So long, super-cycle

By Javier Blas

New York Times: December 9 2008 19:56

Many Asian emerging markets were in recession, along with Japan, while Russia had just devalued the rouble and defaulted on its domestic debt. Although continental Europe was buoyed by the imminent launch of the euro, the US and UK were among many countries where growth was weakening. In its latest World Economic Outlook, the International Monetary Fund had agonised over what should be done to address “the current crisis”.

The oil market knew the answer: sell. Ten years ago this Wednesday, the price of the North Sea’s benchmark Brent crude closed at the lowest level in its history, at $9.64 a barrel.

That era resonates anew, says Mr Laughlin: “People today do not want to buy oil either.” What is different, however, is the speed of the reversal. Just five months ago, Brent stood at an all-time high of $147.50. This week it traded below $40. Other commodities have also fallen rapidly out of favour: the Reuters-Jefferies CRB index, which includes oil and a range of commodities from copper to cotton, is plumbing its lowest level in six years after October brought the largest monthly drop since it started life in 1956.

The severity of the crisis has surprised natural resources companies’ executives, commodity traders and Wall Street bankers alike. After all, the commodities boom of 2003-08 has been the most notable for a century in its magnitude, duration and the number of commodities whose prices it has lifted. The sudden plunge poses a fundamental question: is this just a temporary blip within an upward trend, with prices likely to rebound in the medium term, or is it the conclusion of another commodities cycle of boom and bust, with a period of relatively stable prices coming ahead?

The common belief in the industry itself, and among most Wall Street analysts, is that the market is undergoing a correction but that the boom years have not ended. As many point out, the main drivers of what many have come to see as a commodities super-cycle – such as strong pent-up demand in emerging countries and supply constraints caused by a lack of investment over the past 20 years, along with the rise in resource nationalism – are intact. The current drop is, in the words of one senior mining executive, a “reset” of the boom, not the end of it. Prices will rebound, in this view, and continue rising.

Blip or bust?

In addition, they argue, the credit crunch that today is depressing prices as economies slow could end up having bullish implications as companies stop investing in new oilfields, mines or farms because of lack of finance and low prices. That points to a shortage of supplies in the future and, potentially, higher prices when demand recovers.

But a growing minority disagrees with this rosy view. With its report released on Tuesday, the World Bank has put itself among the most vocal in warning that the commodities boom has come to an end. Some executives in the natural resources industry agree – in private. Like earlier booms, this one has ended as a period of solid economic growth gives way to a recession in the US, Europe, Japan and a sharp slowdown in emerging countries including China.

“As the rapid decline of commodity prices since mid-2008 attests, the current boom is best understood as yet another cycle in a long history of commodity price cycles,” says the bank, comparing the 2003-08 period to similar booms in the 1973-74 oil shock and in 1950-57 after the second world war. Both of those turned to bust.

Although most proponents of this argument see prices remaining well above the lows of the 1990s, they do not forecast a return to the torrid levels of this summer. That is because a more slowly expanding population and weaker rises in income will ease global economic growth – and commodities demand – in the next two decades.

They dismiss the notion that the credit crunch will trigger shortages in the future as companies cancel investment projects. Any increase in demand will first slowly have to absorb the current build-up in dormant capacity as companies cut their production. “Certainly, it is unlikely that we are going to see any time soon another boom across a wide range of commodities lasting so long and going so high,” says Andrew Burns, an economist at the World Bank in Washington.

For its part, the natural resources industry points out that falling supply in some areas and commodities – such as mature oilfields in the North Sea or old gold mines in South Africa – will support prices even if demand is weak. But pessimists say that the rapid fall in demand will leave the system with plenty of spare capacity.

Slippery oil

Both sides have powerful arguments but history says that commodities booms last about a decade – almost exactly the length of time that oil prices were on the rise.

Whatever the disagreements, pessimists and optimists see eye to eye on the next 12-24 months: it looks grim for commodities. The IMF forecasts only 2.2 per cent in global growth next year, with the rich countries suffering a full-year economic contraction for the first time since the second world war while growth in emerging countries slows appreciably.

“The main difference for commodities is that our view for emerging countries’ near-term economic growth is now more pessimistic,” says Thomas Helbling, an IMF economist who specialises in commodities issues. Relatively high-growth emerging countries consume more energy and other basic products than developed nations as they build infrastructure and embrace new forms of consumption, from cars and washing machines to meat and refrigerators.

The paradigm of fast growth and a high propensity to consume commodities is China, which has been the world’s engine of raw materials demand during the past five years. But now the engine has stalled. “It would be an understatement to say that there was not much positive news,” says Jim Lennon, a London-based commodities analyst with Macquarie Bank, who recently hosted a commodities conference in China.

According to the World Bank, Chinese economic growth will slow to 7.5 per cent in 2009, the lowest rate since 1990. But some bankers and mining executives are even more pessimistic, saying that activity in some sectors has already almost stopped. “Demand has really ground to a halt in the past month,” says Mr Lennon.

The early signs were masked by the Olympics, when Beijing ordered heavy industries to shut temporarily in order to reduce pollution. When the sporting events ended, it began to become apparent that Chinese industrial activity was failing to return to its previous heady pace. Commodities prices tumbled as a result.

Kamal Naqvi, who advises institutional and hedge fund clients as a director of commodities at Credit Suisse in London, says big long-term investors remain committed to commodities. “We have not seen a major change in attitude towards commodities as an asset class from large institutional investors,” he says. But Mr Naqvi agrees that for retail clients and hedge funds, the outlook has changed, adding: “Activity has declined and we expect to see further redemptions in the next six months.”

In general, bankers agree that although the sharp price declines of recent months could be a buying opportunity for longer-term investors who missed the boat earlier this decade, the desire to increase exposure to risky assets such as commodities is unlikely to re-emerge until the global financial crisis abates.

That would mark a significant change since investors started to pour serious money into commodities about five years ago. For some it was the lure of strong returns, for others a hedge against inflation. For all, it was the appeal of diversification, amid a notion that commodities prices usually do not move in the same direction as equities or bonds.

By the end of June, investors’ commodities assets under management had risen to $270bn, up from about $10bn in 2000. Not all the increase had come from fresh inflows: a significant portion of the rise derived from the appreciation of the assets themselves. However, assets under management fell in the third quarter for the first time since 2003 to about $211bn, according to Barclays Capital.

Price markdowns rather than outflows accounted for the bulk of the fall, however. Whether investors start pouring money into the asset class again will depend on which view prevails: that the current drop in prices is just a blip or that the boom has ended.

But for investors, executives and bankers alike, the commodities boom and bust cycles teach that extrapolating today’s events into the future may prove the wrong bet. Ten years ago this week, when oil prices bottomed at $9.64 a barrel, the common wisdom was that commodities prices were heading down. Today’s forecasts could prove equally fallible.

PEAK PERIODS OF THE PAST: IN STRENGTH, LENGTH AND SCOPE, IT HAS BEEN THE BOOM OF A CENTURY

Common characteristics

The last five years’ commodities price surge has been the most marked of the past century in its magnitude, duration and breadth – with the cost of energy, metals and food all swept upward.

Previous booms included one or two of those segments but never all three. The reconstruction effort that followed the second world war lifted metal prices, while bad harvests pushed up the cost of agricultural products.

In the 1970s, oil prices spiked and agriculture followed. But metals, after a brief jump, collapsed because of waning demand amid lower economic growth. The 1915-17 boom saw metals and agriculture rising, with oil prices playing no role.

The length of the 2003-08 boom has also surprised many. The jumps of the 1950s and 1970s were shorter, although the first world war brought a similarly long period of strength.

Moreover, the latest surge has involved not only conventional commodities such as oil and wheat but also exotic raw materials such as rhenium and cobalt, two metals used as superalloys in jet engines among other applications.

Yet the sheer size of the rises also stands out. “The magnitude of commodity price increases during the current boom is without precedent,” says the World Bank in its latest report.

It notes that prices in real terms – inflation adjusted – have increased by 109 per cent in US dollars since 2003 and 130 per cent since the cyclical low of 1999.

By contrast, increases in earlier booms never exceeded 60 per cent, according to the bank’s estimates.

From trough to peak in the oil market, prices rose – in nominal terms – by 1,415 per cent between December 1998 and last July.

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