Questioning the Commodities Super Cycle

Conventional wisdom is that the plunge in commodities was due in part to the deflating of a speculative bubble, the balance the result of the nasty contraction now in full force. Once things recover, basic materials should enjoy a strong rebound as China and other emerging markets get back on the growth path. Comparisons to the Great Depression are also encouraging, since commodities rallied before stocks did.

But the optimistic case is not as clear cut as it sounds. Oil bulls point to the unusually steep contango, where futures prices are markedly higher than spot (backwardization is the more normal state of affairs). Traders can now reap attractive risk free profit by buying crude, storing it, and selling it forward.

And when was the last time the contango was this steep? In 1998, when the price of crude fell to under $10. Historically, a contango this steep is consistent with a glut. And while oil prices did increase from the 1998 bottom, they had reached just under $12 by year end and $16.50 by year end 1999. That may sound like an impressive recovery, until you consider that oil had been nearly $29 at year end 1984, $23 at the close of 1990, and over $18 at year end 1997 (which was lower than 1996). That is a long-winded way of saying a sharp recovery from the bottom (which some are now saying could be as low as $25) does not appear likely.

An article in today’s Financial Times keys off the downbeat oil demand forecasts from the World Bank and the US Energy Department. First, from the FT piece on the two studies, “Global demand for oil to plummet“:

Global oil demand will collapse next year and commodities will not return to the highs they reached this summer in the foreseeable future, two authoritative reports said on Tuesday as they forecast a long and painful worldwide recession….

The US energy department said global oil demand will fall this year and next, marking the first two consecutive years’ decline in 30 years….

Meanwhile, the World Bank’s Global Economic Prospects report said the commodities boom of the past five years – which drove up prices 130 per cent – had “come to an end”.

The World Bank’s analysis of the commodities boom contrasts with the prevalent view among natural resources companies – and most Wall Street analysts – that the ongoing price drop is a correction within an upward trend….

Oil would return to about $75 a barrel within the next three years, it said, while food would trade 60 per cent higher than in 2003, but about half below this year’s record.

“Over the longer run, the price of extracted commodities should fall,” the bank said, adding that because of slower population and income growth, world demand for raw materials will ease.

Andrew Burns, the leading author of the report, dismissed the idea – widely supported among the industry and international bodies such as the International Energy Agency – that the credit crunch could result in higher prices when the economy recovers as companies cancel supply expansion projects.

The bank forecast that world trade – an engine of growth for many developing countries – would contract for the first time since 1982.

The World Bank report is significant because it tends to err on the optimistic side with growth forecasts.

The longer FT article, “So long, super-cycle,” looks at how our latest commodities cycle compares with past ones, and also focuses on the role of emerging markets. We’ve extracted (no pun intended) some of the juicy bits from this long but worthwhile article:

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….

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….

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.

Yves here. Demographic changes have not gotten the attention they merit. In addition, China also announced its intent to use the plunge in oil prices to reduce its energy subsidies further next year. China has come to realize that making fuel artificially cheap has made its manufacturers and products energy-inefficient, and it need to move pricing to world levels.

Back to the article:

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….

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.

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 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….

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…

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.


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…

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…

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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  1. mxq

    Commodities are about the most economically sensitive (cyclical) businesses out there.

    Yet it never ceases to amaze me how investors (sell-side esp) have continuously pushed commodity related names as overweights/buys into the worst downturn (or one of) in history.

    I guess after 10 years and 1400% of gains, this one-way bet becomes habitual and overwhelms common sense.

  2. Lune

    I don’t think the contango is that anomalous, and probably reflects higher costs of credit more than anything else.

    According to Bloomberg, the cost of storing a barrel of crude in a tanker is ~90c/barrel, and the financing costs are about 35c/barrel. According to my math, that adds up to $1.25/bl/month which yields ~$15/bl to take delivery in Jan ’09 and sell in Jan ’10. The difference between the Dec ’08 and Dec ’09 contract is (54.65-40.81) = 13.84, which is less than the costs cited. While Bloomberg notes that storage in Cushing OK is much cheaper, my guess is their storage capacity is completely filled and none is left over for the carry trade.

    Unless my math or Bloomberg’s figures are incorrect, I’d say that for those without access to primary storage in Cushing, OK or similar cheap storage elsewhere, the carrying costs still exceed the contango.

    What’s more, as credit costs will likely go higher in the coming months, unless you’re able to secure a 1 year loan, you might find yourself with rapidly escalating carrying costs in the coming months while the money you earn from the contango is fixed by your original contracts. Not a situation you really want to be in these days…

  3. Anonymous

    With the steep fall of oil prices, exploration is being slashed and projects are being cut. Add to that a natural decline rate of ~6% and we are in quite the pickle. Just as prices fall, consumers resort to old habits, opting for SUVs over Priuses; Cantarell and other fields are falling off a cliff in terms of output; new fields are being mothballed… I think we have a real shot at a steep run up… in spite of whatever happens in the rest of the economy.

  4. Anonymous

    Suggesting the Commodity Super Cycle is over is way too broad a generalisation. Different commodities are going to act differently. Lets first look at oil and we can see that during a downturn inventories build, production is slow to scale down, but equally investment in new production are curtailed. The question then becomes which will win the race of reducing demand or existing oil fields declining. Personally I don’t see demand picking up in the next few years at all, but there will come a point when lack of investment becomes a problem.

    What rather disturbs me about the FT article is the assumption made about the build-up in dormant capacity as companies cut their production. For the likes of Iron and Steel during a downturn there is the opposite affect on inventories to oil. Demand drops even more than usage as inventories are used up leading to a risk that production will be over cut in relation to basic demand. For iron and steel this takes a long time to work through, and we must not ignore the demand created from the stimulus packages.

    Food acts in a different way again. Here you will have limited inventory build up, but credit conditions and pricing mechanism failures will cause significant production cuts, while demand will not fall off as quickly. This I think is going to be a bit of problem as consumers see prices at the grocery store continuing to go up next year.

    Three different stories with oil prices being depressed for years unless the Saudi’s cut production, but ultimately rising very quickly some years hence down the road. Iron and Steel will most likely rebound somewhat the longer the recession goes on. Food commodity prices I think will go up next year.

  5. patrick neid

    A casual perusal of the history of acknowledged bubbles dating back several hundred years all end in the same splat.

    Once they pop, determined by the speed/depth of the sell off, they are dead for decades. The two most recent examples are continued living proof. Japan inc and the Nasdaq tech/internet bubbles. Rallies aside by individual stocks of sometimes 100’s of percent still, by and large, leave even the best companies 60-80% below their old highs 10-20 years later.

    What does that suggest going forward? Housing, oil, and commodity companies will be dead money for at least a decade or more.

  6. Anonymous

    The tech bubble and commodities are two completely different things. The tech bubble was based on hope and hype.Those are not a function of price or even supply and demand. Commodities particularly those such as food grains are real and tangible their prices will depend on supply and demand and the cost of production.

  7. macndub

    Lune is right. You are equity financing storage right now. There is no riskless profit with the carry. Note that the storage owner charges the current spread plus extrinsic value on any optionality. The guy who stores oil brings only his credit as a competitive advantage.

    So the current contango is a function primarily of spot prices getting smashed because credit is unavailable to store. It’s an equity risk, now, and demands an equity return.

    Could it be a sign that the crude bull market is over? Who knows. Forecasting future prices from the shape of the current curve is as stupid as forecasting future prices based on outright prices. Chance of being right is 50/50. I’ve seen contangos lead to a recharge in the spot price (ie, it can go either way).

    By the way, any discussion of crude without looking at natural gas is a deficient analysis. Gas production in the lower 48 increased 8% year over year, an increase that has no historical precedent. (It’s due to new technologies unlocking preveiously uneconomic basins. Should sound familiar to anybody who understands commidities). Worldwide, LNG will double in the next five years, an increase that’s financed by NOCs and is pretty much locked in. All those BTUs will have an impact on all energy prices, whether now or later.

  8. Sivaram Velauthapillai

    Anon: "Commodities particularly those such as food grains are real and tangible their prices will depend on supply and demand and the cost of production."

    It doesn't matter if the asset is a physical asset or not. What you said could have been said of commodities or other physical assets such as real estate at any point in the past few thousand years. I know I'm oversimplifying your argument (supply & demand changed over various periods) but the point is the following:

    What matters, as value investors would say, is the price! The key question is whether oil at, say, $50 is overvalued or not? It's down 50% from its $140 peak; but it is also up around 500% from its low of around $12. If the price is too high, fundamentals can be positive and yet the price will just stay still or even drop (i.e. fundamentals "catch up" to price.)

    Most people forget that oil demand growth was positive all throughout the 80's and 90's yet oil prices kept going down. Partly it was because of increased supply but mainly it was becaues the price in the early 80's was too high (i.e. oil was overvalued.) If one is bullish, they better be sure that the asset isn't overvalued regardless of how positive the fundamentals seem.

  9. tompain

    Plain old microeconomics tells you that commodities over time will be priced at the marginal cost of producing them. That’s all there is to it. In this cycle, the growth of China took the commodity industries by surprise a little bit, and it took them longer than normal to do what they have always throughout history done and always will do – build capacity in response to high prices. They were eventually going to catch up to demand. The global economic slowdown accelerated what was going to happen anyway.

    Demographics don’t mean squat for commodities. The world’s population has doubled and doubled and doubled again over history and always commodity prices remain nothing but cyclical. Indeed, for all of history, the real, inflation-adjusted price of commodities has fallen over time because of massive technological improvements that have lowered the cost of production.

    EVERY time there is a boom people say, this is it, this time we are really running out of the planet’s finite amount of XXX. The way you can see that is not true in any given cycle is to simply look at whether all the commodity prices are moving together. Is the world going to just happen to run out of oil at the same time as it runs out of copper at the same time it runs out of iron, zinc, aluminum, platinum, gold, and corn? Nope. If and when we are ever REALLY running out of something, that price will rise independent of what other materials do.

    Note that all the iron, copper, aluminum, gold, silver and other metals that have EVER been “produced” on this planet is still here. If we have to someday “mine” metals out of landfills, we will, but for now there is plenty that is easier to get to in other ways.

    The commodity that really is being in some sense destroyed as it is consumed is hydrocarbons. But the carbon molecules are still here. Who knows what technology may eventually be able to do with them. In 100 yrs you could have solar or nuclear or tidal or geothermal powered factories that extract carbon from the air and reassemble it into fuel, if hydrocarbon fuel has not been completely displaced by then. People living in a temperate Siberia will start to protest the global cooling effect of taking all that carbon out of the air…

    (Crops of course are destroyed as they are consumed, but they are different from the extracted commodities in that they are “renewable” – and no, we are not running out of land on which to grow them, nor fertilizer with which to feed them, nor water – all the water that has ever been on the planet since humans have been here is still here – perhaps not as conveniently located as we might like, but it is here)

  10. tompain

    It is not true that backwardization is the normal state of affairs. Contango is. That’s why backwardization is called backwardization. It is backward from the norm.

    Contango is the norm because you always have a choice between buying something later or buying it now and storing it for later. There is storage cost and opportunity cost of capital, so the forward price is normally going to be higher than the spot. When oil was at $150, it would not have been surprising to see backwardation, reflecting the fact that very strong forces were at work to increase supply and reduce demand.

    It’s pretty much like the yield curve. Normally it slopes up. When it slopes down, we say it is “inverted”. Backwardized is synonymous with inverted. Neither is the norm.

  11. Joe

    Hmmm, all this talk about commodities and no one even mentions the dollar. There is a very strong correlation between commodity prices and the value of the currency in which it is priced. If the dollar falls, commodities will rise, at least in dollar terms. And I suspect that is exactly what will happen.

    As for the contango/backwardation argument it is true that contango is normal for a commodity that is non perishable and oil is of course in that category. The spread is historically wide right now and the reason, as someone else mentioned, is that financing is bascially not available for the traditional storers of oil, i.e. refiners, etc. That being said, there is a profit to be made in the contango market. The spread is wide enough now that you don't need much financing to make the trade profitable. The problem is that storage is very hard to come by, especially in Cushing. I know; I've been trying to find it for the last month. I have access to financing but I don't have access to storage – at least not yet. When I do, I'll be doing the trade. Others already are by leasing tankers:
    My only problem right now is that I'm not big enough to lease a tanker and need the Cushing storage which may not become available.

    I don't think the commodity super cycle is over because I don't think the dollar is done going down. A good way to anticipate a rise in commodity prices is to watch the Aussie and Canadian dollar versus the US dollar. There is academic research that shows that those currencies move before the commodities with a lag time of anywhere from a couple of weeks to a couple of months.

    Full disclosure: I'm long gold and started buying a commodity index today. And I was a seller in March and July last year.

  12. Anonymous

    Agree completely with Joe @3:58 – dollar devaluation could easily cause the price of commodities to shoot up, irrespective of actual demand.

  13. macndub

    Joe, there may not be storage at Cushing, but there is plenty of natural gas storage at distressed valuations. We’re talking about multiyear deals at the intrinsic value only (just the current spread). If I had a few million dollars, this is where I’d put it, without question. Especially with exchange-traded futures: safe as treasuries, and way, way more yield.

  14. freude bud

    Contango may be normal for non-perishable commodities, but backwardation is normal for oil futures.

    There must be some financing issues, as storage is still below the top of the five year historical average, unless a bunch of storage was destroyed or converted or the data is bad.

    The data may be bad, and Verleger seems to suggest that demand is much lower than the EIA, IEA, or OPEC have inferred, which has the effect of lengthening the days covered by crude already in storage. However, he still seems to suggest (from reports) that there is more in storage than has been reported, meaning that the data is flawed … a not unusual estimation in the oil business.

    Still, I suspect there is more storage out there … and that if Russia does as it announced it would do yesterday and coordinate production cuts with OPEC on November 17, then prices should recover if the total cut is 2.5 mb or more. The announcement coincides with a narrowing of the full curve contango which began two days ago.

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