Are the wheels falling off the commodity market?
This week, a leading commodity index hit 10-year lows as many hard commodities, such as copper and iron, precious metals commodities, energy commodities and soft commodities such as cereals have all weakened in price over the last four years.
Eighteen of the 22 components in the Bloomberg Commodity Index have dropped at least 20 percent from recent closing highs, meeting the common definition of a bear market. That’s the same number as at the end of October 2008, when deepening financial turmoil sent global markets into a downward spiral.
So what’s going on?
Commodities had a boom time from the late 1990s until the 2008 financial crisis, with most experiencing double-digit annual real (inflation-adjusted) price growth, a period known as the commodity “supercycle.” For example, the price of oil rose 1,062%, copper rose 487% and corn rose 240% as growing emerging market demand finally caught up with years of underinvestment in various commodity markets. Despite the credit crisis, many commodity prices continued to rise until the peak in 2011.
The wheels were definitely on the commodity truck at that point – indeed, it was tyres that were in desperately short supply during these golden years when the price of a Caterpillar truck tyre rose from $30,000 to $300,000 (each) because the mining companies just couldn’t get enough of them.
Since the 2011 peak, however, a number of factors have come to bear to bring prices back. The slower pace of growth in China has been a key drag on demand. China’s insatiable demand for raw materials as it went through a significant period of growth meant that it is the main determinant of many commodity prices – for example, in 2013 China accounted for 65% of all iron ore imports and 43% of the world’s import demand for cotton.
Another major brake on demand has been the strength of the US dollar. Most commodities are traded globally and paid for using US dollars as the standard currency for settlement. However, the strength of the US dollar against most major currencies has meant that although commodity prices have weakened, this has partially been offset by an increase in the $ cost of 25% since 2011.
China’s slowing pace of growth and the rise in value of the US dollar over recent quarters have served to stem demand but supply also remains buoyant, pushing down prices.
Why is supply rising when prices are falling?
The high levels of capital expenditure that the mining companies spent on new mines and equipment leading up to the peak in 2011 is resulting in rising output. To build a new mine takes many years, if not decades of planning and investment. Unlike a tap, this investment cannot simply be turned off and abandoned (although a lot has been written off as a bad deal) and thus even now new supply is coming into the market from projects started during the upturn of the supercycle a decade ago.
In the energy sector, another factor has entered the equation. Shale oil and gas production in the US has rapidly risen over the last 5 years. This has meant that the country has become far less dependent on imported oil and gas, much of which would have come from members of the Organisation of the Petroleum Exporting Countries (OPEC). The result has been falling prices as the OPEC countries reduce prices to find buyers elsewhere – the oil price has fallen from $104/barrel to $45/barrel over the last 14 months.
What are the implications of these weaker prices?
For the investment world, weak commodity prices have many and varied implications. Some are simple – lower global prices mean lower inflationary expectations which is positive for fixed income investments such as bonds; performance of stocks in the Mining sector are likely to remain moribund whilst prices remain weak.
Others are not so simple – for example, the effects for certain emerging markets will benefit depending on whether they are net importers or exporters. India, for example, is benefiting from lower oil price subsidies as energy prices fall whilst Saudi Arabia is shortly expected to announce a major bond issue to try and make up for the shortfall in oil revenues.
In general, however, the lowering of input prices for most companies will result in the opportunity to improve profit margins or lower prices with an aim to raise market shares – both positive aspects for future equity earnings growth.
At Equilibrium, we have never made direct investments in commodities. By their nature the markets are dominated by unregulated cartels and traders that have far greater ‘insight’ into future prices. This gives those participants an unfair information advantage.
We will, however, pursue investment opportunities that may be generated by this super (down) cycle where the odds are clearly in our clients’ favour.