It is said that the surest cure for high prices is high prices. This is especially true of commodities. Inherent in the market for these materials is a self-correcting mechanism that ensures prices never get too high or too low without eventually rebounding back … kind of like the water in your toilet.
This phenomenon occurs for a simple reason: Commodity prices are a tax. And like all taxes, they are an evil, blood-sucking, demon that must be banished to hell! (sorry, my Republican half took over there)Thisparticular tax is paid from commodity consumers to commodity producers (whether companies or nations). The higher the price, the higher the tax. When commodity prices increase, profit margins for consumersare squeezed, projects go from positive to negative returns on capital, and purchase managers the world over cuss, scream, fear for their jobs, and then stop buying. We call that demand destruction.
Producers get really horny in a rising price environment and ramp up production. Unfortunately for producers, they rely on consumers … you know, to exist. So when demand plummets because prices are too high, producers are left holding a bag full of sawdust and emptiness.
“You can never convince a man of the truth if his salary depends on him not knowing the truth” – John Maynard Keynes
Some of you don’t like to hear this whole “commodity prices are a tax” argument. Take my buddy … let’s call him “Lane” for the purposes of this article. Lane is an investment broker from Calgary, Canada, which is essentially the Texas of Canada, equipped with fake cowboys, oil barons, and even Taco Bell. All of Lane’s clients are oil executives. Every single one of them, including Lane, is almost entirely invested in oil. Ask Lane how he feels about the economy when oil is at $110 and he’ll invariably respond “Great!”. And, of course, the oil industry is always stunned when prices collapse. Calgary vehicles should have bumper stickers that read “Please God, just one more boom! I swear I won’t screw it up this time!”
***Foot-in-Mouth Aside: Obviously, oil has some supply side issues that will likely ensure it trends higher over the next few decades. Prices will, however, exhibit extreme volatility brought about by the factors I am describing. Either way, I just couldn’t resist the opportunity to take a shot at my buddy “Lane”.
While I’m sure some of you won’t let a good rational argument get in your way, might I present Exhibit A.
Looking at this chart, one could reasonably state that we are simply in the latest bear market rally in what could be called commodities’ “Lost Century.” This bear market rally has been caused by a number of factors.
First, the US dollar has been pummeled for the last decade by gigantic US federal deficits, 0% interest rates, and enough quantitative easing to make a grown man cry. The poor US dollar. If the US dollar had a face it would look like that of a battered UFC fighter.
Then there was the housing bubble. Remember that? Almost $1 trillion in bad loans were handed out to build houses that neither people nor businesses could afford. I bet that will cause some commodity demand.Housing certainly cannot be blamed for the near record prices that prevail today, however.
Then, there’s China.
We’ve been hearing about it for at least the last 5 years: Chinaand its insatiabledemandfor commodities. It’s been called many things: the Chinese Economic Miracle, the Great Paradigm Shift, the MagniferrificExpansNation (ok, no one calls it that).Since the 1978 economic reforms, China has not experienced annual GDP growth lower than 3.8% (a great year in the developed world). China’s massive infrastructure needs have created an economic black hole, sucking up raw materials like an industrial strength vacuum cleaner (or 1.3 billion industrial strength vacuum cleaners).
(I spent 20 minutes looking for a suitably impressive vacuum cleaner video on Youtube and I came up with NOTHING. Youtube, you disappoint me).
***ME-SAVING-YOUR-BUTT ASIDE: Investors should always treat with caution any statement that conveys absolute certainty. They promise investment Utopia and deliver pain. A slam dunk! A can’t miss deal! A sure thing! … a riskless return on your money. My fund guarantees 1,000% per year! Housing prices never go down! The Rapture is coming! China’s demand for commodities is insatiable.
P.S. The last time anything turned out to be truly “insatiable”, it was called The Blob … and that didn’t turn out well for anyone.
Anyone that’s ever been long commodities uses the same old story. They travelled to Beijing and saw hundreds of brand new buildings that weren’t there 10 years ago. “How incredible!” they marvel. Too bad they never took the time to actually look inside the buildings. They may not have been so impressed.
1.3 billion is a lot of people, but has anyone ever investigated what China actually does with all these commodities? Thankfully, a few people have over the years.
That’s right: they build entire cities that are empty. Bridges. Museums. Schools.Stadiums. Concert halls. Entire. Cities. EMPTY!
Does this bother anyone else? I realize I’m not a businessman the likes of Mark Cuban or Sir Richard Branson, but this doesn’t strike me as a money-making proposition.Most banks require 50% to 70% of a condominium project be presold before construction even begins. Once the building is erected, all your capital is invested and there is no way to get it back … you know, unless you sell some units. If you can’t sell any, then the banks are stuck with a bag of literal emptiness.
I have heard some common rationalizations for this absurd malinvestment. My favorite: “Oh, don’t worry about that. A large portion of China’s population is still rural and all of these empty buildings will be filled as China’s population urbanizes. They’ve got these 5-year plans and that’s part of the next plan. And that’s that.”
Let’s exam this statement, shall we.
First of all, China is not the Borg. I know many business leaders have romanticized China’s ability to make swift policy changes without having to bother with that petty thing called Democracy, but it’s not the well-oiled machine they make it out to be. China has many political bodies with their own ambitions and over a billion individuals with their own welfare and interests paramount to any dictate from on-high. And if that dictate involves moving to Ordos, forget it.
It’s true that China’s population has urbanized at a rate far faster than any developing nation before it. And this pace is expected to continue due to natural market forces and government incentives. Estimates vary greatly but a ballpark figure is that ~500 million people will likely urbanize from now to 2050.
See. Those homes will be filled no problem! Except ….
China has a difficult demographic situation. Its population growth is already much lower than many developed nations and its population is old, damn old. China’s as old as Europe! … and Europe is practically back in diapers. By 2050, over 1/3rd of China’s population will be 65 years old. These empty cities don’t strike me as the ideal retirement communities.
There’s more! In order to move to these cities, the average Chinese worker will actually need to afford to live there. And that’s going to be pretty difficult considering the average urban Chinese worker makes no more than $6,000 per year and the average home costs upwards of $100,000. Not even Lehman Brothers would buy that mortgage … nevermind, they probably did.
I almost forgot! To combat inflated housing prices, China has actually enacted a number of new regulations that limit investment in domestic real estate. That’s always a good way to deflate demand for commodities.
So where does all this lead?
Well, in the worst case (or the best case depending on your investment strategy), China completely collapses. Years of massive spending halts almost immediately. This pushes up the US dollar (for many reasons) and creates tremendous slack in the commodity market. Commodity prices plunge.
In the best case scenario, China miraculously stickhandles through this mess by developing a consumer culture of its own. I have read many articles that suggest this is happening to some degree. The Chinese middle class slowly is able to afford to move into all these empty buildings. But even in that scenario, building ceases or at least slows greatly. The Chinese have pulled forward all this future demand for housing, so when the future arrives, they won’t need to do any building. Commodity prices fall.
In the “pray-to-God-it-doesn’t-happen” scenario, the Chinese continue to build these Ghost Cities to hit their GDP targets pushing commodity prices even higher, eventually plunging the global economy into another recession.
None of these outcomes is particularly appealing to those long commodities.
Thankfully, the Chinese appear to have woken up a bit. Their latest 5-year plan states they want to focus on the “quality” of GDP. Hhhmmmm …. Perhaps building empty cities qualifies as GDP growth of “low quality” variety.
HERE ARE A FEW CAVEATS THAT I WILL FALL BACK ON SHOULD I BE PROVEN ENTIRELY WRONG
This thesis pertains mainly to industrial metals. Oil, as I mentioned, has its own supply issues that will keep its prices elevated. And, of course, precious metals like gold trade as though entirely unhinged from reality, so forget them too.
But industrial metals like copper and iron will get walloped.
Here’s how to play it:
Commodity exporters like Brazil, Australia, Canada, and Russia will feel the pain, Australia probably the worst of all because it doesn’t have as much energy or agriculture to rely on as, say, Canada.
The countries likely to benefit are the US and India. These are consumption economies that are paying a lot of tax to commodity-producing nations.
I am personally looking to short small-cap copper producers that trade like a high beta copper etf.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.