Commodity Bulls' Seven Fat Cows Will Be Followed by Seven Skinny Ones

by: Cam Hui, CFA

Remember the biblical story of Joseph and the seven fat cows?

For commodity bulls, this may be the era of the seven fat cows. In a recent article, Cynicus Economicus points out that the world has seen an imbalance between the supply of resources and labour:

[T]he availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available…

In such circumstances, the resources will flow to the labour that utilises the resource in the most cost effective way, and where there is the commensurately high return on capital.

Notwithstanding all of the fiscal and monetary stimulus, he believes that resource prices are on an upward trajectory. This may mean, that at an extreme, we may see a seven in front of gold or oil prices (and I don’t mean $700 gold or $70 oil).

Followed by seven skinny ones…
Don’t think that scenario has a happy ending, however, as the seven fat cows are followed by seven skinny ones (see my previous comment here). Commodity inflation would inevitably be followed by a deflationary collapse caused by massive demand destruction.

James Hamilton, who blogs at Econobrower, wrote extensively on the connection between oil prices and economic growth [emphasis mine]:

When I first began working on my Ph.D. dissertation in 1980, I was intrigued by the fact that the oil embargo of 1973-74 and the collapse in Iranian oil production after the revolution in 1978 were both followed by global recessions. But when I called attention to the fact there had been a sharp increase in the price of oil prior to 6 of the 7 postwar U.S. recessions up to that point, the general response was one of skepticism.

By the time I was presenting evidence of this relation at various seminars in 1981-82, the Iran-Iraq War had produced yet another shock to world oil markets and the NBER declared that the U.S. experienced a new recession immediately on the heels of the previous downturn, meaning that the evidence had now become that 7 out of 8 recessions had followed oil price increases…

We received some more evidence on this relationship when Saddam Hussein invaded Kuwait in August 1990, causing oil prices once again to double and coinciding with the 9th postwar recession. The price of oil also shot up before the 2001 recession. Add in the conjunction of the oil shock of 2007-08 with our current economic pickle, and my count is now up to 10 out of 11.

Inflation and recession?
Gregor MacDonald at believes that we are likely to experience higher volatility in commodity prices as the world economy oscillates between the forces of commodity shortages and deflationary growth:

We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–the latter well above the price levels of just a few years ago. The risk, in my view, is that both trends now accelerate. And, that we experience next something more akin to an inflationary depression.

For now, we are seeing the start of a commodity friendly environment that may culminate in a hyper-inflationary blowoff, especially if the world loses confidence in the USD.

By all means get on for the ride on the hard-asset train, but don’t forget to get off when you get to your station.