The Commodity "Super Cycle"
We are sceptical about the "commodity super cycle" theory that has become widely accepted over the past couple of years. Or, to put it more aptly, we have been long-term bullish on commodities since 2001-2002 and remain so to this day, but we are sceptical about the explanations generally bandied about for the secular upward trend in commodity prices. In particular, we do not believe that the rapid growth of China and India is the primary driving force behind the long-term bull market in commodities.
Due to technological advances the production of commodities tends to become more efficient over time. Our theory, therefore, is that commodity bull markets lasting 15-25 years ("super cycles") only occur as a result of inflation, that is, they only occur when rampant money-supply growth over a lengthy period causes a large and prolonged decline in the relative value of money. And everything we've seen over the past several years indicates to us that the current bull market in commodities is no exception, especially the fact that the unprecedented gains in commodity prices have been led by and accompanied by unprecedented increases in global money supply. Of course, anyone who thinks that the price indices spewed by governments are valid indicators of inflation will be in complete disagreement with our view.
But even if we put aside, for a moment, the likely effects of dramatic monetary expansion on commodity prices, there doesn't appear to be much evidence to support the view that the "commodity super cycle" is being driven by the rapid growth of China and India. We say that because GLOBAL demand for commodities has not risen at an unusually fast pace over the past several years. For example, according to a recent BCA (Bank Credit Analyst) report the global demand for copper rose by only 1.8% last year after a 0.7% increase in 2005; and global oil demand rose by a modest 0.8% in 2006 after a 1.5% rise in 2005. In fact, since the beginning of the commodity boom it seems that 2004 was the only year of above-trend growth in worldwide commodity demand. China's commodity demand has certainly increased rapidly, but this has largely been offset by reduced demand elsewhere due to the shifting of manufacturing facilities from the higher-cost developed world to the lower-cost developing world.
This leads to the question: if there has not been above-trend growth in the global demand for commodities, what caused the markets for most base metals to become so tight?
Part of the answer is that the initial response to higher prices was not increased supply as would generally be expected, but reduced supply due to industrial action (strikes) and government theft (also known as nationalisation). Another part of the answer has been put forward by Frank Veneroso.
According to Mr Veneroso in a report delivered to central bankers on 17th April 2007: "...speculation in metals markets in this cycle has gone further than in any other cycle in history. What we have been undergoing is a speculation to the point of manipulation, perhaps involving collusion, across a whole array of related metals markets. I argue that it is as though the famous episode of the Hunts in silver decades ago has now been taken to a power." In this report Mr. Veneroso claims to have solid evidence that the massive speculation in commodities has involved creating the appearance of shortage by removing physical metal from publicly-reported inventories.
Most commodity bulls dismiss Mr. Veneroso's analysis out of hand because he has been making similar claims for a couple of years and prices haven't yet tumbled. However, just because he hasn't yet been proven right by the price action doesn't mean his reasoning is wrong.
Given what has happened in the world of credit and credit derivatives (CDO, CDS, etc.) it is not hard for us to believe that the metals markets have been subject to, and distorted by, speculation on a grand scale. In fact, it would be surprising if well-financed hedge funds have not attempted to boost their returns by pushing the prices of some base metals to well above levels justified by traditional supply/demand factors. We therefore acknowledge that Mr. Veneroso is probably partially right, although in our book he can't be completely right because he refers to an absence of inflation during the current cycle. In particular, in his report he says that the commodity price rise of the past several years has occurred "without an accompanying generalized inflation" and that "inflation has been minimal since late 1999".
Well, someone who believes that inflation is minimal at a time when the supplies of 18 of the world's top 20 currencies are expanding at double-digit rates does not understand inflation; and someone who doesn't understand what's happening to money cannot possibly have a thorough understanding of what's happening to prices.
Unfortunately, Mr. Veneroso's well-researched report is tarnished to some extent by his lack of understanding of inflation and his resultant willingness to use government price indices when adjusting for the effects of inflation.
As mentioned near the start of this discussion, we maintain that inflation (money supply growth) is the primary driving force behind the long-term upward trend in commodity prices that began in the early part of this decade. We also think that Mr. Veneroso's analysis has some merit because it can be shown that base metal prices have made huge gains in inflation-adjusted terms over the past few years even using realistic estimates of inflationary effects. We therefore perceive considerable downside risk in the base metals over both the short- and intermediate-term.
The base metals sector is acutely vulnerable to a severe shakeout, but we expect these metals to remain in long-term upward trends relative to the paper currencies of the world. Their upward trends relative to gold probably won't continue for much longer, though, because they are now extremely over-valued in gold terms.
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