The commodity super cycle - less super and more cycle

The Commodity Super Cycle - Less “super” and more “cycle”

The current so-called commodity super-cycle started in 2002 and is a decade old.[1] 2012 is starting to feel as though there is less “super” and more “cycle” in this commodity move.[2] A drawdown and more sensitivity to global macro growth makes the focus on microeconomic effects and macroeconomic factors and less on long-term price themes more relevant. There are some clear factors which affect whether there will be a long cycle in commodities and they still have potential for causing a further run-up in commodities, but their potential impact on current return generation has to be tempered.

The DJUBS index declined in May by 9.13 percent, the second worse month outside of the July through October 2008 market debacle in the last ten years for an YTD loss of 8.74 percent. The commodity index is in a drawdown of 26.78 percent since the end of April 2011. The DJUBS Agricultural index saw a decline of 9.90 percent and is down 7.37 percent for 2012.  Its drawdown is 23.93 percent since the end of August.

The bearish bias for May was extreme. All major energy markets were down double digits except for natural gas which was affected by North American weather. Both base and precious metals showed declines. Agriculture markets were down except for soybeans and meal, feeder cattle, and hogs.

Continuation of any cycle across all commodities is by definition a common macro-factor across markets and that key macro-factor is still money. Alternatively, policies which inhibit trade and growth can turn this super-cycle into a period of prolong decline. Behind this backdrop are localized market factors which are still the most important determinants driving markets. 

The complexity of commodity cycles[3] -

We have mixed views on the concept of a commodity super cycle. There has been a strong cycle that has reasonable economic foundation. It was interrupted with the 2008 financial crisis. The general commodity market has improved, yet levels for many markets are still below the highs of 2008 and is in another drawdown.

Large cycles in commodities exist. However, the measurement of any so called super or long cycle is hard to measure because there have been so few. There is no clear basis for saying what should be the length of any commodity cycle whether super or not. While there have been super cycles which have lasted for more than a dozen years, it is clear that we are at the longer-end of any cycle.

The rationale for any strong cycle is clearly associated with the overall global business cycle as well as the production and investment cycles within commodity markets. There is a long lead time between the production of commodities and the infrastructure development to generate production.  The production development time for agriculture may be as short as one or two years. For oil and metals, production development may take several years.  Given these development times, there will be a natural cycle that may not be as responsive as other production processes.   

Any super cycle has to be driven not just by production and supply constraints but also by a shift in demand. We have had a structural shift through the growing middle class in emerging markets as well as overall GDP growth in developing countries. There has been an extended period without an emerging market crisis as well as an extended period of stable growth with controlled inflation. Government have embraced market-based growth strategies that have raised income levels. Trade has blossomed over last decade even with the financial crisis. The explosive growth in the BRIC countries has been the most discussed theme on emerging market developments.

The longer-term demand side from emerging markets as a driver in this super-cycle is real, but it is still subject to changes in the global business cycle and changes in consumer tastes and demand. For example, China is moving from a phase of infrastructure capital to consumer development. The current decline in commodities matches the slowdown in global growth over the last year. The commodity slowdown also correlates with the reduction in emerging market stock prices. Given this correlation with emerging market equities, the commodity markets are behaving like other asset markets tied with growth cycles.

The length of this long cycle is related to the structural changes in emerging markets. Commodity demand growth will increase with longer-term world income levels and enhanced global trade. A simple depiction of this relationship is looking at world trade year-over-year changes against the year-over-year changes in the DJUBS total return index. While the correlation is not be perfect, world trade growth as a proxy for structural change in global markets matches with commodity gains and loses.  The slowdown in global trade has coincided with the decline in commodity prices.

The seeds of destruction for any super-cycle are sewn through price increases. Commodities are inherently mean-reverting. As prices rise, there will be a natural rationing of demand. As prices fall, the demand for any commodity will rise. Similarly, there will be a greater response in supply as prices rise. Given the natural response of supply and demand, there will be long-term price reversals at cycle extremes. 

What is the cause of any super cycle?

There may be four general reasons for a strong super cycle:

• There is a structural constraint on demand or more importantly, there are structural reasons why income cannot grow to create demand. If there is a lifting of government constraints on demand, there will be a long-term increase in prices as markets move to equilibrium. 
• On the supply side, change in government policies or structural changes will lead to price gains. If there was a period of underinvestment, the ability to produce is curtailed and prices will rise. Similarly, if there is a period of high real rates of interest, there will be less investment in commodity production.     
• Extended periods of low (high) price levels will create more long-term demand (supply) which will see a general rise (fall) to fair value. Consumer and producer behavior adapts to prolong price levels. 
• There is an increase in demand associated with inflation. A long-term cycle will occur if there is a long-term excessive money growth.[4]

Most super cycles have been associated with war and economic upheaval. These periods are also   associated with inflation. Price cycles have been closely associated with wars. World War I, World War II, and Cold War have all been periods of cycle extremes. The breakdown during the Great Depression, the Industrial Revolution, the evolution of emerging markets and the WTO have all served as catalysts for commodity cycles. The current cycle is actually missing the more traditional global dislocation stories for price highs. Not that we need a war or higher inflation, or  structural change that will lead to higher price, but this is the requirement for a much longer up cycle.

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[1] There is no well-defined method for determining the beginning or end of a long commodity cycle. In fact, the dating process of any business cycle is not clear-cut and the peak of and troughs of business cycles is often subject to delays. In the US, the NBER business cycle committee determines dating and even though there is a set of variables, the process is not mechanistic.

[2] An analysis of commodity prices back to 1973 in the recent IMF World Economic Outlook suggests that the current cycle is very different when broken down by commodity sector. Agriculture and raw materials are still half the price level in real terms. Metals are flat and only energy has increased by over 150%.

[3] Many market commentaries and investors have focused on the concept of a commodity cycle as measured by the fluctuations in a commodity basket. The concept of a broad commodity cycle is somewhat suspect given the diversity of markets within any basket. Agricultural markets can move in opposite direction from energy or base metals. However, the financialization of commodity markets and the growing linkage between markets makes any cyclical amplitude more likely.

[4] The monetary growth story which will lead to commodity inflation is still one of the key rationales for a continuation of the super cycle. The money inflation link during this financial crisis has been tenuous, but most prior super cycles in commodities have been linked to excessive money creation.