As crude oil prices have plunged in recent months, there has been a lot of talk about the end of the commodity supercycle. For those of us who trade in other commodities, or follow the Chinese economy, this realization is a bit late. Many commodities have already gone through the correction that is now facing crude oil, and many lessons can be learned by their experience. However, oil, like all commodities, will have characteristics that are all its own. This article lays out a history of recent commodity price movements – first violently up and now just as violently down – and insights on why they occurred. The next move for commodities is likely to be a considerable period of consolidation, with prices trading in a narrower range as both suppliers and consumers of commodities adjust to the interim new normal of a rough balance between supply and demand. We see another explosion in commodity prices on the far horizon as the next wave of global consumers – with an impact even larger than China’s entry – make their way onto the world stage.
For us, the global commodity supercycle began on July 20, 2005, which was the day that the Chinese government first allowed the yuan to appreciate from its long fixed ratio of 8.28 to the dollar. The Hu-Wen Government was in the third year of their leadership and was beginning to implement their policies of expanding into the west. Allowing the yuan to appreciate both tamed the American anger over alleged currency manipulation and forced coastal provinces to move up the technological ladder as labor costs rose. The advances China enjoyed since its admission to the WTO in 2000 would now spread from the 300 million beneficiaries in the coastal provinces and cities to the additional billion Chinese living inland.
From mid-2005 to mid-2008 the yuan appreciated roughly 20%, at the same time China’s nominal GDP growth was averaging about 20% per year. As a result, China’s buying power in dollars – the currency of international exchange for all commodities – accelerated from a 15% growth rate in early 2005 to over 35% just before the Lehman crisis. Booming real GDP growth and a soaring ability to pay made China the price setter for all commodities – and the major global purchaser of just about all kinds of resources. Iron ore consumption more than trebled from 14% of the world’s production in 2000 to 61% in 2010. Soybeans more than doubled from 23% to 59%; copper from 13% to 29%; coal from virtually no imports in 2000 to 15% of the world supply by 2010. By 2011, China was consuming more than 25% of the world’s supply of nearly everything – except oil, which languished at a paltry 10% roughly in line with China’s share of world GDP.
With China as the world’s biggest purchaser, the commodity supercycle was not derailed by the Lehman crisis. To the contrary, as the financial markets of the western world collapsed, China merely stopped its steady currency appreciation. However, as the result of the massive 4 trillion yuan stimulus in early 2009, nominal GDP growth – which is to say buying power for commodities — had rebounded to 18%, with real growth near 9%. By mid-2010, with the economy booming again and inflation running near double digits, China again began to appreciate the yuan – stemming growth and inflation at home, while increasing its international buying power for ever more expensive commodities. With China running red hot, global supply of commodities still had not caught up with demand and prices moved higher as the invisible hand worked to call out new technologies and exploration of more remote regions.
The day the Supercycle died was March 11, 2011 – the day the Japanese tsunami unexpectedly disrupted supply chains across much of Asia. The budding recoveries in the US and Europe, which started after the first round of the Greek crisis in 2010, were put on hold. Meanwhile, commodities production which had been whipped ever higher by prices finally caught up with demand as world growth paused. Virtually every major commodity hit a peak sometime in early 2011. Copper (the metal with the PhD in economics) top ticked in February and retested that high in August. Gold, silver and cotton all hit record highs. Grains faded, then temporarily made fresh highs in the spring of 2012 on poor harvests, but ultimately declined. Aluminum, platinum and crude oil, which had not recovered to pre-Lehman highs, started their descent. Oil has fared better than most commodities since 2011, in part because the tsunami’s shutdown of the Japanese nuclear reactors provided a final surge in demand that was not experienced by any other product.
On the backside of a commodity cycle, falling prices seek to drive out the marginal producer – which in the short run means the operator with the highest variable costs. With fixed costs high for many commodities, due to land and the sunk cost of capital investment, variable costs are generally far lower than the price previously needed to call out new production. Moreover, the costs of inputs for commodities production tend to tumble along with output, so variable costs decline rapidly in a correction. The experience across many commodities shows us that the bottom generally comes above the price needed back in 2005 to first call out new supply. Corn has bottomed near $3.30, its low in 2007 and 2009. Aluminum broke out from $1750 and bottomed there in late 2013. Similarly, platinum broke out and has retreated to $1200. Silver, cotton and natural gas have similar charts. Oil below $$60 appears to have met this condition. Copper and gold have avoided a complete retreat – so far.
As in a financial crisis, it is often the margin clerks – the bankers – who decide who survives and who does not. At the bottom, those firms with the strongest hands are able to pick up bargains. In past cycles, the winners with strong hands have tended to be industry participants with the knowledge and moxie to take on the risk of shattered competitors. Currently, due to the surplus of savings still available in the world – and zero interest rates for risk free investments – there are more financial players snapping up assets hoping to sell to operators later.
It is our view that the $50 a barrel decline in oil prices is just what the global economy needed to spark a worldwide recovery. At 80 million barrels a day, this tax cut – financed by the oil producers – is equivalent to $1.5 trillion a year, or 2% of world GDP. That’s a fairly robust stimulus by normal Keynesian standards. Most critical for commodities is whether the decline in prices will re-ignite growth in China, the world’s biggest consumer. We believe that Chinese growth faded to 4% last year – as indicated by electricity use – and will rebound to closer to 7% in 2015. Stronger Chinese demand should help stabilize commodity prices, but we expect the next rise is still a ways off as many resource producers are being acquired at deep discounts financed by near zero money.
The real spark for the next commodity cycle is likely to come from a broadening of global demand into the next tier of Asian producers – Indonesia, the Philippines, Vietnam, the next 100 million employees in India and the remainder of rural China. These populations combined are larger than the initial development of the Chinese coast or the first push inland. Chinese growth started slowly when Deng Xiaoping allowed Guangdong province to tap into the capital and managerial expertise of Hong Kong. The experiment accelerated when the opening to WTO brought in more foreign capital to the mainland and managers spread their local knowledge to China’s east coast. Under Hu and Wen, that success was forced inland by currency appreciation and infrastructure investment.
Now, under Xi and Li, China appears ready to go out and share its system of success with anyone willing to accept their money and immigrant labor. Bottom line, the population of educated managers, like the supply of previously scarce commodities, has caught up with world demand – and the price of developing the next tier of global expansion is declining. These new nations, like China in 2000, have low incomes and a voracious appetite for commodities. Moreover, the techniques the Chinese will teach are likely to be commodity intensive – as you teach what you know. Thus, we expect another commodity super cycle on the far horizon as better global growth raises all boats.
Michael Drury
Chief Economist, McVean Trading & Investments
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