities. While this is not going to happen with basic foodstuffs, it could well happen to metals or to sources of energy. By way of example, advances in battery or capacitor technology could well introduce new sources of demand for certain metals and, around the margins, potentially reduce relative demand for crude oil as an energy source. (In the US, for example, per-capita gasoline demand has been in decline for many years. This could well accelerate as the capital stock evolves further through advances in battery, fuel cell and capacitor technology.)
Thinking shorter term, relative commodity price fluctuations will always occur in response to entirely natural shifts in relative supply and demand that not only have nothing to do with fundamental scarcity but are independent of macro-monetary developments and the technological innovations that occur over longer horizons. This is an area where there are real opportunities for dynamic commodities trading to generate excess returns on a portfolio.
It is commonly held that commodities markets ‘overshoot’ shifts in fundamental supply and demand to both the upside and to the downside. Some might see this as a market flaw—only economists could imagine something as impossible as a ‘perfect’ market—but to a commodities speculator, this tendency to overshoot provides the basis for opportunistic trading.
Commodity prices overshoot for reasons similar to why asset prices or exchange rates can overshoot: There is a herd mentality in financial markets and the sense of security conferred by following the herd and chasing trends is tempting to some, even if it leads to excessive price swings from time to time. At Amphora, we specialize in identifying herd-driven overshooting in the commodities markets (although we also look for it elsewhere). We have a range of tools at our disposal, most of which are statistical in nature, that enable us to make sensible judgments about which markets are overshooting and which are not. We then concentrate our attention on the former.
A market that is overshooting may, of course, continue overshooting for a good while. This is what bubbles and busts are made of, and fighting the herd can of course be dangerous. Unlike with financial assets, however, commodities market overshooting soon approaches real, physical limits to immediately available supply or demand. From that point forward, an asymmetric price reversal becomes likely, even as the speculative herd continues to pile into the trend. Beyond a certain point, given limits to market liquidity, if the speculators decide for whatever reason to reduce positions, even marginally, they will be unable to do so without moving the price sharply in the opposite direction from whence it came.
The most recent Amphora trade recommendation, featured in the May report, was to open a long position in silver vs a short position in palladium.³ Last week, following a multi-week period of mostly sideways trading, this ratio reversed, abruptly and asymmetrically, by over 7%. While there might still be some potential in the trade, the market is now probably somewhat better balanced and thus it is time to take profits on this particular trade.
Two new opportunities may now be arising in the agricultural sector, and I am watching them closely. In both cases, it is too early to initiate a position, but if things continue to develop favorably these might feature in the next Amphora Report.
¹ Among other places, this study was featured in The Economist.
² The link to this paper is here.
³ Please see The Crisis of Interventionism, Amphora Report vol 5 (May 2014). The link is here.
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