As commodity prices crash below levels last seen at the nadir of the financial crisis its worth asking when, or indeed if, the cycle will turn and commodity prices will bottom out.
From an investors point of view commodity futures returns (which include the spot price and the risk premium from taking on hedging risk) are linked to the state of inventories in the economy. And so commodity returns can therefore be expected to be a lagging indicator of recession.
During the late-expansion period (anticipating a recession), low inventory levels imply that commodity futures experience higher-than-normal returns. Further, because of inertia in inventories, it is not until a recession sets in that commodities experience low returns (i.e. where we are now). Coming out of a recession, commodities futures returns have tended to improve only after the early expansion period has begun.
However, identifying the turning point in the cycle is becoming more difficult. The global business cycle is out of kilter with the US firmly coming out of recession while many emerging economies (Malaysia, Thailand and Latin America for example) yet to enter a slowdown. All of which makes the timing of the rebound, in terms of commodity demand growth difficult to guess.
Could shorter business cycles mean shorter commodity cycles? The rate of change in Goldman Sachs Global Leading Indicator, which tracks ten early indicators of global activity, suggests that cycles have becoming shorter over the last few years, i.e. neither positive nor negative data points persisting for too long.
As Goldman notes, shorter cycles could extend to capital investment too…a key driver of commodity supplies.
This uncertainty provides a reason for companies to delay long-term capex and instead opt for as-a-service alternatives that provide greater flexibility. But, extending this argument on outsourcing capital intensity to its extreme would also imply shorter capex cycles for the users. If the advent of ERP software led to more efficient supply chains and shorter inventory cycles, we wonder if the rise in tech-driven services business models could do the same for capital investment cycles.
If this was translated to commodity supplies it could mean that cycles become shorter and shallower than those seen in the past, even more difficult to identify and take advantage of turning points. While the rise of ‘shale’ extraction techniques has arguably reduced the supply price in-elasticity of oil production, allowing oil supply to respond more rapidly to changes in demand this is unlikely to be the case for all commodities (consider the lead time of several years required to bring on a new mine). Indeed, it can be argued that shorter, shallower cycles may not be enough of a signal to encourage commodity producers to invest, setting up the risk of a more extreme price spike further in the future.
Related article: Oil prices: History does not repeat itself, but it often rhymes