“All political lives…end in failure”, wrote controversial British politician Enoch Powell in his biography of Joseph Chamberlain. You could say the same of all upward cycles in commodity markets. In both, the seeds of that failure are within their nature; politicians get voted out of office, and even those who believe they are (by choice) getting out at the top are rarely given that benefit by posterity (Tony Blair springs to mind, for some reason….). And upswings can’t last for ever because, well, they can’t; if they did, we’d be in a fantasy world where Gordon Brown’s “no more boom and bust” was actually a rational concept. A couple of thousand years of history would seem to throw that one out of the window. That’s why I’ve always found the ‘new paradigm’ arguments pretty unrealistic.
The cycles are long – typically something around twelve to fifteen years – because of the way supply bottlenecks appear after years of low growth and choke off supply just when it is needed. At the other end of the cycle, the implications of reducing production tend to lead to its deferral beyond the ideal. In other words, at the beginning of an upswing, it takes a long time for supply to catch up with growing demand, and at the end, the reverse is true – supply overshoots declining demand.
This comes about because commodity cycles are not the masters of the economy but rather the servants of other factors. So in the late 1990s, we’d been through a period of sluggish supply growth, since low prices had been non-conducive to big exploration and development spend, but that alone was not the catalyst for the sudden surge in prices. The extra factor was the unleashing of demand – and projected demand – from China. That was the thing that fired the motor, and the prices generated by that were what caused a resurgence in exploration and production spending.
Fast forward to 2008, and the circumstances that would bring about the end of the cycle became apparent – the bursting of the credit bubble, hitting demand an almighty slap. This time, though, the run of events had a little surprise in store, in the shape of QE. That availability of ‘free money’ and its effect in depressing the return on the bulk of fixed-interest assets meant that the incentive that would normally have been there to push producers into cuts was not there. So the world sits and looks at a stockpile of aluminium that it doesn’t need at the moment, but which is there because it was more cost-effective to keep producing it than it was to take the step of closing production facilities. All the debate about warehousing, premium and so on, is for a different place, but that surplus is going to weigh on the market for some while to come.
The end of the boom coincided with a change in the oil business. Shale oil in the US has shifted the balance of that most political of all commodities away from the traditional producers; their reaction, it would appear, has been to attempt to re-assert their hegemony by not taking the expected route of reducing production in the face of declining demand but rather to increase it, with the clear intention of depressing the price below levels economic for the shale producers. There is, of course an additional side-effect to this, namely, the weakening of Russia’s position as an oil-producing state. If the price is pushed low enough, that gives real problems to the Kremlin’s ability to finance its economy and that in turn throws up disturbing geopolitical considerations.
The same strategy of pushing prices down seems to be being followed by the major (low-cost) miners of iron ore. The political dimension is perhaps not there in the same way, but the intention is the same: use your low costs to to force others out of the game.
Now, these may all seem to be a bunch of random thoughts, but there is a coherent point. I suggest that few would deny that the powerful upward cycle of the first decade or so of this century is now well and truly over (although I do believe there are still a few rock-solid bulls who regard the action of the last couple of years as no more than a setback, strangely); but I would contend that these few random thoughts suggest that the fall-out from the end of the boom is nowhere near over yet.
This is by no means an exhaustive survey, but if you’re investing in commodities, it may be a long while before you see much of a return. Flat markets look like the order of the day.