Start of a new super cycle in raw materials

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It is said that monetary policy has caused many bubbles (the Everything Bubble) since the Great Financial Crisis (GFC). There is at least one asset class that has not benefited from this. These are commodities.

Commodities are not a structural investment category. There is no structural risk premium. Keynes’ theory of normal backwardation, in which the current price on the futures curve is structurally higher than the future price, is often protected. Empirically, this theory does not seem to be correct and Keynes’ assumptions are not correct either. According to Keynes, commodity producers prefer a certain sales price and were prepared to pay a premium for this in the form of a lower price. 

This may have been the case in the crisis of the 1930s, but almost a hundred years later, we can see that purchasers also have an equal interest in a certain purchase price, fuelled by strong price fluctuations as a result of speculation. Therefore, the market for raw materials does not always seem rational. For example, raw material prices often have several equilibrium levels. Take, for example, the price of oil. Many government budgets are based on that. In order to meet the budget when the price of oil halves, production has to be doubled. Perfectly rational from a budgetary point of view, but the theory of market efficiency can immediately be abandoned.

Raw materials are much more of an opportunistic investment category. In the past, there were regular super-cycles in which commodity prices rose for several years at a time, followed by a long period of falls. Therefore, the best remedy against low commodity prices is a low commodity price. Due to the time between an investment decision and actual production (sometimes as much as 7 to 10 years) in mining and oil companies, there is a long pig cycle. 

The last cycle began at the end of the 1990s with oil prices below USD 10 per barrel, gold which had fallen only in price after the bubble in the early 1980s, and agricultural commodities which had reached their lowest level in the last 35 years. Low prices have increased capital discipline, for example in large mining companies such as Vale de Rio Doce (literally: fresh water valley, a very euphemistic name given the polluting activities) and BHP Billiton (formed in 2001 by the merger of Broken Hill Proprietary and Billiton). 

An important variable was also China’s accession to the World Trade Organization in 2001. At that time, the Chinese economy was still following the typical Asian growth model, with high infrastructure investments financed by export earnings. Including the rapid urbanisation in China, the demand for raw materials rose sharply, at a time when low prices had given the incentive to invest for the time being but not for a few years previously. A large buyer was added, and these were institutional investors. For the first time in history, commodities were included on a large scale in institutional portfolios. They were helped by commodity investment sellers, who paid scientists for publications to convince investors of the added value of commodities in a portfolio. Rising commodity prices due to the imbalance between supply and demand took care of the rest. This makes it easy to convince investors. But a combination that could only end in a valley of tears. Commodity prices, therefore, halved during the largest bull market in equities. But as a result, commodities have not been as cheap compared to equities for the past 100 years.

It is quite normal for commodity prices to fall in the long term. Every time the price of a certain raw material rises, people adjust. A high oil price results in energy-saving measures and therefore less demand. For many raw materials, there are often cheaper alternatives. In addition, the high price makes extraction more and more efficient. Take, for example, the development of fracking and horizontal drilling. This has ensured that the United States has once again become the world’s largest oil producer.

Nevertheless, everyone seems to be convinced that an ageing world population consumes less and that IT will ensure that the world economy will become less dependent on raw materials. Even without a recession, there are enough factors that keep the price of raw materials low. However, as has been said, the best cure for low raw materials prices is a low price of raw materials. Then there will be no investment and production sites will close down. The supply goes down. The assumption that the world’s population is ageing and therefore consumes less is wrong. Global consumption will double in the next ten years due to the rapidly growing middle class.

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