Lesson 4: Why cycles are so important in commodities

In yesterday’s lesson you learnt more about commodity futures markets and the role that speculators play. Today’s lesson looks at the role that cycles (both short term and very, very long-term) play in commodity markets.

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.

How does the commodity super-cycle work in practice? Well, both demand and supply for commodities are inelastic in the short term. Essentially this means that it can take quite a long time for consumers and producers to react to pricing signals.

The cure for high prices, is high prices…eventually

When oil prices spike, for example, motorists may have no choice but to continue to use their car to get to work, but eventually they may be able to invest in a more efficient car. Meanwhile, commodity producers take time to invest and then bring on new supplies, ie, exploring for oil and then eventually bringing the crude to market.

Given that the typical time horizon of a major mine can be as long as 20–30 years, with high initial capital outlay and traditionally slow capital return, the planning process is very risk averse. However, once the economic status warrants a mine being brought into production then it typically takes 7–10 years to take the discovery of a new deposit through to production (although lead times can vary greatly between metals).

Agriculture supply typically responds much faster to changes in underlying demand than either metal or energy. This cycle can vary from as little as a year for grains such as corn, wheat and soy, to 3–4 years for cocoa, but perhaps even decades such as for forests.

This time delay to bring on new supplies and for demand to slow can mean that commodity prices continue to rise. The saying goes that “the cure for high prices is high prices”. Eventually the price signal will have done its work, reaching a peak and will begin to decline.

The cure for low prices, is low prices…eventually

Economic and commodity price conditions may be very different when a mine is eventually brought into production. For one if all commodity producers reacted to earlier high prices in the same way then there will be a surge in supply as they start production.

In the event of low commodity prices, producers may find it very difficult to stop production quickly given the need to generate a return on investment.

This incentive may result in prices remaining low for long periods. Eventually though demand will start to rise and commodity producers will become more disciplined. This then sets the foundations for the next super-cycle in commodity prices.

Bull markets in commodities tend to end where they start

If there is anything that you take away from this lesson it is this, demand and supply will (eventually) react to the price signals.

High prices provide an incentive to invest in new technology (e.g. genetically modified food), they provide the incentive to invest billions more in developing new supplies and they encourage consumers and manufacturers to search for alternative materials.

Evidence suggests that the expected long-run real return (ie, after inflation) from commodities is zero.

The challenge and the opportunity for investors are being able to identify where we are on the cycle. If it is near the start of a super-cycle invest but then take your money off the table once the signs are there that the market is near the peak

I hope you found this lesson on why cycles are so important to commodity markets.

In the next lesson we focus in more detail on one of the main metal markets – gold.

Go to lesson 5

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