An Interview with Nicholas Brooks

Includes: GCC, GSC, GSG
by: Hard Assets Investor

ETF Securities is one of the fastest-growing providers of exchange-traded commodity products in the world. Operating out of London, the group has attracted more than $5 billion in assets in the past year, and now offers over 100 commodity ETCs, including individual commodity funds, leveraged funds, short funds and more.

The company recently brought on Nicholas Brooks as its new head of research and investment strategy. Brooks has spent 15 years as an economist on both the buy side and sell side, and was recently the senior economist and market strategist at Henderson Global Investors.

He spoke with the editors of about where he sees opportunities in the commodities space. (HAI): There has been a tremendous flood of new assets into the commodities space, and many say this is driving up prices. Is this true?

Nicholas Brooks (Brooks): We're currently preparing a paper on the topic, as it is a major issue in the space that is not going away.

Without having the hard numbers yet, I would say this: It depends on the commodity and the market. In some of the more liquid markets, like oil and gas, the proportion of index-type assets is relatively small compared to the underlying size of the market. In more illiquid markets, there could be more of an impact.

As an economist, however, I would highlight the fact that the price of rice, iron ore and other commodities that do not have liquid futures markets have also been rising ... sometimes faster than commodities that are heavily traded. If investment flows were the only thing driving up prices, you'd expect to see these less-traded commodities lagging significantly behind. But you don't.

It's a strong indication to me that the rise in commodities is not purely investment-driven.

HAI: But do the fundamentals really support, say, oil at $125/barrel?

Brooks: I think the issue with commodities generally and oil in particular is that putting a number in it is very difficult. I don't think anyone is using a valuation model to come up with target prices on these things. When Goldman Sachs mentions $200/barrel oil, they're not doing that based on a valuation methodology. It's a directional call.

When you are trying to get a sense of where prices will go, down or up, you look at the underlying fundamentals. And those are quite price-supportive at this time. Therefore, the idea that prices will continue to rise in the near-to-intermediate terms seems entirely possible.

HAI: How are the fundamentals price-supportive?

Brooks: Very tight supply relative to demand. Everyone knows the demand story, but the big issue right now is that non-OPEC supply has been disappointing. In the past few months, most analysts have revised down their non-OPEC supplies. People think Russia's oil production in the near-to-intermediate term has plateaued. Russia had been the key driver of non-OPEC supply.

With OPEC, there's very little indication that they want to boost supply. I also question whether they even can in the near-to-intermediate term.

I'm not questioning if there are enough reserves in the ground. I wouldn't call myself a peak-oil person. But spare capacity in OPEC is near all-time lows. You have capacity utilization rates above 90%. I think it's difficult in the near term for them to boost supply even if they wanted to.

Unless you saw signs of a very sharp slowdown in Chinese or emerging markets demand, or you saw signs that OPEC was about to substantially boost supply, I think oil prices rising from current levels is very possible.

HAI: Why has new supply been so slow to come online generally?

Brooks: Starting with industrial metals in particular and metals more generally, the big issue is that we saw a substantial fall in CAPEX from 1998-2003 when prices were low. Although we've seen a pickup in CAPEX over the past few years, it takes quite some time before that leads to new supply on the market. I think the other factor is that a lot of the easy-to-access resources have been utilized already. Now, when you want to bring up more copper or gold or produce more oil, you have to dig deeper or go into unstable regions. That's added to the problem, slowing down the process of turning CAPEX into new supply.

Another element is that the costs of production have risen substantially, thanks to energy costs. You're seeing issues with being able to access water on the agriculture side as well.

HAI: Speaking of agriculture, why are agricultural goods rising so fast? Can't we just plant more crops? It seems like that's easier than developing new mines entirely.

Brooks: One issue of course is arabale land, and the limits to how quickly you can increase arable land. There's very little capacity to increase that in the U.S., for instance.

Another issue is weather. Whether it's global warming or something else, the weather has become far more disruptive than it was in the past. Australia, for instance, had two straight years of major drought, which drove up prices.

Also, you have the new source of demand from ethanol and biofuels, which has had a very large distorting impact on agricultural prices across the board.

Another element has been higher energy prices - fertilizer is energy-intensive, and the cost of labor and water and other key inputs are rising.

What you get is a series of rolling price increases across the agricultural market. When prices for corn rise, people plant more corn and less soybeans, and then the price of corn comes down but soybeans go up.

I think you can get a situation in agriculture similar to industrial metals - you get a pinch point situation where inventories and excess supplies fall low enough that consumers become price-insensitive. They need the product and they are going to get it whatever the price.

HAI: One area of the ags market that has been sitting out the rally is livestock. Is its turn coming?

Brooks: We had a situation where the feed for raising livestock got a lot more expensive along with other agricultural prices. So, the general cost of raising livestock rose in a very short period of time. As a result, you saw farmers slaughtering their stock much more aggressively than would have been the norm, which put more supply on the market in a rapid fashion, which drove prices down. In other words, the reason livestock prices were falling was driven because other agricultural commodity prices were rising.

We're now reaching a level where you could argue that supply has fallen enough that potentially you could start to see some pickup in prices. Although demand hasn't changed much, supply has been reduced. It is hard to predict when that will happen, but looking at the cyclical nature of these commodities, it wouldn't surprise me to see price increases in livestock over the next 12 months.

HAI: Are we closer to the beginning or the end of the commodities bull market overall?

Brooks: My sense is that we are really just at the beginning of the commodity bull market. I don't think it will be a straight-line rise. There are good arguments for why prices have gotten ahead of themselves right now. If the U.S. stock market comes back and investors start pulling money out of commodities, that could take some steam out of the rally.

But in terms of the long-term structural trend, I think we're at the early stages of this bull market. The key drivers are emerging markets growth is very high; China's growth looks very well supported; India's growth is coming through, and demand for commodity-intensive products is likely to continue to grow at a very rapid rate.

Outside of agriculture, a lot of these resources have been very substantially mined. You need a structurally higher price to incentivize companies to bring out more commodities. The combination of these supply/demand factors and cost factors would keep prices well supported on a medium-to-long-term basis.

HAI: What are the risks?

Brooks: The key risk to this scenario rests on China. If China were to falter substantially, that would have ripple effects on other countries. But I started in this business covering China, and I have not yet seen it stumble in any major way. The slowest growth rates over the last 15 years are 8%, if you can believe the numbers. Given demographic trends, it seems likely that will continue for some time to come.