By Greg Peel
Said the Macquarie resources analysts yesterday morning, "We have incorporated material changes to our commodity price deck. As a general rule, we see high prices being sustained for an extended period".
Now where have we heard that before? On yes – we began to hear it suggested some time after about 2004 and by 2006 it was all anyone in the sector could talk about. China was on the move, far more quickly than even the most bullish predictions had assumed. A nation of over a billion people was industrialising and urbanising in a catch-up process that would take decades. And behind China loomed India.
The world would have to readjust its thinking, some analysts suggested. There was a secular shift underway which would ensure the longer term prices of scarce global resources would step-jump to much higher average levels. Prices would remain "stronger for longer". Commodity prices had traditionally followed cycles of boom and bust, but there was a new "super-cycle" upon us given the demand impact from emerging markets.
Crusty old analysts shook their heads in disbelief. Smug in knowledge gleaned from decades of experience, many analysts suggested the "super-cycle" would only last as long as it took for supply to catch up with demand, as it always had. There would be a lag, but "scarce" resources were not necessarily that scarce. The cycle ebb of the 1990s had simply meant underinvestment in new projects. High prices would reawaken the sleeping giants, new supply would hit the market, and prices would fall. The amplitude of the cycle might extend, but "super" was a bit of a naïve assumption.
It all became academic when the GFC hit. Commodity prices "blew off" in mid-2008 and then plummeted faster than anyone had ever experienced. The GFC was the super-cycle's kryptonite.
But – and this is an important "but" – the reality is that both analyst views expressed above proved to a varying extent to be correct long before Americans started defaulting on their sub-prime mortgages. Oil might have peaked out in 2008 at an amazing US$147/bbl but nickel, for example, entered 2006 at US$6/lb, hit US$24/lb within the year and then collapsed, spending all of 2007 no higher than US$15/lb before the GFC hit.
Zinc followed a similar pattern, and copper and aluminium also suffered pullbacks before pushing back towards previous highs. Lead and tin had been slow to move and thus peaked just before the GFC.
So while the "crusty old" analysts were forced to admit they had overestimated the speed of the supply-side catch-up, they were right in that a "super-cycle" would not imply prices just kept going up forever. There would still be booms and busts based on demand and supply cycle leads and lags.
But the GFC was a game-changer. Suddenly the word "super-cycle" disappeared from the lexicon.
There was also another game-changer going on behind the scenes, starting around 2003 and then accelerating at a rapid pace into the GFC and beyond. And that was the emergence of commodities as an "asset class".
Way back in the twentieth century, investors would attempt to profit from rising commodity prices by investing in mining companies. And they would hedge against the inflation implied by rising commodity prices by investing in gold. Simple stuff.
They didn't play in futures markets – those were only for cowboys. Indeed any derivatives market was deemed too risky by the bulk of mutual funds and bans against using such instruments were even written into fund constitutions. But in the mid-noughties the issue was clouded by the rapid growth of exchange traded funds. These are listed on exchanges – just like stocks – and thus don't necessarily breach fund constitutions. They allowed direct investment in commodities.
The prices of mining stocks have always been leveraged to commodity prices. But mining brings with it a lot of other risks. ETFs provided the opportunity to invest directly in commodities and thereby bypass those risks.
Inflation is caused either by price rises or money "printing" or both. Commodity prices are behind all (non service sector) goods prices, so it made sense that the best hedge against inflation was to buy those commodities themselves. And if the reserve currency weakened as a result of the GFC, well again – buy commodities on the inverse US dollar relationship.
"It seems obvious to us," said the resources analysts at RBS yesterday, "that financial speculators and investors are exerting increasing influence on industrial commodity prices, as we note that as much as US$4 trillion has entered these markets over the past ten years, far outstripping growth in physical trade".
So not only have we had the emergence of the Chinas and Indias pushing commodity prices higher this past decade, we've had the emergence of a new breed of direct commodity investment which has pushed up prices in anticipation of the Chinas and Indias pushing up prices. And as a direct inflation hedge against the US deficit.
This is pretty much what happened to nickel, as our example, in 2006. Speculation was very much behind the parabolic price curve of that year, but what speculators failed to realise was that the price of stainless steel could not just keep going up accordingly. Demand was being destroyed. So stainless steel producers simply switched to chromium alloys and it was all over for nickel.
And zinc is not the only metal which can be used for galvanising, lead is not the only metal suitable for car batteries and tin is not the only plating that can be used to make "tin cans". Only copper and aluminium, of this group, can boast by their sheer utility that they are not substitutable (although light-weight composite plastics are beginning to replace aluminium). Yet copper and aluminium still suffered big dips in 2006 before recovering.
Another factor was the rapid response in China to rising prices (which China was feeding) as metal producers and smelters and fabricators sprung up like mushrooms, uncontrolled by an inexperienced government. Soon there were just too many players and not enough spectators.
When metals prices fell out of bed in the second half of 2008, and here we can include bulk minerals (reflected in 2009 contract price drops) and oil, the unprecedented price collapse came about due to a combination of demand collapse, the rapid destocking of high-priced inventories, and the panicked exit of speculators. All hope seemed lost. Super-cycle? Forget it.
But China began turning things around, in a desperate attempt to single-handedly revive the global economy and restore its much-needed export market for manufactured goods. If the speed of the collapse of commodity prices surprised many, the speed of the recovery (as so far as prices have recovered to date) has been even more of a shock, so quickly after the supposed worst economic disaster since the Great Depression.
China aside, for most of 2009 many market observers could not justify this rapid bounce in prices. It was clearly a lot more to do with a growing US deficit and weakening US dollar than any concept of global demand recovery. Inventories were rising just as fast as prices, and such a contradictory dichotomy implied at some point it would all end in tears.
But it hasn't.
"There is a growing body of evidence," said the resources analysts at Barclays Capital yesterday, "that the biggest ever recovery in global base metals demand is taking shape. Scepticism over the sustainability of this recovery and, in some cases, total blindness over any recovery at all, means that prices have yet to fully reflect what are turning into very positive demand dynamics indeed".
The sceptics include those who are not only sceptical about the speculative nature of recent commodity price increases, but also those who are sceptical about the strength of economic recovery in the developed world. With massive universal government stimulus now winding down, there are grave fears of a "double-dip", whether or not the developing world is driving the train. And Greece has a lot of investors spooked.
Barclays acknowledges that "market attention is still squarely focused on macro themes and news flow". That is why, the analysts suggest, commodity prices are yet to reflect the "increasingly positive demand backdrop".
Critical to Barclays' view is that global consumption of base metals is now growing at a double-digit pace, according to the data. Moreover, those inventories that kept growing in 2009 are now falling. If supply is yet again slow to catch up to demand growth, those inventories will rapidly diminish and prices can only rise. In short, Barclays believes the magnitude of the 2008 commodity price collapse is about to be equaled in the subsequent bounce.
"If demand continues to recover for the rest of the first quarter at the pace of growth implied in January [the latest data]," say the analysts, "then global base metals demand will be on track for the strongest recovery on record".
It's a bold statement. Indeed, Barclays actually expects second quarter growth to accelerate even further beyond first quarter growth. The implication is that the world will return to pre-GFC settings very quickly – just as if nothing had ever gone wrong.
You won't get much of an argument out of Macquarie. In fact, the Macquarie analysts suggest the GFC provided "valuable insight into the dynamic relationship that exists between commodity prices and supply". It's as if we needed the GFC to set the valuation models straight, because prior to the GFC we were just running into largely unknown territory – this "super-cycle" concept.
Macquarie has just revised up all of its long-term commodity price forecasts, by "material" amounts. For example, copper has been given a 10% boost. That's a small increase for a spot price forecast, but a very large increase for a long-term price. This was the whole basis of the super-cycle argument once upon a time. The "crusty old" analysts bleated that "prices always return to long term averages". The more progressive analysts said "that's true, but China is influencing a secular jump that will increase those long term averages".
And here we are. Macquarie has upgraded its listed mining company valuations across its resources universe as a result of its forecast price increases. The analysts have also increased energy price assumptions in a similar fashion – their long-term oil price has been increased by 13% – and taken this into consideration on the cost side in mining company valuations.
So is the "super-cycle" back on? Barclays sees "record demand recovery" ahead. Macquarie sees "high prices being sustained for an extended period". It sure sounds like it.
And reports last night suggested the biggest iron ore producer in the world – Vale – is demanding a 114% increase in iron ore prices for 2010. When the iron ore price near doubled in 2007, no one could quite believe it.
Before we all get a little too carried away, let's return for a moment to the speculation theme. Barclays and Macquarie are focused on physical demand, but RBS suggests that "While demand has been often discussed, mostly in the context of an urbanising emerging world, supply has been less of a concern for investors. We believe that this is about to change, and that significant speculative flows could reverse".
In short, we're back to the old argument again. The "super-cyclers" always saw demand outstripping supply, while the sceptics always saw supply catching up eventually. RBS believes that "secular drivers" – the "stronger for longer" demand argument – are already reflected in current resource sector share prices. Those secular drivers are likely to subside, say the analysts, while supply will continue to grow at an "elevated pace".
In the twentieth century, notes RBS, the US was the largest consumer of the world's base metal output with a 20% share. In 2003, China passed the US and today consumes 43%. Take China out of the equation in 2010 and "everything else is largely irrelevant".
The apparent global demand for commodities at present has been driven by global fiscal and monetary stimulus as an emergency response to the GFC and China's major initiative to stockpile commodities for various reasons, including cementing its own cost base and also helping to restart "customer" economies. In 2009, estimates RBS, China's metal imports increased by a record 18%. Over the same period, US demand fell 19%.
Barclays has noted that global metal inventories have begun to fall. But they are falling from very high levels and in the meantime, RBS's Chinese analysts assure them Chinese inventories are still in excess after the 2009 spree. Those stockpiles were built not just on government initiatives but also on local speculation, suggests RBS, and many other analysts agree.
Outside of China, RBS notes that developed world financial participants (meaning investors and speculators) now range from retail investors in ETFs, through hedge funds and short-term futures traders, to institutional asset allocators, pension funds and endowments. Investment banks are assembling whole new teams of traders and advisers to service the new "asset class". To RBS, it all adds up to the word "bubble".
In the short-term, RBS cannot see any real improvement in developed world demand. In the short-term, assuming China's GDP growth carries on at 10% (and Premier Wen is targeting 8% now), China will be drawing down stockpiles before it pays overly inflated prices. In the long-term, RBS does not see the pace of urbanisation in China in the next ten years matching the rapid pace of growth in the last ten years. Indeed, for global commodities supply to go into under-supply, as was the case in 2001 before China really burst onto the scene, the pace of Chinese GDP growth would actually have to accelerate from here, not just hold current levels, and RBS suggests this is "highly unlikely".
To take some writer's licence, RBS sees 2006 approaching.
The RBS analysts are suggesting that if investors don't have to be in the resources sector, then get out now. If they do have to be in commodities, choose soft commodities. If they do have to be in hard commodities, the bulks are a better bet than the base metals. For traders, pairs-trading (long/short across miners of different metals) is an option.
It takes two opposing points of view to make a market. We have been down this path before and we will surely be down it again in the future. The trick is simply not to be the last investor in and the last investor out.
Current indicators suggest short-term increases in commodity prices. But if it all starts getting carried away, be wary.