Commodities: Bust or Boom?

The American economy has been called a bubble economy. We have bubbles everywhere you look—from real estate and mortgages to bonds and consumption. There are many on Wall Street who believe that commodities have become an asset bubble as well. Oil prices have risen from $20 a barrel to today's prices of close to $60. Copper prices have gone from $.60 to over $3.00. Some would argue that base metal prices don't reflect the economics of production and are due for a sharp fall. In the short term, prices may decline based on investor perceptions. However, the bubble theory for commodity prices doesn't hold up on closer scrutiny. Unlike real estate or tech stocks, there aren't large stockpiles of supply and Larry Lawnmower and John Q aren't buying commodities as they did in the late 1970s. And unlike most asset bubbles, there aren't any signs of excess supply and the public hasn't come on aboard.

Talk to your neighbor. Is he buying sugar futures, cashing in the family silverware, or hoarding bullion coins? I doubt it. He may own an oil stock or two, but it is doubtful he is invested in commodities in the same way he owned tech stocks in 1999. He may have mortgaged the family castle to the hilt, but I don't believe he is day trading currencies or commodities. The only participants in this commodity bull market have been institutions like hedge funds and pension funds. Because the commodity markets are infinitesimally small in comparison to the financial markets, any influx of funds—albeit a hedge fund or pension fund— has a large impact on such a small market. Therefore by leveraging or concentrating its investment, any institution of size can have a huge impact on a commodity's price whether sugar, copper, or natural gas. Money coming in drives prices up precipitously and conversely in the opposite direction when hot money exits a trade.

This bull market in commodities is based on the simple economics of supply and demand.

Demand for basic commodities in the past few years has not been as strong in the western world. However, that is only part of the story.

Prices move at the margin and that marginal demand is coming from developing countries from Asia to Latin America. It is this marginal demand that is driving prices as a result of limited supply. The 2.4 billion combined population of these two countries is adding to demand pressures in a world where supplies and stockpiles are shrinking. For example in the past decade Asia has accounted for 50% of the increase in global demand for oil and 80 % of the demand for copper. Are we to believe that if the U.S. economy slows down, a new car owner in China will leave his car in the garage and ride his bicycle? I don't think so. In fact as shown in the two charts below, there has been no demand destruction in the U.S.

Source of chart at left: The Bank Credit Analyst, September 2006

So much for the myths of the marketplace. In fact by 2012 China will surpass the U.S. in automobile production. Oil consumption by the Chinese will also surpass that of the U.S. by the end of the next decade. More cars and more drivers mean greater consumption of oil.

On the supply side, many commodities are running a supply deficit that is being made up from stockpiles or dishoarding from silver to uranium. As shown in the charts below—despite higher prices—the build in stockpiles has been minimal whether nickel, copper, zinc, or oil.

Source of above four charts: The Bank Credit Analyst, September 2006

Unlike the bull market in commodities of the 1970s, which was demand-driven, this bull market is supply-driven. Since this bull market began back in 2001, it has been mainly driven mainly by inadequate supply. What we have here is a structural deficit created by decades of neglect. Inventories of many base metals and uranium are still low. Capacity expansions are being curtailed by rising costs, shortages of skilled labor and equipment, and transportation bottlenecks. What has been surprising in this cycle has been the unusually slow supply response to higher prices. Many CEOs running commodity companies today have long memories and remember the two-decade bear market in commodity prices. Yes, oil prices have gone up and oil companies have invested vast sums of money in oil and gas production. Last week's WSJ highlighted industry investment of 0 billion in 2005, up 70% from 2000. However, factor in industry inflation, which ran as high as 35% last year, and real investment increased by only 5%. That is nothing and hardly a figure that will generate the vast new supplies that will be needed to fuel global GDP growth in the next decade.

Theperception in the financial markets is that a slowdown in the U.S. economy and a global economic slowdown will reduce demand for basic commodities. However, decades of neglect and supply deficits will take time and money to correct. This is a structural bull market, which is going to last for a lot longer than most experts predict. If China sells 2,000,000 automobiles this year and next that means there are going to be a lot more Chinese consuming larger amounts of gasoline. China's economy may slowdown from its breathtaking rate of 11%. However, an 8-10% growth rate means more copper, more iron ore, more cement, more steel, and more gasoline consumption. Let us also not forget India, whose economy is growing at 9% per annum. As I have mentioned above, this is a supply-driven bull market where excess capacity has shrunk. The less excess capacity the sooner demand will overwhelm the system which is why we have been experiencing price spikes from oil, natural gas to copper, lead and zinc. You might ask yourself, if there was really a commodity bubble, would the Chinese be shopping around the globe trading their dollars for commodities? Securing access to commodities like iron ore, uranium, oil and natural gas has now become a priority in foreign policy.

As an investor you have another opportunity. Market valuations in the energy and the metals sectors are still cheap. And they have gotten cheaper as a result of investor fears and misperceptions. Investor psychology is temporarily out of whack with the underlying economic realities. This spells opportunity.

Don't Worry, Be Happy

This week Cambridge Energy Research Associates (CERA) shocked the financial markets with a report that supposedly debunks "peak" oil. Not to worry—we are told—there is plenty of oil out there. According to the folks at CERA, there is no evidence of a peak before 2030. Global production will follow an undulating plateau for the next two decades. What we will experience is a period of strong production growth as a result of a combination of conventional and unconventional oil. The report is available at CERA's website, www.cera.com. The 16 page report will cost you ,000 and is well worth the read, if you want to hear the other side of the story. I paid the money and read the report and remain unconvinced. According to CERA our global resource base of reserves is 4.82 trillion barrels and not 1.2 trillion as peak oil theorists believe. The source of this greater oil bounty is summarized as follows:

Source: "Why the 'Peak Oil' Theory Falls Down," Decision Brief, CERA, Nov. 2006

I have to question Middle East oil reserves, which we know were over-inflated in the late 1980s to achieve production quota advantages. In a similar vein I have reason to doubt heavy oil, oil shale, and exploration potential. There may be huge oil reserves in the tar sands of Canada and in the Orinoco belt in Venezuela. But reserves don't equate to big increases in production. The best example is Canada's tar sands. The reserve potential is vast. But oil sands is a mining operation that requires large amounts of energy to produce. It is doubtful that oil will flow out of the tar sands the same way that is flows out of Gharwar.

While peakists alarm us with the dearth in new oil discoveries each year, the experts at CERA point to the fact that most oil companies have made up the shortfall in replacement by the upgrading of existing fields. In the recent past the industry has replaced more oil reserves each year through field upgrades than from exploration activity. Furthermore they argue that global oil production will not be a simple logistical or bell curve as Hubbert suggested. Instead it will be asymmetrical and skewed as it passes the geometric peak. Instead of a cliff as peak oil theorists argue, we'll experience various inflexion points and plateaus as conventional oil declines gradually and unconventional oil picks up the slack, extending the peak and as well as the decline.

Are there caveats to this rosy forecast? Just a few? But these are above ground issues such as war and political changes, and the intractability in decision making by governments. But these problems are not geological as peakists believe. However, one has to consider today's oil markets where 85% of the world's oil reserves are held by OPEC and the former Soviet Union. The real players in today's oil markets are NOC's not IOC's. Their motivations may be different than public oil companies. National Oil companies are the main source of government money for their nation state. Much of these revenues are siphoned off to pay for state expenditures. A nation state may not have the desire to invest oil revenues back into exploration and production, especially as prices rise. The state instead may choose to spend that money on public programs, infrastructure and other projects that it deems necessary to maintain political power and keep the voters at bay.

For a greater understanding of this dilemma, I would suggest reading Dr. Valerie Marcel's book "Oil Titans: National Oil Companies in the Middle East." You can also listen to the author at FSN. I had the pleasure of interviewing Dr. Marcel in July of this year. [interview]

When we get down to it at, a certain point in a well's history—usually when half of the reserves have been pumped out—production peaks and then declines. Technology may extend a well's life and enable oil companies to get more oil out faster. But in the end, all wells go into decline. Oil companies have been able to replace their reserves through enhanced oil recovery techniques. However, this doesn't take away from the fact that once a well peaks, it goes into decline. And when enough wells go into decline, you have a problem. Despite enhanced recovery techniques and technological breakthroughs, the U.S. produces less oil today then it did last year, the year before, or the last two decades.

The chart on the left shows total U.S. oil production as well as projected declines by the US DOE/EIA. Our production continues to decline each year.

Companies may be replacing their reserves, but they have had great difficulty in increasing their overall production. This is a geological problem that all oil wells face. What has happened here in the U.S. is also happening elsewhere with over 45 of the 65 major oil producing countries having peaked in production. So as sanguine as the CERA folks are about peak oil remaining far out in the future I wouldn't go out and buy a new Hummer.

Why Detroit Can't Compete

Forbes published a short story on Detroit's competitiveness. On average Toyota, Honda, and Nissan generate ,400 more profit per vehicle than GM, Ford, and Chrysler. GM has to support three retirees for every active worker. The breakdown as to why Detroit loses money follows.

Cost Push Inflation

Talk to anyone today about inflation and you'll be given various explanations as to its cause. They will usually boil down to the following three culprits.

1. Cost-push inflation. This kind of inflation is due to the arbitrary demands of labor unions, which drive up wage rates and the cost of production.
2. Profit-push inflation. This kind of inflation is attributed to greedy businessmen raising prices like oil companies.
3. Crisis-push inflation. This kind of inflation is event-driven or otherwise known as "acts of God"—a hurricane, tornado, tsunami, bad winter storm, or oil embargo.

When the subject of inflation is brought up, you'll find that one of the three culprits listed above will be given as the reason prices are rising. Hence all of the talk this year by government and Wall Street officials centers on rising energy prices. What the media leads you to believe is that inflation is caused by an extensive list of things that seem causeless. It is usually the result of ill will and big business raising prices in a greedy fashion to make more profits. So the folks on Main Street hold the view that inflation is a causeless phenomenon born of the ill will of greedy businessmen.

For much of this year we have seen or witnessed politicians or media types railing against oil companies for creating higher prices at the pump, the grocery store, the doctor, the dentist's office, or anywhere else where prices are rising. We'll call this kind of inflation "profit-push inflation." But hold on, another kind of inflation is soon to visit us. The next bout of inflation is coming from the "cost-push" side as a result of rising wages. The latest batch of economic reports shows a productivity slowdown and a pickup in wages. All major gauges show labor costs picking up at a time when most company productivity gains are too weak to offset them. In addition to rising wages, the new Congress is going to make raising the minimum wage a priority. Raising the minimum wage is going to drive labor rates up and you'll soon hear about cost-push inflation as the new inflation threat. Bank on it.

Meanwhile the real reason for rising inflation is the supply of money and credit, which are ignored by the markets. There lies the real reason inflation rates are advancing. Although the Fed no longer reports M-3, one can only guess as to the rate of its rise. It was growing at an annual rate of 8% before they stopped reporting it. I have read reports by those who have reconstructed it and according to their calculations, that rate is now close to 10%. We know that credit creation this year is tracking at an annual rate of .4 trillion, up over 30% from last year. In the final analysis, this is why inflation isn't going away. It will just manifest itself in other forms like asset bubbles. My guess is the next bubble will be stocks again and eventually commodities. Take comfort in the fact that "core" rates remain benign.

Recipe For Recession

Goldilocks, a soft landing, a mid-cycle slowdown—which is it to be? It depends on three factors in my opinion. It boils down to interest rates, housing and taxes in that order.

If the Fed doesn't start lowering interest rates soon, then "Houston, we have a problem." Next year a trillion dollars in mortgages are due to reset. If rates remain as high as they are on adjustable rate mortgages, then a lot of folks sitting on 3-4% adjustable mortgages may have difficulty refinancing and absorbing higher rates and concomitant higher mortgage payments. The Fed needs to bring short-term rates down so that adjustable rates come down and allow for less pain for those whose mortgages are due to reset next year. That can help stave off making the current real estate situation go from bad to worse. Lower rates could keep more homes off the market by allowing owners to refinance and stretch out their payments over longer stretches of time.

The final issue is taxes. Each year more Americans will automatically pay higher Social Security taxes as the wage base is indexed by inflation. This captures more of your pay that will be subject to Social Security taxes. On top of that more taxpayers are finding themselves subject to AMT tax. So as it stands, taxes are going up for most Americans by default with our present tax system. However, we now have a new Congress that has raised the specter of higher taxes on capital gains, higher taxes on dividends, and higher income tax rates. There are constituents to please, new entitlements that have been promised, and new goodies to dole out to the voters. The only question is who will pay for all of these new goodies? My guess is every politician's whipping boy—the "rich" people. That definition is loosely worded and can mean different thresholds for different people. Here in the People's Republic of California, you reach the highest tax bracket on income of over ,000. On an income of ,000, you can't afford to buy a house and it barely pays for a decent apartment, but in the taxman's eye you're rich. So be careful when you hear talk about taxing rich people—it could mean you.

Raising taxes at a time when interest rates have been rising, energy prices have been escalating, real estate prices are falling, and the economy is slowing is a recipe for a recession. Maybe we'll get lucky with nothing done as a result of gridlock. Maybe Bush II will keep a promise his father didn't and say "read my lips."

So what are the chances we get a mid-cycle slowdown, a soft landing or a Goldilocks economy? It depends on a lot of things going right. Interest rates need to come down to keep the housing sector from falling into the abyss, which would also harm the banking system. Taxes need to be left alone and politicians need to rein in spending instead. What are the chances we'll get this lucky? Perhaps we get a little of both with the Fed creating lots of dollars to throw at the financial markets and the economy and maybe—for a few more years—those rain clouds can be pushed back just one more time.

Until the next time... fair winds and clear skies!