Many investors in commodities could be forgiven for thinking that the good times are back. Since the start of 2016 one measure of commodity prices is up over 41%. The best performing commodity, natural gas is up over 70% in the past twelve months while both crude oil and zinc are up around 50%.
Investors and other with an interest in the outlook for commodity markets might assume that because some commodities have gone up sharply then others are sure to follow or that the recent increase in commodity prices heralds more extensive, longer term gains. Indeed, net positioning among investors in commodity futures contracts is at record levels, reflecting optimisim of further gains. The question is more than just academic. Investors in particular might be emboldened by recent gains and think that this is just the start of a whole new super cycle.
But rather than try and know the unknowable (i.e. the future) it far better to try and understand where we are now in the cycle. In the world of investing nothing is as dependable as cycles. Commodity price cycles rise as demand overwhelms the pace of supply to respond before eventually supply overwhelms demand before the cycle eventually returns to square one, and it begins again.
Research examining centuries of commodity price data has tended to sketch a pattern of 15–20 year super-cycles (a period of rising prices), followed by a slide in prices over the following 10–15 years when excess investment leads to a flood of supply.
The most recent super-cycle in commodity prices had its origins in 1998, when prices approached their lowest for 20 years (equal to depression levels, when adjusted for inflation). This was followed by the emergence of China as an industrial force, which drove commodity prices up in the first decade of the 21st century. Most industrial and agricultural commodity prices peaked in 2011 with oil peaking in mid-2014.
Stating the obvious here but that would mean that the down cycle in commodities has been less than half of previous commodity cycles. Is that really realistic? Has all the excess baggage (debt, overcapacity etc.) that was built up in the boom times really been rung out of the system?
A cursory look at any long term chart showing nominal commodity prices shows that even within long periods of rising or falling prices there are still lengthy periods when prices run counter to the longer-term trend. In addition, not all commodities will necessarily behave in the same way during the period of a commodity cycle. We have highlighted before that commodity prices are prone to sharp price spikes or drops even within much longer term cycles.
Related article: Copper and oil prices: Lower for a bit longer?
And that begs the question, if this is the start of a new super-cycle then what are the catalysts? And more importantly are they strong enough to drive commodity prices back to and beyond the highs achieved in 2011?
The prospect of a weaker US dollar and rising inflation expectations are perhaps the main two macro factors that have driven investors towards commodities over the past year. Coupled with a sense that prices for many commodities had hit a bottom early in 2016 funds have moved back towards the sector. Nearer term a rapid expansion in credit in China as well as curbs on production at domestic coal plants has increased demand for seaborne coal, in turn boosting prices of iron ore and many other metals. Producers have also taken direct steps to influence the supply-side too from Glencore’s decision to shut-in significant amounts of zinc output to OPEC’s agreement to cut output. But arguably there isn’t yet at least a powerful enough driver of commodity demand (or persistent curtailment to supply) on the horizon that could drive gains longer term.
Most commodities are arguably then still in the normalisation part of the commodity cycle. This is where oversupply and low prices incentivise production cuts and encourage incremental demand growth. Once through this there is the rebalancing phase as falling supply and rising demand lift prices, eventually returning the supply-demand balance to equilibrium.
History suggests that this rebalancing phase tends to be associated with the sharpest increase in prices. This is probably the phase that industrial commodities such as zinc, lead and cotton and more recently copper and oil have been going through. Agricultural commodities such as corn, soybeans and wheat could be next.
Once commodities move through the rebalancing phase, the trajectory typically becomes less certain due to the length of time and the many variables involved. Analysis of historical cycles by Cohen & Steers estimated that commodities move from rebalancing to tightening approximately 70% of the time.
What is the inference from the rebound in commodity prices? Investment banks, other pundits and the media are becoming increasingly confident in their attitudes to commodities. Although the peak might not be here just yet, it always pay’s to look to the opposing side when one side of the boat becomes too crowded. Goldman Sachs recently likened the credit driven rally in commodity prices to the 2008 boom in commodity prices. There is no sense, yet at least of euphoria in the market where investors are getting ahead of themselves.
The size of the net long position will require prices to increase further or otherwise risk investors pulling funds out of commodities. The possibility of a stronger US dollar coupled with rate hikes in the US could put a lid on further gains in commodity prices. A sharp rise in US shale crude production combined with a return to historical levels of OPEC compliance could finally break out the narrowing in crude price levels to the downside. China meanwhile may well slow during the rest of 2017 putting pressure on industrial metals in particular.
There is a possibility that this commodity super-cycle and those of the future may become shorter and shallower. More data and importantly more accurate data on the stock of commodities in use at any one time, the expansion of ‘manufacturing like’ processes in US shale oil and gas to other commodities and more liquid and sophisticated hedging tools may enable both producers and consumers to more accurately balance commodity supply and demand.
That could be the future. With oil being one of the primary driver of cost across many other commodities a stable equilibrium around $50 per barrel could prompt less volatility in other commodities. The more likely outcome though is the way it has always been, that oil and other commodities are never in equilibrium, always moving further away and towards it but never stable.
For now though be cautious about extrapolating gains in industrial commodities out too far. There are likely to be further disappointments ahead before fundamentals justify higher prices.