Tuesday, July 3, 2012

The end of commodities super-cycle?

The sharp decline in oil prices in recent weeks - amidst talk of slowdown in emerging economies, including China, to add to the Eurozone crisis and America's economic weakness - has triggered a debate as to whether the sustained rally in oil prices is nearing its end. More importantly, given the similar downward trend with other commodity prices, is this the end of the commodities supercycle?

The commodities supercycle is premised on the belief that "the rise of emerging markets led by China would continue to drive up prices for oil and other commodities, from copper to corn". It has, over the past decade, spectacularly boosted the fortunes of many commodities producing economies. This quote from the Governor of Reserve Bank of Australia, Glenn Stevens nicely illustrates the magnitude of the supercycle,
Five years ago, a ship load of iron ore was worth about the same as about 2,200 flatscreen television sets. Today it is worth roughly 22,000 flatscreen television sets.
Ruchir Sharma feels that the latest round of commodities supercycle is merely following the 200 year long trend in commodity prices - one decade up, followed by two decades down. Now with the decade of rise over, the long period of decline is round the corner. This, he argues, is likely to boost the mainly western commodity importing economies, and result in capital allocation to more productive industries. He points to certain interesting features of this supercycle,   
At the height of the dotcom bubble, tech stocks comprised 25 per cent of global markets. After the bust, commodity stocks – energy and materials – rose to replace tech stocks and, by the end of the last decade, accounted for 25 per cent of global markets too... The total invested in commodity funds has more than doubled over the past five years to more than $400bn in 2011. The daily volume of trades in energy futures is now a staggering 25 times higher than daily global demand for energy...

The dotcom billionaires were truly creative people, many of whom are still advancing the tech revolution. Today’s billionaires make money by digging stuff out of the ground. In 2001, the world had 29 billionaires in the energy industry, 75 in tech; by 2011, the numbers had reversed, with 36 in tech and 91 in energy, mostly in oil. These tycoons contribute only in so far as they inspire competitors to devise alternatives to oil.
The spectacular rise of Australian iron ore mining heiress, Gina Rinehart, to the position of the richest woman in the world mirrors the fortunes of Australia in particular and the commodities supercycle in general.

A recently released study of commodity prices changes since 1865 by Bilge Erten and José Antonio Ocampo (via FT) claims that the remarkable strength and length of this upswing in commodity prices reflect the extraordinary resilience of growth performance of major developing countries, particularly China.

The graphic below puts the current supercycle in perspective. In the top section, the figure displays the natural logarithm of the real total non-oil commodity price and the long-term trend superimposed on it. The real commodity prices trended very slightly upwards from 1865 to the mid 1910s, trended downward until late 1990s, and then trended upward through the end of the sample.

The authors analyse their graphic,
The non-trend component representing the difference between the actual series and the long-run trend is shown in the bottom half. The left scaling in logarithms shows that a value of 0.40 indicates a 40 percent deviation from the long-term trend. The cyclical fluctuations illustrated by the non-trend component... contain shorter-term as well as the super-cycles, which are not always symmetrical. The latter are estimated to be in the 30-40 year range. The super-cycle component... reveals three and a half long-term cycles in real commodity prices since the late nineteenth century. 

The first long cycle begins in late 1890s, peaks around World War I, and ends around 1930s, and shows strong upward and downward phases. The second takes off in 1930s, peaks during the post-war reconstruction of Europe, and fades away in mid 1960s. It shows a strong upward phase but a weak downward one. The early 1970s marks the beginning of third cycle, which peaks around early 1970s and turns downward during mid 1970s and ends in late 1990s. This cycle shows a weak upward phase and a strong downward one. The post-2000 episode is the beginning of the latest cycle, which has shown a strong upward phase which does not seem to have been exhausted so far.

The degree to which the total non-trend component deviates from the super-cycle component shows the significance of other shorter cycles induced by business cycle conditions and medium-term factors. These shorter fluctuations appear to be strikingly large, particularly in the interwar period of the twentieth century. This implies that periods of high volatility resulting from business cycles often accompany the long-term trend and super-cycle in real commodity prices. The presence of shorter-term high volatility further brings large price risks for those involved in the investment decisions that may be long-term in nature.
A cursory analysis of the graphic appears to indicate that the non-oil commodities supercycle is now primed to start winding down. Incidentally, its amplitude in the latest cycle, since the nineties, has been bigger than in earlier periods. A comparison with the supercycles in crude oil prices reveals that its supercycles have gotten far bigger in the recent cycle compared to those in earlier cycles. Further, in sharp contrast to the non-oil prices, the real oil prices have been rising sharply since the seventies.

Given these trends, it may not be unwise to argue that the supercycle in both crude and non-oil commodities are set to wind down in the years ahead. Slower growth in China - which formed almost three-fourth of the consumption growth in iron ore, coal and copper - adds credence to this arguement. In fact, as the FT recently reported, the FTSE All-World mining index has already dropped 31.8 per cent from its peak in April 2011. It will be interesting to see the pace and trends associated with this easing of the supercycle.

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