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, fuelled demand for resources. In a virtuous cycle, the growth drove demand in major commodity producers such as Russia, the Gulf, Australia, Canada and South Africa, whose strong economic expansion fuelled further growth globally by way of increased consumption and investment.
Changing times: The Atlantis Hotel in Dubai, United Arab Emirates. The hotel is an example of how oil-rich countries enjoying rapid growth in commodity revenues embark on grand and expensive projects. Charles Crowell / Bloomberg
The effect of increased demand on prices was exacerbated by decades of significant under-investment in commodity infrastructure, (mineral processing; refining; 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 in several ways—to play the macroeconomic cycle betting on strong growth and catch the updraft in emerging markets, indirectly reducing problems of direct investment.
In 2008, each one of these factors went sharply into reverse. The global financial crisis 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.
Resources companies compounded the problems through aggressive acquisitions that were sometimes debt-financed. 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 prices, for example, in oil, led to a sharp reduction in demand as people lowered consumption or used substitutes, such as ethanol, which can be produced from corn. Falling prices shift this balance, especially in energy importers such as China, Japan and India.
Ultimately, commodity prices will depend on recovery in growth, consumption, housing markets, durable goods (especially cars) and stability in financial markets and resumption of more normal financing activity. None of this seems likely in the short term.
Firms with large debt serv-ice commitments are being forced to produce at uneconomic prices simply to generate cash flow. Some oil exporters are producing below operating cost to maintain revenu-es to finance ambitious spen-ding plans conceived in more prosperous times. This overproduction distorts prices.
A known unknown is the performance of the US dollar. There is a complex and unstable relationship between commodity prices and dollar. An International Monetary Fund study noted that a 1% increase in the value of 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 will be mirrored in commodity prices.
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 programme 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 29km 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 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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