Commodities Run in Supercycles

Tue, Dec 20, 2011 - 9:44am

Commodity prices can be very volatile, oftentimes more so than just about any other asset class. These large price swings, which have been particularly evident in recent years, have given commodities their reputation for high risk. Those investors who lack a large buffer of disposable risk capital are repeatedly advised to steer clear. But for those investors who can bear the risk, and who look to invest in commodities as an inflation hedge, there is some evidence to suggest that commodity prices move in long term "supercycles," which play out over years and even decades. By observing and understanding these movements, these investors may be able to be more strategic in their approach.

Commodity booms and busts oftentimes last far beyond the time frame normally associated with a typical business cycle. IMF analysis of historical price movements in commodities filters out less significant short term movements to search for "trough to peak" and "peak to trough" cycles. They found that between 1862 and 1999, long booms were followed by large slumps, resulting in cycles of several decades.

For example, after hitting lows in 1868, prices then followed an uptrend until 1907, when they reversed course and drifted downward until 1915. That complete cycle lasted a full 47 years. There is a 16 year cycle from 1915 to 1931, and a still longer, nearly symmetrical 40 year cycle, which saw rising prices for 20 years between 1931 and 1951 and falling prices between 1951 and 1971.

For much of the late 1990s and early 2000s, booming commodity prices lent powerful support to the idea that the world was locked into an uptrend of a supercycle. A World Bank index of commodity prices climbed 109% between early 2003 and 2008. From trough to peak, oil prices rose 1,145% in nominal terms between December 1998 and July 2008. But when commodity prices suffered a significant collapse in the latter half of 2008, many had assumed that the down leg of the cycle had settled in. The stunning collapse in oil prices, with Brent sinking from $146 per barrel in mid-2008 to $36 per barrel five months later, was a decline of historic proportions. Having jumped aboard the train too late, many investors booked staggering losses and wrote commodities out of their asset allocations strategy for the post crash era.

But the rapid price rebound from the lows of 2008 and 2009 has challenged these conclusions. Between December 2008 and June 2009, the price of Brent crude oil more than doubled, ultimately returning to $126 in April 2011, within spitting distance of its 2008 peak. The recovery was not only in oil: the Rogers International Commodity Index total return product also doubled between February 2009 and April 2011. Given these rebounds, it is possible that the panic drops of 2008 were not in fact a fulcrum of a supercycle. Indeed, the robustness of the price recovery has led some to wonder whether any corners were actually turned and whether we are still locked in a commodities uptrend that began more than a decade ago.

Indeed, key drivers like global inflation are still in place to propel commodity prices upward for what appears to be years to come. There now can be little doubt that overly indebted nations in Europe and the U.S. will look to inflate currencies rather than cut spending or raise taxes to solve their fiscal woes. To maintain a global status quo, Asian economies will also inflate to limit the rise in their currencies. At the same time, demand emanating from the developing world has exceeded available supply on a near-continual basis since the early 2000s, except during the depths of the Great Recession. In addition, the marginal cost of production also appears to have increased across a variety of commodities.

Even without these drivers, there is ample historical precedent to allow for the continuance of a multi-decade commodity boom. Even if commodity prices continue rising over the next 20 years, as Jim Rogers has argued, the total boom period would still be 10 years less the boom between 1868 and 1907, and just a few years more than the one that occurred after the Great Depression and World War II.

Certainly a global economic boom between 2003 and 2008 was part of the story that pushed up commodity prices so severely during the early part of the last decade. Real world GDP grew by more than 4% each year from 2004 through 2007, which the IMF points out was the first time that level of growth on a global level had been achieved since the early 1970s. Many people who are negative on commodities mistakenly focus solely on demand as a key driver. They argue that a continuance of a commodity boom can't occur absent growth in the developed world.

But a look at the aluminum market over the course of the twentieth century makes clear that demand is not the only, or even primary, factor in spurring a decades-long increase in prices. Based on surging demand, global aluminum output rose 40-fold for a full three decade span, from 1939 to 1969 - yet real prices trended downward over that time. The example of crude oil is even more dramatic. Between the years 1965 and 1970, global oil consumption exploded from 30.8 million barrels per day to 45.4 million barrels per day. But according to BP data for Saudi Arabian crude, prices over those same five years declined from $12.43 to $10.10. Despite the outward shift in the demand curve, the supply response was more than sufficient, in both cases, to keep prices tethered. Climbing demand is necessary, but not sufficient to provoke an upward commodities supercycle. More thought should be given to supply issues and monetary distorti ons.

Currently the actions of central banks have supplanted private sector activities as the principal driver of price movements. The price movement of the U.S. dollar is of primary importance. Weighted against the currencies of the U.S.'s main trading partners, the dollar is bumping along the bottom. Any political solution to the chronic sovereign debt crisis in Europe should put much greater pressure on the dollar, and push up commodity prices.

As a result, although we do not expect the economies in the United States or Europe to suddenly strengthen, we don't believe that the supercycle has turned south. As soon as the situation in Europe finally shows a moderate degree of stability, long term growth-oriented investors, who can tolerate the heightened volatility, may consider adding weight to their exposure to a broad basket of commodities, either through direct exposure to commodities or through a carefully selected portfolio of commodity-related equities.

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President & Chief Global Strategist
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