If the Federal Reserve reaches for its holster and starts guns blazing with bullets of QE3 (a third phase of quantitative easing), skip over everything I say about a coming correction and go straight to buying up commodity plays. I feel compelled to make this conditional statement given the stock market has been heavily supported by government intervention for the past two years, primarily through the first two rounds of quantitative easing.
Two months ago or so, a friend directed my attention to Jeremy Grantham’s GMO Quarterly Newsletter for April, 2011 titled “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever.” I was so struck by Grantham’s statistical analysis of long-term commodity prices, I had to read the newsletter twice and scan it several more times to fully absorb the lessons and implications.
Grantham’s main thesis is that population growth and resource limits have combined to push commodity prices to a tipping point: prices will increase over the long-term. Since at least the last 100 years, commodity prices have persistently declined in real terms. In the short-term, a hiccup in the growth story from China and better weather will cause one more large correction in commodity prices. This correction will deliver the last significant buying opportunity before the new uptrend in commodity prices resumes.
Grantham’s main conclusion:
In general, owners or controllers of all limited resources, certainly including water, will benefit. But everyone else will be worse off, and a constrained-resource world will increase in affluence per capita more slowly than it would have otherwise, and more slowly than in the past.
I have a strong preference for ownership over consumption, so I constructed a list of implications to what I think are Grantham’s key supporting points. I also constructed a list of trading and investing rules for turning these implications into opportunities that I will publish in part two.
Hydrocarbon consumption enabled tremendous growth in the human population starting in the early 1800s and particularly in the 1900s. Hydrocarbons arrived just in time to remove the constraints increasingly imposed by the previous wood-based economy. The hydrocarbon revolution saved the planet from the doom and gloom predicted by Thomas Robert Malthus in “An Essay of the Principle of Population.”
Implication: Invest in the hydrocarbon economy. The transition out of this economy should prove challenging, rocky and problematic, especially given political resistance and the sluggish will to invest in alternatives. As a result, prices should rise much higher and faster than we might anticipate sitting here comforted by the presumed everlasting sufficiency of hydrocarbons to continue fueling the expanding global economy. Early investors in alternative energy will eventually be heavily rewarded especially once all the richest nations are absolutely forced to scramble for each and every viable source of energy.
Increasing volatility in oil prices
Oil prices have experienced increasing volatility since the early 1970s. Before this time, oil averaged about $16/barrel in real terms.
Implication: This volatility should provide dips in prices that I will treat as buying (trading) opportunities…regardless of the reason for the drop, especially given it currently costs $70-80 a barrel to produce oil. See also the implications of the hydrocarbon revolution described above.
Rising productivity helped drive commodity prices down from 1900 to 2002 – with notable spikes along the way (WW1, WW2, oil crisis, easy money 2000s and China/emerging economies) that brought prices back to, or above, 1900 levels.
Implication: Declining productivity and/or a rise in price above previous spikes will be a key signal that confirms the long-term decline in the price of commodities has finally ended.
This time is different
Individual prices of commodities have increased so much that the odds are extremely small for a resumption in the previous price downtrend. There has been “…more than another doubling in annual demand for the average commodity and with a 50% increase in population…”
Implication: A reversion to the mean may only occur on the heels of some disastrous economic calamity or worldwide, massive reduction in population. Shorts on the stock market can cover this possibility (and PRAY that you actually survive this period!).
China’s overwhelming demand
Iron ore has soared in price thanks to China’s consumption of 48% of global output. China consumes at least 35% of the global production of the following commodities and products (in ascending order): nickel, eggs, copper, aluminum, zinc, lead, steel, pigs, coal, iron ore, and cement (53%). Key quote:
Theoretically, we all gain through global trade as China grows. But with limited resources, the faster they grow and the richer they get (and, particularly, the more meat rather than grain that they eat), the more commodity prices rise and the greater the squeeze on the poorer countries and the relatively poor in every country. It’s a gloomy topic. Suffice it to say that if we mean to avoid increased starvation and international instability, we will need global ingenuity and generosity on a scale hitherto unheard of.
If current squabbles amongst the rich, the middle-class, and the poor are any indication, generosity will not be one of the early responses to a resource-constrained world. I will save that topic for another day.
Implication: A hiccup in China will crash prices in commodities dominated by China, like iron ore. Monetary tightening should eventually have a very negative impact. Assuming China stays on a longer-term growth path, a China-driven price correction will not endure. Instead, it will provide a unique buying opportunity.
Productivity declines in agriculture and changes in weather
Agricultural productivity is declining sharply, especially when measured relative to a 5x increase in fertilizer use. The planet has experienced unusually bad weather the past 12 months compared to the past 100 years. Conditions for the next 12 months should greatly improve; weather patterns may even revert to the mean.
Implication: “Agflation” could dissipate from here, but the relief will prove temporary. Since betting on the weather is extremely difficult (or at least best left to upstart firms like WeatherBill), prepare to act opportunistically. Climate change and instability should wreak havoc on agriculture in a myriad of ways (see “Coping with Destabilizing Coffee Prices” for one of many examples). Climate change is another area where political wrangling will slow constructive action and suppress proactive efforts to the point where severe disruptions and price surges are almost sure to happen in agriculture. Investing in agricultural inputs, land and even crop futures should be profitable.
Grantham’s overall warning to anyone who will listen is that we are entering a world much different than the one defined by the declining price of commodities. However, there is some band of uncertainty around the timing of all these calamities. First and foremost, the global economy is still recovering from a major recession, and China has emerged as a major reflating force. This dependence will bite if (once?) China soon stumbles again. Grantham creates a hedged strategy to deal with the uncertainties in timing of a commodity correction and subsequent resumption of the secular bullish trend:
How does an investor today handle the creative tension between brilliant long-term prospects and very high short-term risks? The frustrating but very accurate answer is: with great difficulty. For me personally it will be a great time to practice my new specialty of regret minimization. My foundation, for example, is taking a small position (say, one-quarter of my eventual target) in ‘stuff in the ground’ and resource efficiency. Given my growing confidence in the idea of resource limitation over the last four years, if commodities were to keep going up, never to fall back, and I owned none of them, then I would have to throw myself under a bus. If prices continue to run away, then my small position will be a solace and I would then try to focus on the more reasonably priced – “left behind” – commodities. If on the other hand, more likely, they come down a lot, perhaps a lot lot, then I will grit my teeth and triple or quadruple my stake and look to own them forever.
In response to Grantham’s advice, I developed my own playbook to define specific actions, trades, and opportunities. I will develop and describe these in part two.
For now, here is my current line-up that is relevant to the above discussion:
Be careful out there!
Disclosure: I am long DBO, GG, GLD, SLV, PAAS, PBR, SOL, FSLR, JKS, LDK, JASO, JO, JJG, MCP, OTCPK:HREEF, OTCQX:UURAF, OTC:GWMGF, HEV, ECTY, ASYS, ANR, AONE, AONE. I am also short CAT and CCJ. I am long SSO puts.