3 reasons why we may be at the cusp of the beginning of the commodity supercycle
Commodity prices tend to go through extended periods of boom and bust, known as supercycles. They are expected to last much longer than business cycles. No two supercycles are the same, however, and the length of the upswing and downswing phases can vary considerably from cycle to cycle. It can take anywhere from 5 to 17 years, for example, for the cycle to reach its peak and another 14 to 28 years to reach its trough.
It is generally accepted that commodity price supercycles are likely triggered by unexpected increases in demand. The immediate effect of a change in global Gross Domestic Product (GDP) on commodity prices is fairly large.
The results show that an increase in global economic growth of 100 bps leads to a rise in oil prices of 1400 bps. The increase in oil is higher than the rise of 900 bps in base metal prices or the rise of 700 bps in agricultural prices.
Many researchers note that supercycles tend to roughly coincide with periods of rapid industrialization in the global economy.
The first cycle, generally coincides with the industrialization of the United States in the late 19th century; the second, was the onset of global rearmament before the Second World War in the 1930s; the third, with the reindustrialization of Europe and Japan in the 1950-1960s.
The last supercycle began in the mid to late 1990s, the same time as a series of important reforms were occurring in China.There are several ways in which prolonged periods of industrialization can have long-lasting effects on commodity prices. If the increase in demand is unexpected, then prices should temporarily rise above their long-run equilibrium until new production capacity is built.For commodities, the delay is further accelerated by the high start-up costs for many projects. These can cause firms to delay investments until they have a better sense of the sustainability of the unexpected demand shock and the long-term profitability of new projects.
Start-up costs are generally higher for oil and base metal projects than they are for agricultural products. It can take more than five years for a new mine to generate cash flow after initial spending.
In contrast, the supply of most agricultural products can react much more quickly, usually within the next growing season.
Start-up costs can also change over time because of technological advances. The maturation of technologies for producing shale oil has significantly reduced the time needed to develop new oil production capacity.
Also, supercycles in non-oil commodities follow supercycles in global GDP.
World shocks that drive commodity prices and the world interest rate are major drivers of aggregate fluctuations in developed and emerging small open economies.
The role of inventories has been widely analysed to explain the dynamics between spot prices and futures prices. Many scientific articles have attempted to determine whether the boom was mainly attributable to more favourable market fundamentals or to the rise of index funds.
The role of China’s economic growth was the focus of much attention. The sheer numbers influencing China’s consumption activity (economic growth, construction, automotive sector, inventory levels, etc.) gives an idea of their impact on the commodities market.
One must identify in a given commodity sector, what is attributable to a short-term logic, and conversely what is attributable to long-term structural story.
For example, falling oil prices in the second quarter of 2014 can be explained by growing uncertainty about China’s economic activity and by increased shale oil production in the United States.
Causal links between commodity markets and the real economy are obviously not limited to interactions between price levels and the business cycle.
A study in Sub Saharan countries, which are exporters of agricultural commodities show that the countries can become more macro-economically fragile: high commodity prices and the resulting extra export revenues can encourage the banking sector to excessively extend loans, which eventually become non-performing after prices lastingly fall.
As they become more financially fragile, exporting businesses may find it quite difficult to repay their loans. If this becomes a widespread and persisting phenomenon, the country’s macroeconomic and financial stability may be under threat.
The test for a supercycle is high demand and high supply with high prices.
Currently, all the three features are not present, but we find that we may be at the cusp of the beginning of the commodity supercycle due to the following reasons:
1. The global population is thought to have increased beyond 8 billion people— a striking milestone for commodity analysts.
2. Per-capita consumption of commodities remains low in emerging market economies, particularly India, which is only at a relatively early stage of the emergence of a sizable middle class, like China.
3. A higher commitment to the energy transition across G-20 nations could create the conditions for a sustained surge in demand, supply, and prices. Battery metals such as lithium carbonate are showing the sort of sustained price increases that suggest a bigger cycle is on its way, and hydrogen and carbon markets are in early days of showing strong growth in both supply and demand.
Therefore, one needs to be well-positioned to ride this cycle.
(The author is the Chief Investment Officer at IndiaFirst Life)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)