Why Commodities Are Still In a Bull Market
The price of commodities has declined substantially over the past year. Not surprisingly, many commodity investors are wondering whether or not we were ever in a bull market and whether the move up to record highs was simply based on speculation. While speculation had a significant impact on the volatility that occurred in the market, I do not believe that this multi-year move in the commodity markets was simply a byproduct of speculation. In fact, I believe that the fundamentals still point to a continued bull market in commodities.
A Look Back
The surge in oil prices to $147 per barrel in 2008 best illustrates the past commodity boom. Global economic growth, tensions in global hot spots pertinent to oil production provided the conditions necessary to see the steepest 6 month rise in oil prices in 35 years.
Of course, since the peak this past summer, commodity prices have now fallen at a record pace. One again, oil best illustrates this with its 75% decline since last summer as the "bubble" deflated. The broader commodities market has been drastically affected as well. The UBS Bloomberg CMCI gauge of 26 raw materials fell by 53% from July 2008 to April 2009.
Market fundamentals are largely responsible for the decline in commodities prices over the past 9 months. This summer, economic reports warned that the economies of the developed world were headed into recession and that the growth rate of developing countries was slowing. This suggested that demand for oil and also other raw materials would weaken significantly in the near term.
That the recession in Europe and the United States is worse than what the estimates of most market players were has also impacted prices; prices adjusted to reflect this disparity between actual and expected demand. Such inaccuracy is evidenced by the EU Economic and Monetary Commissioner's 2007 projection of 2% GDP growth in 2008 and 1.7% in 2009. Contrast this to actual GDP growth of .9% in 2008 overall and a year over year growth of -1.5% by the last quarter of 2008! Worldwide GDP is now projected to decrease by 1.4% in 2009. Such a drastic deterioration of economic conditions took many market participants by surprise, fueling the velocity of decline from the peak of the 2008 bull market.
The exit of speculators bullish on these commodities exacerbated the speed of the fall, but the decline simply mirrored economic realties. For example, the global recession resulted in oil demand declining in 2008 for the first time since 1983. Furthermore, the IEA recently cut its 2009 world oil demand forecast by 1 million barrels a day from earlier projections, representing an additional decline of 3% from 2008 levels.
PRICE LEVELS WILL INCREASE ONCE AGAIN FOR SEVERAL REASONS
Regardless of the recent price declines, I argue that commodities are still in the midst of a historic bull market. The price decline is only a temporary pause. I believe that the resumption of global economic growth, the continued maturation of the developing world, the finite nature of many commodities, and prospects for a falling dollar will provide the impetus for a bull market continuation.
Resumption of economic growth
The economies of the developed world constitute most of the current demand for commodities and account for most of the global GDP. Because of this, the current recession across developed countries has resulted in lower demand on a global level for commodities, especially raw materials.
As countries emerge from recession in 2010, demand will once again increase across the developed world. While US growth in 2010 may not meet the 3.2% predicted by President Obama's budget office, even the IMF forecasts US growth of 1.6% in 2010. Although the prudence of the TARP and TALF programs is questionable, the programs are beginning to unthaw the credit markets. This improved access to credit by businesses is an essential component to economic recovery.
Signs of recovery are already evident within the housing sector. Sales of existing homes nationwide rose 5.1% in March. While foreclosure sales have constituted a large portion of this increase, there are some indications that other factors are involved. For instance, the Phoenix market saw an increase in sales of 63% in March 2009 compared with a year earlier. Foreclosures as a percentage of sales in Phoenix declined from 51% to 39% during this same period. Furthermore, the combination of reduced prices and mortgage rates has made homes more affordable than ever before. The National Association of Realtors' Housing Affordability Index stands at 173.5, up 36.3% since February 2008.
Rapid economic growth within developing countries
More important to long term demand than the developed world's resumption of economic growth is the impact of the developing world. For decades, Europe and the United States have dominated global economic output, both in absolute value and on a per capita basis. However, this dominance is fading.
Since 1978, China has experienced approximately a 1000% increase in GDP, to $7.8 trillion. However, even after this rapid expansion, China remains a lower middle-income country with per capita income of $6,000. This rapid economic growth has not affected commodities demand on the same level as a similar expansion within a developed country.
However, after decades of torrid growth, China is now the second largest economy in the world. As China continues to close the gap between its per capita GDP and that of the developed world, China will require an even greater share of global commodities output. In fact, according to Barclays Capital, China already accounts for more than 60% of the global growth in demand for copper, coal, and aluminum.
According to the Wall Street Journal, Chinese demand for raw materials is once again increasing, with crude oil imports hitting a one year high in March. Chinese steel mills reported record quantities of iron ore usage in March.
Another developing country which will have long term impact on commodities demand is India. India's per capita GDP is just $2,800, compared with $6.000 in China. Currently, industry employs just 12% of the labor force in India compared to 25% of the labor force in China. As India transitions from an economy dominated by agriculture to one dominated by industry, this gap should close. .
The forces of rapid economic expansion in China, India, and across the developing world will provide increased demands for commodities. China, with a population equal to 400% of the US, consumes just 38% of the amount of oil used by the US and just 11% of the amount of natural gas used by the US.
I believe that as this large gap will continues to close, the increased demand will contribute to rising commodity prices.
Infrastructure construction in the developing world
Directly related to raw materials demand is the fact that much of the infrastructure required for industrialization within the developing world has not been completed. The roads, electrical grids, transportation networks, and modern housing all require concrete, copper, steel, and other raw materials.
As an example, consider the differences between China and the US. While China occupies a geographic area nearly identical in size to the US, it contains just 3% of the number of airports with paved runways, 25% the number of kilometers of paved roads, and 33% the number of kilometers of railroad tracks. The comparison between the state of infrastructure within India and the US is even more stark. Of course, these statistics only encompass some of the vital infrastructure needs of an industrialized country.
Specific examples of improvements include construction of nineteen additional nuclear power plants and waste treatment plants. China also contracted with Alstom, a French firm, for sixty electric regional trains which travel at 200 kilometers per hour. The regional transportation systems alone are growing rapidly, with 1,400 Metropolis cars already sold to China from Alstom. In April of this year, China announced an initiative to construct infrastructure in areas inhabited by ethnic minorities. These projects involve providing access to schools, drinking water, and electricity to the villages. Ethnic minority groups alone have a total population of over 100 million.
Providing this foundation for continued economic growth involves consumption of an enormous amount of raw materials. Quite simply, the demands of these much more populous countries will dwarf the amount of raw materials used in the prior industrialization of the developed world-in a much more condensed period of time.
The developing world will experience a rapid increase in population growth. The US Census Bureau estimates the world population to be 6.7 billion currently. The United Nations predicts that this will increase to 8.9 billion by 2050. Nearly all of this increase will come from the developing world. The demands of an additional population equal to four times that of the EU and US combined will impact the demand on both raw materials and food commodities.
Finite resources for agricultural production and raw materials
Agricultural products, while renewable, face constraints of yield and acreage. The slower advancement in yield increases on crops along with the increased urbanization of available land should limit supply as a growing global population demands more food.
Raw materials will face even greater upward pressure for a myriad of reasons. These reasons are in addition to population growth, resumption of economic growth, and industrialization which were already discussed. The supply of raw materials is finite. New deposit discoveries and increased technological efficiency have allowed production increase possibilities to exceed increases in demand until recently. However, this may be difficult in the future. Discoveries on the scale of years past are not likely to happen as much of the world has been mapped out geologically. In addition, many of the most accessible and easily extractible areas are currently producing or already completely extracted. Furthermore, across areas of North America where many areas are known to contain materials, environmental restrictions and invasive government regulations will inhibit production into the indefinite future.
In regards to oil, the OPEC cartel controlling nationalized oil companies has shown a significant reluctance to purchase the equipment required to increase capacity or to open new wells. While private companies would likely divert resources towards increased production, the countries in control of production have a dual need to transfer the funds for social welfare programs and to diversify their economies away from energy production. In addition, refinery capacity has not kept up with either the increased energy demands or petroleum extraction. Environmental restrictions are a major reason for this lack of increase. Such a situation provides further upward pressure on pricing.
In short, the most basic economic concept is the supply and demand curve. As demand increases, an increase in prices and/or increase in supply can be expected. When supply cannot be adequately increased, a sharper increase in prices is required to cause an equilibrium in the supply and demand curve. Finite materials constricting supply with growing demand will cause prices to increase.
Lower valuation of the US dollar
Currently, prices for commodities are denominated in dollars. As such, the value of the dollar impacts the pricing of those commodities. All things being equal, the value of a currency in relation to goods can expect remain relatively stable only if the increase in monetary supply does not exceed the growth in an economy. Into the foreseeable future, the growth in the "number" of dollars in existence will exceed US economic growth. Not only is the Federal Reserve recapitalizing banks with new funds, but it is also purchasing US debt directly from the Treasury in an amount of approximately $1 trillion in the next year alone.
This results in an increase in money so great that it in effect devalues the currency. Such currency devaluation will have a direct impact on commodities in general as the dollar is worth less.