By John Plender
Published: February 14 2010 19:34
It was a seductive story for the new millennium. Popularised in the heady days before the financial crisis by Jim Rogers, the author and investor, the so-called commodity super-cycle promised a period of spectacular demand for commodities of all kinds following the emergence of a big new industrial power.
This, it was claimed, was what happened with Britain in the 19th century and the US in the early 20th. So now it was China’s turn to drive the cycle. “If history is any guide,” said Mr Rogers in a widely quoted statement that fired investors’ imaginations, “this bull market is going to last until between 2014 and 2022 and everything is going much higher.”
Global warming and population pressure added a twist to the argument by reviving interest in the catastrophe theory of the economist Thomas Robert Malthus, who argued in the late 18th century that the world’s food supplies would run out. Further impetus came from “peak oil” theory, which held that the rate of oil production was about to go into terminal decline.
Yet a compelling tale in 2007 about strong demand and short supply looked like snake oil in 2008 as commodities crashed, with the notable exception of gold. Even after their recovery in 2009, most commodity prices are still well short of their peaks. With prices wobbling again as investors have become more risk-averse over the past month, faith in the super-cycle is being put to yet another severe test.
None of this has prevented long-term investors such as pension funds from investing in commodities for the first time. Yet it is far from clear that they are a suitable match for pension and other long-term liabilities . So how do the arguments for investing in commodities stand today?
The common feature of all commodities, whether industrial and precious metals, energy or agricultural produce, is that they yield no income and are therefore at the risky end of the investment spectrum. They are, then, a speculative alternative asset class whose portfolio characteristics have more in common with foreign exchange than with traditional assets such as bonds, equities and cash. Their appeal as a hedge against inflation, trumpeted in the 1970s, has diminished since the arrival of index-linked securities such as US Treasury inflation-protected securities (Tips).
Most importantly, their theoretical long-run real return is negative. For soft commodities such as food or textiles, says Charles Dumas of Lombard Street Research, this is because rising labour productivity over time cuts the worker hours needed to produce a given unit of the commodity.
For hard commodities, such as metals and energy, finite resources and the difficulty of making fresh discoveries is clearly a constraint on supply. Yet even here, says Mr Dumas, gains in extraction technology and efficiency are still likely to reduce the real all-in cost of supplies over time. In other words, as commodities become cheaper to produce, it is hard for prices to show long-run appreciation in real terms. “While prices may be driven up from time to time by strong demand,” says Mr Dumas, “supply always has ultimately risen to match – hardly surprising, since such prices offer super-profits vis-a -vis long-run total costs.”
The long-term trend exhibited by the Commodity Research Bureau total index since 1947 appears to bear out the theory on negative returns, although oil is in a special category. Since 1945, real oil prices have increased by a notable 2.5 per cent a year. But while this is better than the negative long-run real return for soft commodities and metals, it is not very different from government bonds. On the basis of BP data going back to 1862, adds Mr Dumas, the trend line of the real oil price is flat. “This suggests,” he says, “that oil is not by itself an asset class to be recommended for the long run.”
What this underlines is the sheer power of the elasticities of supply and substitution in commodity markets – that is, when prices rise in response to an imbalance of supply and demand, the incentive to find new sources of supply and to look for substitutes increases. It also explains why countries such as Australia, with a strong commodities bias in the economy, over most of the 20th century suffered a constant deterioration in its terms of trade, or international purchasing power.
Y et in the consternation that often accompanies price shocks such as the most recent one in 2007-08, the lesson about elasticities is easily forgotten – especially since elasticities work with a long lag in capital-intensive industries such as energy.
“The argument that as the world runs out of oil we shall slip back into pre-industrial ways as energy is rationed and human behaviour has to change as a result has been regularly trotted out over the past five centuries,” says Chris Watling of Longview Economics. He cites the 16th-century scare when Britain was thought to be running out of wood and the belief of the economist William Jevons 300 years later that Britain’s primary energy supply, coal, was in terminal decline. Another case in point is the 1970s oil shock, which brought huge attention to the Club of Rome think-tank’s argument that finite natural resources would impose severe limits on global growth.
So has anything changed to undermine traditional arguments that commodities are not a genuine asset class, suitable for mainstream investors? In recent years financial innovation has certainly made commodities more investor-friendly, as bankers have made it possible to invest in baskets of commodities such as exchange-traded funds. This has removed the worry of having to source or store the real goods involved. The income disadvantage of commodity investment has also become less apparent since most institutional investors use commodity futures, paying only a margin up front while investing the remaining cash in collateral, such as Treasury bonds, that yields an income over the term of the contract.
The more fundamental attractions of the super-cycle theory to investors are twofold. First, for all the hype, there is probably something in the story. Emerging economies undoubtedly played a big part in the surge in commodity prices in the past decade and are expected to become still larger users of natural resources. “The impact of this extra demand will not be offset fully by the possibility of a reduced consumption in industrial countries even as the US enters a phase of declining growth,” says Mohamed El-Erian, chief executive of investment management giant Pimco, in his 2008 book When Markets Collide, “because emerging economies are less efficient users of natural resources and will remain so for a while.”
T he second big argument for the super-cycle theory lies in the value of diversification. Finance academics – led by Harry Markowitz, who pioneered modern portfolio theory in the 1950s – established that buying assets whose returns were not correlated reduced portfolio risk. This came to be known as a rare, possibly the only, free lunch in economics.
Yet optimism turned out in 2008 to be ill-founded when most risk assets, including commodities, fell in tandem. As for the concern about endemic shortages of supply, it is not yet clear that industrialisation in the emerging markets is leading to the structural rise in prices that would be required to turn commodities into a legitimate long-term portfolio asset.
With oil, the most promising candidate, the price set by the market still sends powerful signals to producers. The biggest owners of oil reserves, such as Saudi Arabia, Iraq and Kuwait have the ability to continue increasing capacity and production levels, while newer producers such as Brazil, Angola and Kazakhstan have also been ramping up production. Thanks to technological advance and a higher oil price, Canada’s tar sands are now economically viable. On some estimates, they are the second largest oil reserves outside Saudi Arabia. 
Peter Davies, former chief economist of BP, has long discounted the idea of an imminent oil production peak in a resource-constrained world, even if there is room for concern about the adequacy of future levels of investment. “Historically,” he told a UK all-party parliamentary group on peak oil last year, “peak oil pessimists have not only used an incorrect theoretical approach; they have also consistently and critically underestimated the world’s recoverable oil resource base.” He believes world oil production could peak within the next generation, but that this would result from the peaking of demand, not supply, because of climate policies.
For his part, Longview’s Mr Watling expects that after levelling off in recent years, oil supplies will expand enough to absorb the increase in Chinese demand to 2017 and beyond. That matters, he adds, because China will be the biggest driver of oil demand in the next decade.
In the meantime, the notion of excess demand pulling up commodity prices sits oddly with global imbalances. While the world’s biggest excess savers – Japan, China and Germany – have taken temporary measures to boost their economies, there is nothing to suggest they are willing to make the structural reforms required to prevent them saving more than they invest and consequently piling up current account surpluses.
Against that background, and as long as the larger deficit countries such as the US and UK remain reluctant to increase their already huge debt overhangs, the risks of deflation in the global economy are as great or greater than those of inflation. Deflation arising from deficient global demand is rarely good for commodity prices – witness the 1930s.
Those who wish to argue that there has been a structural change in commodity markets capable of raising the long-run real return have to provide a convincing theoretical explanation of why the elasticities of supply and substitution no longer work in these markets as they have done throughout history. Simply asserting that global population is increasing fast while Asia is industrialising is not enough.
What is clear is that the world has experienced an extreme commodity cycle, in which industrialisation in the emerging markets, combined with an astonishing construction and property boom, forced commodity prices to unprecedented levels. Financial speculation and recent stockpiling by China have added volatility to the mix. In the absence of a better theoretical explanation, it seems likely that commodities will remain a speculative asset for those seeking to make money out of cyclical fluctuations.
This, then, is a dangerous game in which fleet-footed investors such as Mr Rogers, a co-founder of the hugely successful Quantum Fund with George Soros, will probably do better than the solid citizenry of the institutional investment world.
THE ULTIMATE HAVEN
Gold can long be dull but may soon shine even more
Gold bugs through the ages have been mesmerised by the yellow metal’s capacity to provide a safe haven and a store of value. Hence the tendency for investor interest in gold to grow in response to turmoil in financial markets or to geopolitical shocks, in spite of the lack of income on the investment. The gold price also tends to rise when investors want a hedge against dollar weakness.
Unlike most other commodities, the global stock of gold is a sky-high multiple of its annual supply, which makes it a better store of value. And since there is little industrial demand for the metal, it is not correlated with the economic cycle, making it attractive in diversifying a portfolio.
In real terms today’s gold price is similar to the prevailing price in 1265. Yet gold has often failed to live up to its reputation as a good store of value. As Dylan Grice of Société Générale writes: “A 15th century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years.”
While gold has retreated from its peak late last year of $1,214.80 per ounce, it has still had a huge rise from its last deep low of $255.30 in 2001. In spite of that increase, a further rise could be in prospect. Managers of official reserves have been seeking ways to reduce an overdependence on the dollar. Since the gold market is very small relative to the US Treasury market, even a modest move into gold would have a big impact. Expectations of this have mounted since December, when the Reserve Bank of India revealed that it had bought 200 tonnes of gold from the International Monetary Fund.
Gold also has attractions for those managers of private institutional funds who are wary not only of the dollar but of sterling, the yen and the euro – on the basis that the US, Japan and the UK have serious budgetary problems, while the fiscal difficulties of southern Europe present a threat to European Monetary Union.
Gold, by contrast, has no fiscal dimension. Many are looking to the metal as a hedge in case inflation provides a backdoor means of defaulting on excessive public sector debt. And for gold investors in the current period of exceptionally low interest rates, the opportunity cost – the income forgone on other investment opportunities – is also unusually low.
PEAK COAL
In The Coal Question, published in 1865, British economist William Jevons directly anticipated today’s peak oil debate by arguing coal was a finite, non-renewable resource that would soon run down. Since he saw coal as the source of Britain’s prosperity and international supremacy, he feared its decline would undermine the country’s competitive advantage in manufacturing and shipping, while leading to what is now referred to as imperial overstretch. Britain’s coal production peaked in 1913, to be overtaken by alternatives such as oil despite Jevons’ fears that coal was irreplaceable as an energy source.
Copyright The Financial Times Limited 2010.
0 comments:
Publicar un comentario