You would have to have been living on a desert island for quite a long time now not to be aware that something has been going on in the world of industrial commodities. Oil increased in price sevenfold between 1999 and 2006. Copper did almost the same in 4 1/2 years from its low at the end of 2001. The precious metals have also soared in this new decade. Now it’s the turn of the grains, where wheat and particularly corn have exploded higher on the US futures exchanges.
This has all given rise to much loose talk in investment circles of a commodities super cycle which will stretch several years into the future. But what do people mean by a super cycle? Over the years some economists have observed that there are phases of economic activity, where waves of expansion and growth are followed by slowdown and recession, and that these phases can be quantified in terms of duration.
Kondratieff was probably the most famous exponent of this approach in the 1920s, while in the US Dewey and Dakin took up the theme in their book “Cycles – The Science of Predictions” published in 1947. In both cases, a long wave (or super cycle) is posited as lasting between fifty and sixty years in which we move from trough to peak to trough again. Within the long wave there are deemed to be smaller waves, in which activity ebbs and flows in briefer time periods. All of these studies focused as much on the historical analysis of commodity prices as on interest rates, trade, inflation and the rest of the available economic data.
The equivalent in the technical analysis of markets is to be found in the wave theory of R.N. Elliott, in which he breaks down the trends in bull and bear moves into cycles that last from minutes through to decades.
Of course, the value of all these cycle studies lies in their supposed predictive power. And here is where the problems begin. Even as convinced a believer in the commodity bull cycle as Jim Rogers points out that the shortest boom lasted 15 years, while the longest lasted 23 years. His conclusion is that we have much further to go, but don’t expect a great deal more precision than that. Oh, and don’t forget that we’ll endure some huge corrections along the way.
The Chancellor, Gordon Brown, has of course famously had his own problems in this area: he laid great stress on balancing the books over the course of the economic cycle only to be forced to change the starting point of the current cycle from 1999 to 1997 in order to meet this “golden rule”.
In reality, all economic cycles and wave patterns are best identified with the benefit of hindsight and forcing current circumstances into some pre-ordained mould will usually prove to be a pretty unrewarding activity, and a dangerous forecasting mechanism.
What we can say is that there clearly are long-term cycles and that they are driven by fundamental changes in the world around us. Global wars, the industrial revolution, major innovations in transport and communications are just some of the factors that can instigate long-lasting shifts in economic growth, that in turn stimulate demand for commodities. Increased demand drives prices higher while producers struggle to increase the capacity to meet that demand. Ultimately, prices peak when excess capacity has been developed – the cycle is then completed when demand abates and general surpluses force prices lower.
The big event of the moment is clearly China. I could run through endless statistics indicating the dramatic nature of the new industrial revolution that is taking place there – its double digit annual growth rates, its spectacular leap up the league tables to become the world’s fourth largest economy and so on. In focusing on China, we shouldn’t forget about India – it is the second fastest growing major economy in the world, with GDP growth up just under 10% – or Korea (up 5%) or countless other booming countries. It’s just that the sheer size and scale of everything Chinese makes it stand out and suits it to the role of representing the emerging market economic boom as a whole.
The staggering numbers on Chinese economic growth are matched by equally impressive figures in relation to its consumption of commodities. The International Monetary Fund reports that its share of the overall growth in global consumption of industrial commodities between 2002 and 2005 was massive – 51% for copper, 48% for aluminium, 110% for lead, 87% for nickel, 54% for steel, 86% for tin, 113% for zinc, and 30% for crude oil. On the subject of oil, the Energy Information Administration (the US government’s provider of official energy statistics) envisages a 47% increase in global demand from 2003 to 2030, and that non-OECD Asia (including China and India) will account for 43% of that increase.
Frankly, all future projections are no more than sophisticated guesswork, but what we can assume is that unless the world economy really hits the buffers and we are plunged into a global depression, the relentless demand for industrial materials of all kinds from the likes of China is set to continue.
We are still at the stage where supply is struggling to match this huge increase in demand. If we take the example of copper, only 12% of supply is generated by recycling scrap, which means that 88% has to be mined from the ground. Commissioning new mining production inevitably takes years not months and in the lag we see copper stockpiles around the world run down. Total exchange inventories have fallen to under a quarter of what they were four years ago, although this is above the alarmingly low levels they reached in 2005. In fact, the inventories held on the London Metal Exchange and New York’s Comex market are as good a guide to ongoing tightness as you are likely to get, and until they rise significantly the current phase will not be over.
Although we are in a generally fundamentally benign environment for the base metals markets right now and will remain so for the next 3-4 years in all probability, this doesn’t of course mean that the prices of these commodities will inexorably rise from here. The dramatic rallies witnessed on futures markets over the past few years have already discounted much of the story. The news is well and truly in the price in the case of copper: the steep parabolic rise, culminating in the final doubling in price in the six months to May 2006, has all the appearance of a speculative bubble. We have already fallen from over $4.00 per lb to a recent low of $2.40 on the Comex exchange. That said, what had previously been a multi- year price ceiling at around $1.60 per lb is still a long way off and will probably prove a floor for the foreseeable future.
As for the other base metals, aluminium peaked around the same time as copper last year, and zinc has also stalled for the time being; only lead, nickel and tin are continuing the immediate surge higher.
Because it began its recent long-term rally at the same time as copper and also peaked (for the moment) in May of last year, it is tempting to put gold in the same category as the base metal. Certainly the supply/demand picture is similarly tight: mining produces around 2,500 tonnes per annum, while demand is running at around 3,500 tonnes per annum. Scrap and central bank sales make up the shortfall. However, there is one crucial difference between the two metals, as the CEO of the World Gold Council reminded us in the Financial Times in early February: only 11% of gold demand comes from the industrial and dental sector. This means that 89% of gold demand represents discretionary spending.
The jewellery business accounts for the lion’s share of this, general investment demand the rest. Not surprisingly, the appetite for gold jewellery is strongest in those traditional regions – India, the Middle East and East Asia – which are currently booming. It shows no sign of abating and underpins the market. What will put the icing on the cake and push gold prices on through last year’s highs is the general investment demand side of things. Low real interest rates, persistent US dollar feebleness and the need for asset diversification will continue to create an attractive environment for speculation in the yellow metal, while new mechanisms such as ETFs will make it ever easier for the less sophisticated investor to access the market.
Although gold has enjoyed a very good rally, nearly trebling in price off its 1999 lows, it has not matched the sevenfold move in copper, and the thing about these major cycles is that they always overshoot in value terms and end with a climactic bang, not a whimper.
In sum, unless the global economy hits the skids dramatically, it is likely to take another 3-4 years for supply to catch up with demand for industrial commodities. This should put a floor under the price of base metals and maintain a secular bullish environment, even if some – like copper – may have discounted much of this positive outlook already. Right now, the best opportunities are in the precious metals, where gold could easily top $1000 an ounce, and would need to reach around $1700 an ounce to match the recent performance of copper.
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