LONDON () -- If a week can seem a long time in commodities then six weeks is a dim distant memory. So when commodity prices have plummeted some 15-35% in less than thirty trading days, and gold is 'only' around the $570/oz mark, it is easy to forget that prices are still significantly above last year's levels. But they are. And recent data confirm that the arguments underpinning the strong commodities bull run - the supercycle - are still in place.
Basic Supercycle Theory
To recap, supercycle theory 101 essentially runs thus:
- Commodities are always cyclical. Demand rises, the price goes up, new production comes on-stream, the price goes down.
- Under certain conditions there can be a supercycle, which was defined by Citigroup Smith Barney in a March 2005 presentation, China, the Engine of a Commodities Supercycle, as a prolonged (decade or more) trend rise in real commodity prices. Supercycles are driven by domestic demand, by the urbanisation and industrialisation of a major economy.
- Citigroup identifies two supercycles from the past 150 years. The first, which resulted from the industrialisation of the USA, dates from the late 1800s through the early 1900s. The second ran from 1945-75 driven by post-war reconstruction in Europe and Japan's economic 'renaissance'.
- Although the underlying price trend in a supercycle is fundamentally upwards there are times when prices become divorced from supply demand fundamentals and are very volatile. As fund manager and commentator Jim Rogers writes, in his 2005 book "Hot Commodities", a secular bull market is not a "stairway to heaven"! There will be overshoots, setbacks and corrections.
- Supercycles eventually end when the driving economy matures from a manufacturing base towards a service economy, or when there is a fundamental shift in global consumption patterns.
The Current Supercycle: Chinese Demand Plus Constrained Supply
The current supercycle dates from around the turn of this century (Rogers dates it from 1998 and expects it to last for at least 15 years). It has been driven so far by Chinese demand, though the other BRIC economies (Brazil, Russia, India, China) will also play a part in the future.
Citigroup, used data from 100 years or more to demonstrate that supercycles are associated with an increasing intensity of use (IOU) of materials - this being the amount of any commodity used per unit of economic activity.
For example the chart below, taken from Citigroup's report, shows the trend in the intensity of usage of copper in four major economies. The US, Germany and Japan have each in turn followed a cycle of rising IOU, followed by a plateau of at least 10-20 years, followed by a decline. In China's case the IOU is only just beginning to rise strongly and is still well below the peak levels seen in the more mature economies. Citigroup contend that it still has a long way to run.
Deutsche Bank, have built a model outlined in a publication this month, China's commodity hunger, to forecast Chinese import demand for commodities to 2020. Their projections, which they stress are only indicative, suggest that although import demand growth rates may have peaked they will still remain in double digits for the next decade, with oil and coal import demand projected to increase by 20% per annum, and iron ore, copper, manganese and wood to increase by 10% per annum. Of the commodities considered only soy will grow in single digits, at 4% per annum.
Turning to the supply side there were not any long-run supply deficits in the previous supercycles. Rising prices spawned the requisite increase in supply, albeit at higher prices.
This time around, however, there are a number of reasons as to why the supply response may be slower than before:
- The severity of the last crash in commodity prices meant that there has been a 10-15 year period of underinvestment in production, exploration and infrastructure
- Existing operations are therefore running at or near full capacity.
- Lead times to develop a mine have lengthened on increasing environmental concerns and local involvement.
- There is a shortages of key resources, particularly skilled labour and mining equipment.
- Access to prospective land is becoming increasingly difficult, and new major mines tend to be found in areas of greater geopolitical risk.
Thus with the world's most populous country on a materials usage upswing, producers unable to over-invest even if they wanted to do and inventories of metals mostly low or falling, the auspices for a continuation of the fundamental supercycle appeared good - a point which, by May, had been fully anticipated by the market and by the speculative and investment funds which had flowed into commodities, spurred by the relatively low interest rate environment.
Time for a Breather?
Citigroup published an update on 3 May, less than 10 days before the recent commodity price peaks, presciently entitled Where are we in the Commodity Super Cycle? Time for a breather? which argued a pause or correction was likely. Although the underlying supercycle story appeared very good the market was already fully valued, driven by cash and optimism and that there were risks primarily from inflation-induced recession and from many distortions in China (energy subsidies, fixed exchange rates) which did not appear to be factored into market valuations.
In the event it was probably inflation fears that were the weakest link which led to the 15-35% price falls.
New Data
So is the underlying supercycle story still intact? Since Citigroup's report there have been several publications of data including BP's Statistical Review of World Energy and the World Bureau of Metals Statistics yearbook, which together with previously published World Gold Council data enable a quantification of the impact of Chinese demand in 2005 on commodity demand (though in all cases it must be remembered that Chinese data are estimates based on apparent consumption data).
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Many interpretations of the data are possible but two points stand out. Firstly it is clear that China has continued to gain market share in most of the commodities listed below.
The market share figures need to be considered against China's 4% share of dollar global GDP, or 13% share on a purchasing parity power basis.
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Secondly although there are a few commodities that don't beat to the rhythm of the Chinese supercycle drum - gold and diamonds are two for example where India holds greater importance - most commodities are continuing to increase their intensity of usage, a primary requisite of the supercycle theory.
Chinese GDP grew by 9.9% in 2005, but the growth rate of most commodities was higher.
Conclusion
In summary the current commodities cycle has been distorted by investment funds. Nonetheless underneath the froth recent data, surveys and analyses of supply-demand fundamentals all continue to indicate that the current underlying cycle is indeed super and that it still has a long way to run.
