Has the commodities supercycle run its course?

By Paul Hodges

The commodities boom of the past decade is starting to look its age. Abundant liquidity and the perception that commodities could be a ‘store of value’ pushed prices to record levels in many markets. But today, investors are rightly becoming nervous about the likely fall-out, once the Federal Reserve starts to wind down its stimulus programs. Markets may therefore start to reconnect with the fundamentals of supply and demand. And this could provide an unpleasant shock for unprepared investors.

Oil markets provide a good example of what may be in store. As Chart 1 shows, there were just four years in 1900-2003 when oil traded above $30/bbl. These were during the 1979-82 Iran crisis when OPEC operated a fixed low production ceiling.

Even in real terms ($2012) oil has similarly been below this level for 78% of the period (23 years). Only since 2004 has the $30/bbl level become a floor rather than a ceiling, as policymakers:

• Held interest rates below market levels in the run-up to the financial crisis of 2008, in an effort to support growth in housing and other markets
• After 2008, initiated successive waves of stimulus and liquidity programmes in an effort to support growth in the wider economy, when the promised swift rebound failed to materialise

This period has clearly been unique in history. Yet investors and companies are now dangerously complacent about the risks they will face once central bank liquidity ceases to be the key market driver and prices begin to revert to historic levels:

• Investors have ignored evidence of slow demand and low operating rates, and have instead come to assume that today’s unprecedentedly high levels have somehow become normal
• Companies have come to assume that oil prices can never fall, and so have failed to develop the necessary scenario analysis to help them survive a period of potentially extreme turbulence

Yet inventory levels in the U.S. recently have been at 80-year highs, whilst supply is back at 20-year highs and increasing rapidly thanks to the application of fracking techniques to potential oil reserves. Equally, demand growth is slowing fast under the influence of today’s high prices. Even more critical for the medium term is that populations in many major economies are now aging. So demand growth is set to slow for decades to come, and even may go negative.

The reason is that aging populations represent a replacement economy. People in their 50s and older already have most of what they need. Equally, they can postpone purchases if money is tight. And with 10,000 Americans now retiring every day until 2030, many people’s spending power is set to reduce quite sharply as they start to depend on pension income for the basic necessities of life.

Chart 2 highlights the issue for the G-20 group of countries, who account for nearly 80% of global GDP. This shows each country in terms of GDP/capita and median population age, with the economy’s size depicted by the bubble.

Its membership comprises three quite distinct groups:

• Rich but Old. These are wealthy western countries, whose median ages are already around 40 years
• Poor but Young. These are poor emerging economies, with median ages of 25-30 years
• Poor and Ageing. This group contains just China and Russia, whose median ages are also approaching 40 years

The Poor but Young countries are too poor with GDP/capita only around $10k to drive major growth in commodity demand on their own. Equally, China is most unlikely to maintain its historical economic growth because of the impact of its one child policy. This began back in 1978, and is now leading to increased labor shortages. And at the same time, the new leadership is already refocusing the economy away from high-value export demand toward low-cost domestic consumption.

Against this background, savvy investors will be relearning the techniques of supply/demand analysis that guided markets until 2003. Demographics drive demand, and so the aging of the Western and Chinese populations means the chances of a new commodities supercycle are reducing by the day.

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