7 March 2009

Satyajit Das: Commodities become individuals

“Holes in the Ground” - The End of the Commodity Super Cycle
by Satyajit Das March 02, 2009

Super Short Super Cycles
The commodity “super cycle” proved super short. The commodity “boom” is now officially a “bust.” Mark Twain once described a mine as “a hole in the ground with a liar standing next to it.’’ The end of the commodity price cycle has revealed that standing next to the liar is a crowd of hapless bankers, analysts and investors. So what happened?

The rise in commodity prices was driven by the confluence of a number of factors. Debt driven growth in major developed countries drove strong growth (both export and domestic) in emerging markets, such as China and India. This, in turn, fueled demand for resources. In a virtuous cycle, the growth drove demand in major commodity producers, such as Russia, the Persian Gulf, Australia, Canada and South Africa, whose strongly growing economies fueled further growth globally by way of increased consumption and investment.

The effect of increased demand on prices was exacerbated by decades of significant under-investment in commodity infrastructure (mineral processing; refining) and transport infrastructure (shipping, ports, pipelines), driven in part by low commodity prices.

The commodity boom was aided and abetted by investors, especially leveraged investors such as hedge funds. Hedge funds used commodities to bet on strong global growth and catch the updraft in emerging markets indirectly reducing problems of direct investment. Commodities also provide significant leverage making them more attractive to hedge funds.

Traditional investors also embraced commodity investments. Commodities were seen as a separate investment class with low correlation to traditional investments enabling investors to improve investment returns and reduce risk simultaneously.

The last factor was inflation. Rising commodity prices and strong growth fueled rising prices. This encouraged further investment in commodities as a hedge against inflation. The higher prices went the greater the threat of inflation and the increasing flow of funds into commodities. The momentum was irresistible.

Engaging Reverse Gear
In 2008, each one of these factors went sharply into reverse. The global financial crisis (GFC) resulted in reduced availability and higher cost of debt affecting commodities through several channels. Leveraged investors were forced to liquidate their positions as leverage was reduced and investors redeemed capital. The reduction in debt also reduced global growth sharply and the demand for most resources.

The reversal was exacerbated by several factors. Rising prices and anticipation of higher demand had led to significant investment in certain commodities and infrastructure. The time needed to build capacity meant that this increase in supply coincided with reducing demand, further pressuring prices.

The GFC also reduced cross-border capital flows and global trade. The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than $165 billion ─ 36% of the $466 billion inflow in 2008 and only one fifth the record amount in 2007. The projected decline in capital flows is around 6% of the combined gross domestic product of the emerging countries. This compares to a decline of approximately 3.5% of combined GDP in the Asian financial crisis and 1.5% in the Latin American crisis.

Global trade is also declining. In late 2008, the World Bank forecast a fall in global trade volumes for the first time in over 25 years. The Baltic Dry Index, a measure of supply and demand for basic shipping materials, has fallen 90% since mid 2008. Exports from Japan, Korea, Taiwan and China fell between 10% and 40% in late 2008 and early 2009, also signaling reduced demand for commodities.

Financing pressures also mean that it is increasingly difficult to finance trade. Some countries have had to resort to barter to obtain essential foodstuffs.

Self Harm
Resources companies compounded the problems by aggressive acquisitions that were sometimes debt financed. Expectations of strong global growth and demand, especially from China and other developing countries, encouraged leading firms in the steel, cement and mining industries to undertake ambitious acquisitions in 2006 and 2007.

For example, steelmaker ArcelorMittal undertook a cash-and-stock-financed merger. India’s Tata Steel completed a leveraged takeover of Anglo-Dutch Corus. France’s Lafarge, the world’s biggest cement producer, bought Orascom Cement of Egypt, while its competitor, Mexico’s Cemex, purchased Rinker, a big Australian rival. Xstrata, the mining industry’s serial acquirer, entered into a number of debt-financed acquisitions. Rio Tinto purchased Alcan, increasing its leverage significantly.

Declining sales and cash flows, debt refinancing requirements, difficulties in selling assets and limited opportunities to raise equity to deleverage further complicates the commodity bust. Some companies are seeking state financial assistance to survive. For example, Corus has sought assistance from the British government.

High oil prices also led to aggressive investments in alternative energy technologies that are not economic at lower prices, further complicating the price cycle.

Laws of Financial Gravity
Commodities posted their worst performance on record in 2008. Commentary on commodity markets reflects Mark Twain’s remark that, “I am not one of those who in expressing opinions confine themselves to facts.’’

Unlike financial assets, commodities, for the most part, are subject to the laws of economic gravity – supply and demand. Individual commodities are also highly idiosyncratic – you can’t drink oil, nor can you run your car on gold though, they seem to go quite well on corn tortillas!

The key to commodities is demand. Higher oil prices, for example, led to a sharp reduction in demand as people lowered consumption or used substitutes. Falling prices shift this balance, especially in energy importers such as China, Japan and India.

It is not clear how much lower global growth is impounded in commodity prices. The falloff in exports in Asian countries and the collapse in freight rates is especially worrying. Inevitable protectionism (buy “local” and currency “manipulation” to gain export competitiveness) is also a concern.

Ultimately, commodity prices will depend on recovery in growth, consumption, housing markets, durable goods (especially motor cars) and stability in financial markets and resumption of more normal financing activity. None of this seems likely in the short term.

A key dynamic is whether deflationary pressures (falling prices) emerge. In a deflationary environment, commodities will be hit hard as demand falls further. The lack of income and high real rates of interest will affect prices. In contrast, inflation would be supportive of prices as investors switch from monetary to real assets. Despite strenuous rhetoric and monetary actions by central banks, it is not clear whether debt deflation can be avoided.

Aberrant Tendencies
Short-term factors also affect the outlook. Falling prices have placed enormous pressures on companies and state treasuries dependent on resource based revenues.

Companies with large debt service commitments are being forced to produce at uneconomic prices simply to generate cash flow. Some oil exporters are producing below operating cost to maintain revenues to finance ambitious spending plans conceived in more prosperous times. This overproduction distorts prices.

There are growing supply constraints in some markets. Junior miners are unable to bring resource properties into production because of financing pressures. New investment and expansion has been deferred or abandoned. These bottlenecks may cause short-term supply disruptions creating significant volatility in prices.

A “known unknown” is the performance of the dollar. There is a complex and unstable relationship between commodity prices and the dollar. An International Monetary Fund study noted that a 1% increase in the value of the dollar results in a decrease in oil and gold prices of greater than 1%. This means the elasticity is around 1. It appears to be higher for gold than oil prices. Continued volatility in currency markets, reflecting pressures as sovereigns attempt to finance their budget and financial system bailout requirements, will be mirrored in commodity prices.

Individuals All!
Oil prices may have further downside, in the short run, reflecting continued reduction in demand as growth slows. Production cuts by the Organization of the Petroleum Exporting Countries (OPEC) may not be effective as revenue-strapped sovereign producers adjust volumes to generate cash flow. Ultimately, the laws of supply and demand, production costs and a finite, constrained resource will support the price.

The outlook for alternative energies is less sanguine. Most alternatives require high oil prices to be economic. Support for alternative cleaner energy is likely to wane as the GFC forces governments to defer climate change initiatives in the face of harsh economic conditions.

The dislocation in financial markets has benefited gold. Gold’s performance reflects increasing suspicion about “paper” money and lower interest rates. Governments continue to attempt to reflate domestic economies by traditional Keynesian spending, increasing concern about possible inflation and providing support for gold. There is a fear of a return to a gold standard, leading to hoarding of gold stock. Emerging market demand for gold, a traditional store of purchasing power, may be fueled by the threat of increased social unrest.

Other precious metals, platinum, palladium and silver, are likely to be affected by decreased demand, especially given the problems in the automobile sector globally.

Industrial metals (aluminum, copper, lead, nickel, zinc and tin) and bulk commodities (iron ore and coking coal) have been a major proxy for global economic growth, particularly demand from a rapidly industrializing and urbanizing China and India. Slower growth and problems related to inventories and oversupply may mean a continuation of weakness.

The performance of agricultural prices is puzzling. After falling in line with commodities generally throughout 2008, in December agricultural products decoupled from other assets. For example, some grains rose sharply in prices by 10% to 20%.

Prices (adjusted for inflation) are around 40% below long-run average prices. Grain inventory levels are low – around two months of global demand. Problems affecting financing of crops and trade, low prices and difficulty of hedging (increased in margins and hedging costs) have meant that plantings have been low. Major seed producers report a sharp decline in sales. The increased problems of food production from climate change also mean the risk of supply disruption cannot be discounted.

Historically, agricultural products have performed well in economic recessions. Tightening supply, risk of supply shocks and the appeal of a recession resistance asset may underpin prices in relative terms.

Agricultural products that have been linked to oil prices (such as corn, palm oil, soybeans and rapeseed) will be dependent on the broader performance of energy prices.

Bridges to Nowhere & Velocity of Pigs
During commodity booms, excesses abound. Oil-rich countries enjoying rapid growth in commodity revenues embarked on grand and expensive projects. For example, in this cycle, Dubai undertook an ambitious expansion program based on real estate, luxury hotels, airlines, financial services and English premier league soccer clubs.

The excesses are notable. The recently opened Atlantis Hotel is at the end of the first (and so far only completed) Dubai Palm, a piece of reclaimed land designed to resemble a palm tree. The Atlantis has its own theme park next door, every shop and restaurant conceivable and a mammoth aquarium (featuring 65,000 marine animals). The Palazzo Versace hotel, currently under construction, features a beach with artificially cooled sand to save guests from the hot sand as they walk from water to the hotel.

The most emblematic project of this cycle is a project proposed by Tarek bin Laden, one of Osama bin Laden’s many half-brothers. The project entails twin cities on either side of the Bab al-Mandib (Gate of Tears) strait at the mouth of the Red Sea linked by a 29-kilometer bridge across the strait. The project cost was estimated at $200 billion.

Recently, an acquaintance in financial markets announced his retirement to a life of rustic simplicity in Umbria, Italy. He had acquired a farm and was restoring it with the help of local “serfs” (his word not mine!) The farm would be self sufficient producing essentials of life ─ wheat, milk, wine and meat. The plan was to avoid the coming financial Armageddon in financial markets and the money economy.

The newly minted farmer was especially excited by the farm’s black pigs that reproduce three times each year. He referred to this as the “velocity” of the pig population. The porcine velocity is much greater, ironically, than the current velocity of money in financial markets as the recession sets in and the implosion of the financial system becomes institutionalized.

Grandiose plans tend to be launched towards the end of the boom cycle. Pigs and food may be well be where the smart money heads in these troubled times.

Fundamental demand for food and energy may emerge as key investment drivers – everybody needs to eat and we are still a fossil fuel-driven society.

Satyajit Das is a risk consultant and author of a number of key reference works on derivatives and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives” (2006, FT-Prentice Hall).


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