Commodity Markets: Where Have We Been, and Where Are We?
Over the last decade, commodities have languished in a deep bear market that saw the prices of various precious, base, and energy minerals underperform.
A brief glance at the inflation-adjusted performance of a basket of commodities finds that only 27% of the basket had an increase in their spot price as compared to today's price, with an average decline of 18%. The median decline in spot prices over the same ten years was even greater at 29%, implying that the performance has been propped up by a few outliers in the basket. Gold and palladium are the culprits in this regard, returning an inflation-adjusted 64% and 120%, respectively.
Turning our eye over to equities, we see an even grimmer picture.
Source: Google Finance
While the S&P 500 has done spectacularly over the last ten years, returning 70% to investors, commodities equities have done precisely the opposite. The TSX Venture, S&P/TSX Global Mining Index, and the iShares Global Mining Index Fund (ended 2015) are down 70%, 26%, and 47% respectively. Being heavily levered to an uninspiring price environment, both producers and explorers have felt the wrath of Mr. Market.
So yes, we have undoubtedly been in the midst of a deep bear market in commodities. But why? I contend that there is a combination of three reasons for this.
Firstly, global GDP has been stagnant since 2010, as shown in the chart below.
Source: World Bank Data
Economic stagnation has been followed by a reduction in demand for commodities. This is not surprising given the relationship between commodities and the global economy: metals share a .73 correlation coefficient with global GDP, while commodities have a .58 correlation coefficient.
Secondly, both a stronger U.S. dollar and stock market have hurt the performance of commodities. Dollar strength hurts the price of commodities a priori: a more valuable USD means fewer dollars are required to buy goods, thus deflating their price. This theory is confirmed by a simple comparison of the US Dollar Index (DXY) and the S&P Goldman Sachs Commodity Index (SPGSCI). From the period of 2008 to 2017, the USD Index rose by 40%, contrasted by a nearly 50% fall in the GSCI. Additionally, the exceptional performance of the broader American stock markets has drained both returns and capital from mining equities in the last decade, and perhaps rightly so. Why should the negative returns on mining equities hold any favour with investors while the broader markets are performing so well? The pitiful state of the mining equities has served only to further exacerbate the bearishness of commodities generally.
Thus, one can conclude that the price of commodities has been in the deep winters of a bear market on account of sluggish global growth, a strong US dollar, and alternative investments that have been performing spectacularly.
But one final, unspoken factor remains at play for commodities and may give rise to optimism in the near future: and that is the supercycle.
The Commodity Supercycle Theory
Commodities prices have always been said to be under the influence of "supercycles": prolonged cyclical price periods lasting 10-35 years that experience extreme growth and decline. And despite many claims that this is a myth, the scientific literature supports supercycle theory. While they remain difficult to predict, one can indeed retrospectively quantify cyclical patterns in historical commodity prices.
In order to have any hope in predicting future cyclical behaviour, one must come to understand the cause of this behaviour in the past. I contend that this cyclical behaviour is on account of two things: a highly elastic demand and a highly inelastic supply. As mentioned earlier, prices are strongly correlated to global GDP. Intuitively, this would suggest that commodities demand is highly elastic, meaning a small increase in demand will have a significant increase in price. Research has confirmed this intuition. Oil, base metals, and agriculture have a global GDP price elasticity of 14, 9.2, and 7.2% respectively. Conversely, the supply of commodities is highly inelastic. An increase in price has relatively little effect on the supply of commodities due to a long production time horizon. While the time to production varies from commodity to commodity, these processes can take years, even decades, in certain industries. Thus, a relatively fixed supply paired with an extreme elasticity of demand leads to the incredible supercycles that commodity prices experience.
The Rise of a New Supercycle?
The most recent period in the commodity supercycle was from the late 1990s to the end of the 2000s. The Great Recession brought the end of that supercycle, and since that time, commodities have been in a bear market excluding a brief recovery then subsequent crash from 2009 to 2010. Thus, it has been a little less than a decade since the end of the last bullish supercycle.
Given this knowledge, it is my contention that we are at the start of a new supercycle in commodities. Despite the rather short 10-year bear cycle, there are a number of factors that are promising signs for the bull cycle to come in the near future.
Supply Side Factors
Firstly, the economics on the supply side suggest that commodities prices are likely to increase in both the near and long term. While prices have been falling, producers' costs have been inflating significantly despite best efforts to stay profitable. The chart below shows precisely how much margins have fallen in recent years for the 40 biggest mining companies globally:
This isn't merely on account of falling prices. From 2006 to 2015, the aggregated operating costs of the top 40 mining producers rose from $141 billion to $390 billion, and this is in spite of the high-grading that has doubtlessly been occurring. These high costs and thin margins will have the effect of creating a sort of "price floor" for commodities. If we re-enter a bear market and prices decline much further than where they are now, producers will be shaken out and supply reduced, re-stabilizing prices.
Viewing supply on a longer time horizon, things get even more encouraging for commodities. In hopes of improving margins, companies have been aggressively slashing CAPEX, as shown in the chart below.
Note that though impairments have been declining, they now consume 40% of all CAPEX by the top 40 miners. Digging deeper, PwC found that of the $49 billion in CAPEX spent in 2016, only half was put towards "growth projects". The other half was spent on sustaining capital.
All this will have devastating consequences for supply. In order to maintain production levels in the future, companies will be forced to compete with one another in bidding on exploration and potential production projects. This bidding will bring about higher share prices for juniors and lower/mid-tier producers, offering some much-needed momentum to the commodities equity markets.
While supply factors are fairly quantifiable, thus making analysis perhaps more straightforward, demand factors are far more difficult to get right. Take, for example, how the Federal Reserve overestimates annual growth by 1.2% every year; prudent analysis would exclude the use of any specific predictions regarding commodities demand.
What we can say is this: Emerging markets will continue to be the primary driver for commodity prices. If that is the case, it is unlikely that demand will be restricted in the coming decade. China will continue to be a commodities vacuum in the future despite a slowing, stabilizing economy in the present. Even more promising is India, a country that will enjoy growth upwards of 7.7% annually until 2025. The expansion of their economy will demand further investment in infrastructure and will naturally push up commodities demand. Populations will continue to grow, and so will demand.
Overall, this demand thesis remains true, barring two key factors. Firstly, the possibility that China's growth slows significantly further, which is unlikely but perhaps possible given the recent tightening; and secondly, a popping of the American stock bubble, which drags the rest of the world's growth down with it. U.S. stocks have performed exceptionally well over the last decade on the back of loose credit and quantitative easing policies by the Federal Reserve. It may be time for a pullback. That being said, a stock market crash would likely cut into the dollar's value, giving commodity prices a boost in that regard.
If either of these events occurs, I would expect the supercycle thesis to be pushed back by at least one or two years. All in all, it is difficult to make predictions based on these speculative events. But it is highly necessary to understand where the supercycle thesis may be weak.
Commodity markets are extremely volatile and extremely cyclical. It is my contention that we have at best reached the bottom of the bear supercycle and at least will soon reach that bottom in the next one to two years. The recent tear that base metals have enjoyed in the last year indicate the potential of a new bull market, though it may be one last recovery before we truly hit rock bottom in commodities.
Trying to reap the rewards of cyclicality is exceptionally difficult, especially in commodities. But with careful and judicious analysis, those who have the fortitude to invest in bear cycles will surely reap the rewards of the coming bull market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.