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Is the commodities bull market over?

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“Nothing new ever occurs in the business of speculating or investing in securities and commodities.” — Jesse Livermore’s Trading Rules Written in 1940 Commodities are cyclical. In fact the price of natural resources has fallen in real terms over the long haul since the beginning of recorded price history. Commodities have actually fallen after adjusting for inflation over their lifetime. This adage is often not appreciated by many because they assume commodities are an inflation hedge. So unless “this time is different” we should expect commodities to mean revert or fall in price from recent year’s elevated levels. This is probably not a popular view given all the mass produced rhetoric on Chinese consumption, peak oil and shortages. Back on March 11 of this year I questioned the whole commodity bull market thesis (see here:

http://www.royalgazette.com/article/20130311/COLUMN05/703119970). Since then commodities have slipped, falling nearly 7% according to the S&P Goldman Sachs Commodity Index.

(see graph, right) I promised at that time to expand my summary explanation in a future column. As I stated the bull market in commodities may be petering out and reversing for three general reasons: the rebounding dollar, demand changes, and supply side response.

The Dollar Secular Change We may, and I stress may, be at a point where the US dollar regains some lustre. A long-term secular shift may be happening where the dollar regains some of its strength versus its trade weighted peers. For adamant dollar-bears this will seem silly but consider this. Do you really feel the finances in Europe and Japan are in way better shape than that of the U. S.? Are their economic prospects much brighter than that of the U. S.? I would argue no for both. Part of the wind in the sails of the commodity markets over the past ten years has been the fading dollar as commodities are priced in dollars. A weaker dollar bolsters returns while a stronger dollar tends to repress prices somewhat.

Demand Changes While overall demand for commodities should continue to grow, higher prices and improved technology will mean that the rate of growth will slow. In China for example, current GDP which is predominately investment driven is likely to shift over time to more consumption. This doesn’t mean demand for commodities will go away but the composition of demand is expected to change. Couple this with weak developed market growth (the International Monetary Fund just lowered global growth to 3.3% this year) means the overall demand for commodities may be slowing. Oil demand in the US, for example, has actually been falling since 2004, from roughly 21 million barrels per day to 18.7 million barrels per day. Gasoline efficiency continues to improve and energy efficiency is being pushed globally.

Supply Surge The supply surge is potentially the most bearish argument on the commodities boom thesis. Here are a few points: n While replacing declining fields globally remains a challenge, technology has allowed production growth to explode in the United States. According to a recent report by the International Energy Agency (IEA), the US will replace Saudi Arabia as the world’s largest oil producer by 2020. At that time, the US is expected to produce 11.1 million barrels a day, which would represent growth of 66% from the 6.7 million barrels per day it produced, on average, during the week ended November 2, 2012. Along with that surge in oil production is also expected to be a jump in natural gas production, reflecting hydraulic flacking. According to the IEA, the US is set to become the world’s largest producer of natural gas by 2015, and is expected to set to become a net exporter of both oil and natural gas over the next ten years. n A report from the Belfer Center recently states: “Contrary to what most people believe, oil supply capacity is growing worldwide at such an unprecedented level that it might outpace consumption. This could lead to a glut of overproduction and a steep dip in oil prices. Based on original, bottom-up, field-by-field analysis of most oil exploration and development projects in the world, this paper suggests that an unrestricted, additional production (the level of production targeted by each single project, according to its schedule, unadjusted for risk) of more than 49 million barrels per day of oil (crude oil and natural gas liquids, or NGLs) is targeted for 2020, the equivalent of more than half the current world production capacity of 93 mbd.” (report can be found here : belfercenter.ksg.harvard.edu/files/Oil-%20The%20Next%20Revolution.pdf ) n The US right now is swimming in crude. Crude storage is at 22 year highs and way above 5 year storage levels averages: n Finally, Chinese oil reserves also appear to be expanding. The Chinese Land Ministry has recently reported that oil reserves are up 13% and natural gas reserves are up 33%. n Copper inventories tracked by the LME have been rising for some time and are at levels not seen since October 2003. Other metals inventories such as LME stocks of zinc, nickel and aluminium are also near record highs. Copper is anticipated to be in a surplus position by the end of this year and into 2014. n Iron ore could be heading toward its first surplus in at least a decade as output expands and Chinese steel mills, the biggest buyers, boost production at the slowest pace in five years. Seaborne supply may advance 9.1 percent and demand 8.3 percent in 2013. A surplus may emerge in 2014 and keep widening until at least 2018 based on new mines that are coming online. In summary the high prices of commodities have ultimately sowed the seeds of their own destruction. Capitalism and human ingenuity is working. High prices lead to more investment which in turn lowers prices and future returns. This is by no means an exhaustive report on the commodities market but just a short review on some more bearish aspects. If the commodities boom was to reverse it would have negative implications for commodity producing countries and positive implications for commodity users. For example, this would be negative for Canada, Australia and Brazil but positive for the US, Europe, Japan and China. As energy and input materials costs get slashed many companies and countries actually benefit. A bearish shift in commodity prices is actually not so much of a negative event. Commodity related investments and currencies may suffer while commodity user currencies and equity investments would benefit. For Bermuda, lower commodities are a boon we should all hope for.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision.