Musings from the Oil Patch
There appears to be a growing number of variations on the theme of the end of the commodity super-cycle that Mr. Morse has suggested, but his seems to be the most well thought out. He believes this seismic shift in the commodity sector means all commodities will be impacted, although others believe the shift will cause little disruption. Mr. Morse believes that returns from investing in commodities will be more differentiated among raw materials in the future depending on their specific supply/demand balances. This is why he argues that long-only commodity investment strategies will not be as successful in the future as in the past. His view contrasts with that of Jeremy Grantham of investment manager GMO. Mr. Grantham recently authored a detailed analysis of the long-term future of the U.S. economy and proclaims that its historical growth of 3% per year is now no longer possible due to demographic and productivity trends that he sees little hope of reversing. Furthermore, he believes that resource prices are likely to continue rising at the 7% per year rate he says has existed since 2000 as we run out of cheaper resources to exploit. The combination of these trends suggests to Mr. Grantham that our future economic output will be consumed merely trying to secure the resources to keep it running, thereby providing little or no growth in the future. There is even the possibility that our economic trend could begin to decline if any of these trends proves worse than he anticipates.
Eoin Treacy's view There has been a great deal of debate about the commodity complex and the sustainability of historically high nominal prices over the last couple of years. A simple reduction to supply and demand dynamics offers perhaps the most accessible way of addressing this issue. Let us consider some inflation-adjusted charts in monitoring commodities.
The evolution of the unconventional oil and gas sector in the USA has been a game changer for the energy complex. This source of new supply has so far only been exploited in North America but is replicable elsewhere and it is only a matter of time before this is accomplished. The result is that while 10 years ago there was a widespread perception that new sources of supply were unavailable, the allure of higher prices has encouraged entrepreneurs to figure out how to tap previously inaccessible reserves. On the demand side, higher prices have forced consumers to become more efficient and this trend is likely to persist. Therefore when we look at the long-term outlook for energy, the potential for oil prices to drift lower over the next decades and more is quite compelling. However, even in the most bearish scenario, much of the new supply is comparatively expensive to develop. Whereas $40 was a ceiling for decades, it is likely to offer a floor in future. Here is the inflation-adjusted chart.
Fullermoney characterised the commodity complex as a Supply Inelasticity Meets Rising Demand theme from 2002, following the completion of a more than 20-year bear market for the sector. As with the energy complex, the industrial metals sector was depressed, supply was unavailable and China's insatiable demand drove a major reappraisal. Billions have since been invested in new supply and China has committed itself to spending more on developing a consumer economy rather than continuing to concentrate on infrastructure development. Inflation-adjusted prices for copper, tin, lead, zinc and nickel have been ranging above their respective long-term bases for a number years suggesting that supply and demand have come back into relative equilibrium, albeit at a higher historical price. This at least partially reflects the higher cost of marginal production. The bull market in base metal prices that occurred between 2002 and 2008 is unlikely to be repeated unless a major new source of demand that soaks up the available supply and spurs additional investment appears. India and the ASEAN region might yet be candidates for new demand but that has not yet been reflected in pricing.
In the precious metals markets gold has returned to the region of its 1980 peak in inflation –adjusted terms. Demand for the metal remains robust and miners continue to have trouble increasingly supply. The wild card is that investment demand for the metal is both driving the bull market at the margin and represents a major source of potential supply when the bull eventually ends. Total ETF Gold Holdings is therefore an important chart for monitoring the sustainability of this bull market and it continues to trend higher. The Total ETF Silver Holdings has a similar trajectory.
In the soft commodities sector global stockpiles of food stuffs are at historic lows amid rising demand and a constrained supply situation which has been affected by weather and underinvestment. There is ample opportunity to increase global food production but this will require investment in plant, machinery, irrigation, refrigeration and transport as well as the lowering of trade barriers and increased cooperation between major producers and consumers. Inflation-adjusted prices for Corn, Soybeans, Wheat, Live Cattle and Feeder Cattle have been ranging in first steps above their respective bases since 2008. Historically, spikes in food prices have been supply related. Due to the low inventories of food crops, this represents an elevated risk at present, not least because of the potential for extreme weather events. Following its spike higher in 2011, cotton has also returned to test the upper side of the underlying base in inflation-adjusted terms while Arabica coffee, cocoa and sugar have fallen back into their respective bases.
When we consider the above charts, the outlook for commodities is much more nuanced than one might expect. A one-size-fits all approach to the sector is not appropriate at present, nor is it likely to be in future. Prospects for each individual portion of the commodity complex need to be judged on their individual merits.
On another topic, the points made on the last page of Allen Brooks report focusing on the USA's aging household goods is a positive for consumer spending over the next few years and should act as a spur to economic growth