An alternative perspective
30 May 2013
The End of the Commodity Super-Cycle?
PROFESSOR DIETER HELM, UNIVERSITY OF OXFORD
Commodities have had a good run. Despite the biggest economic crisis for half a century or more, commodities have marched ever upwards. The reasons might be many and various – from a flight to safety (gold) to Chinese demand (oil, copper and iron ore) – but the trends have been common. Now there has been a wobble. Does this mean the commodity super-cycle has come to an end?
As with every bull market, there are always those who claim “this time it is different”. To believe that commodity prices will go ever upwards, there needs to be a structural explanation. Something fundamental has to have changed, stopping the history of cycles repeating themselves. There are two such theories: firstly, that resources are finite and hence will inevitably run out – in the process driving up prices; and secondly, China.
The finite resources brigade holds esoteric ideas such as ‘peak oil’ and applies them more widely across commodities. It is all very simple: there is a finite amount of oil; we know how much and where it is – hence there is a maximum supply. If demand then keeps going up and supply is fixed, up goes the price. The same logic is applied to copper, iron ore and gold.
TECHNOLOGICAL ADVANCES MAKE RESOURCES LESS FINITE
The trouble with this argument is that almost everything that could be wrong with it is, in fact, wrong. Let’s start with oil. It has lots of substitutes – including gas and coal – and there are a host of other ways of providing energy to transport, industry and households.
As its price rises, people reach for these substitutes. Fossil fuels are present
in massive quantities throughout the earth’s crust. The recent developments of shale technologies make any ‘peak’ for oil or gas a very remote constraint. Technologies make it possible to get more energy from fewer supplies. There is no obvious ‘peak’ any time soon.
The same sort of logic has been applied – with even less credibility – to a number of other commodities. Back in the 1970s, the famous ‘Club of Rome’ report predicted that the finite resources of the planet would lead to a general rise in commodity prices and that scarcity would limit economic growth possibilities. Yet nearly half a century later, there is no obvious physical lack of iron ore, copper, or even gold.
The fundamental mistake is to confuse a dubious physical claim with a very different economic one. Whether or not there are physical limits likely to bite any time soon (and this is unlikely), the impact of price is what matters. If the price of oil is very low, as between 1985-2000, the incentives to discover and develop new resources will be correspondingly low too. In time, the supply/demand gap closes and up goes the price – as it has since 2000. Beyond, say, $70 per barrel, all sorts of new alternatives to OPEC’s oil become attractive – from offshore and tar sands, to the Arctic. Companies start looking, and surprise, surprise, they find lots of new reserves. In recent years there have been major conventional discoveries off East Africa, in the Black Sea, off Israel and Cyprus, to complement the shale oil and gas, themselves facilitated by technological developments, which a high oil price induces. Such a process of market responses to price rises has been witnessed across the commodities in the super-cycle.
DEMAND HAS BEEN FUELLED BY CHINA
The fundamentalists claim not only that physical supplies are limited, but also that demand will go ever upwards. Their ace card is China. Looking backwards, China has indeed played the key role in the super-cycle. From 1990, it has been growing at almost ten per cent per annum, more than doubling its economy every decade. It has been on an export- orientated, energy- and commodity- intensive growth path. The fundamentalists simply project this phenomenal growth into the future. The result is a wall of demand.
Quite a lot of this demand may materialise. But before we get carried away, there are two other possibilities that the commodity bulls need to keep in mind. The first is that it might not happen. There is nothing inevitable about perpetual economic growth at seven per cent per annum plus. China has its problems. It is still a Communist authoritarian state. It has massive environmental problems and the Communist party could either turn inwards or aggressively outwards to preserve its grip on power. The economic policy framework – massive savings expropriated by the state – is not necessarily sustainable and its export markets may be challenged by lower-cost rivals and by the reshoring to the US of much of its heavy industry. China has a big energy cost disadvantage vis-à-vis the US.
But even if China does carry on growing, there is another price effect that the bulls ignore. Higher prices encourage research and development and a search for substitutes. The higher the fossil fuel price, the higher the incentive to develop new sources of energy. There is no reason to assume that energy is immune to technical change and there is a host of new technologies waiting in the wings.
That is true for many commodities.
A CONVENTIONAL CYCLE WITH A BUBBLE AT THE PEAK
The fundamentalist argument for a permanent super-cycle for commodities is therefore shot through with holes. That leaves more conventional cyclical explanations for what has happened – and for what might happen in the future. There are indeed good reasons for seeing what has happened as a conventional cycle, with quite a lot of ‘bubble’ at the top of this cycle.
Think back to the 1980s and 1990s. There was a technological revolution brought about by the new information technologies that rivalled the advent of the railways in the 19th century and electricity and cars in the 20th century. Information technology is a general- purpose technology – it changed each and every business and household. It ushered in a great capitalist boom. This ran its course in equity markets by 2000, and when the crash came, the response by governments was to engage in a massive fiscal and monetary response: ultra-low interest rates and tax cuts (in the US) and more public expenditure (in the UK). The result was a consumer and housing boom – which also provided a great boost to Chinese exports. When even this ran out of steam in 2006/2007, yet another even bigger stimulus was applied. The miracle is that it kept going for so long. Now in 2013, reality is catching up again, but this time a further massive stimulus looks much more difficult.
The result? Even China is feeling the impact – at a time when all those new supplies of commodity resources stimulated by higher commodity prices are reaching the market. So supply is going up as a result of the investments caused by the commodity boom, but demand is falling back. The abolition of economic logic turns out to be an illusion. The market is beginning to reflect these new realities. Cycles tend to bubble up, but they tend to come to an end too.
And it is proving so. The oil price has not gone ever upwards. Instead it has fallen back. The US now has the fastest growing oil production, and it has lots of shale gas as well. Indeed along with Canada and Mexico, it is on its way to a measure of energy independence. Iron ore and copper prices have also come down.
Gold, though a commodity, is in a class of its own. Its price is driven more by market psychology than by economic fundamentals, now that currencies are based on paper not gold, and with central banks reaching for the printing press in the economic crisis. Gold has come into its own as a store of value. Its rise has been extraordinary.
Yet the paradox with gold is that it is both precious and worthless at the same time – save for jewellery. The paradox goes further: if investors want something of real physical value, irrespective of what governments do, then it is better to hold physical commodities which have some use, rather than useless gold. Indeed a bit of this thinking may have helped to explain some of the froth on the top of the commodities bubble.
BUT AGRICULTURE MAY BE THE EXCEPTION
To this return to economic normalcy one exception might be added – agriculture. Here there is every reason to believe that there is structural change. Short of massive technical transformation, the task of feeding nine billion people, many of whom are likely to be richer, is going to put more pressure on land and water. As the Chinese switch more to meat-based diets, these demands may well rise even more sharply than the population number suggests.
Add in a dose of climate change and it is hard to think that agricultural products will not be on a rising price trend. There will still, no doubt, be cycles, but the baseline is likely to be pushed up.
But for the possible exception of agriculture, it looks like the curtain is coming down on one more of the great booms of the late 20th century. First, it was stock markets that fell to earth in 2000 (and have not yet remotely recovered in real terms to those heady levels of the 1980s). Then, it was government spending and welfare, followed by the real economy, employment and the recession. Now, finally it is commodities. Neither the business nor the commodity cycle has been abolished.
Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe