Five Myths About Commodities

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By Rudi Filapek-Vandyck, Editor FNArena

We journalists are an odd bunch. We’re expected to know a lot about a lot, but at times, all we do is display how little we really know; and nowhere does this become more apparent than in our reporting on financial matters. Apart from the fact that we sometimes fall for the same hype as our readers, viewers and listeners do, some times we collectively stop thinking, just like you. We also watch each other and repeat each other’s errors – over and over again. Above all, however, we reveal through the many inconsistencies in our reporting, the small and bigger errors we make, and through the half-truths and misinterpretations in our reporting that we are, at the end of the day, just as human as you, our daily audience.

Unfortunately, you tend to rely on us, or at least on parts of our work, and this carries the obvious risk that some of our errors will become institutionalised. I therefore thought it timely to issue a few clarifications. If it doesn’t prevent you from making seriously flawed investment decisions, at least it will increase your personal insight and knowledge.

Before we continue with what I believe are the five most commonly reported “myths” about commodities that have crept into daily financial reporting, I’d like to make a special mention to the “commodities are now in a bear market” conclusion. At present I come across this sentence on a daily basis.

Last calendar year the price of nickel fell by some 40%, and price falls for lead and zinc were not far off that figure either. Ask yourself: did you only once come across the notion that these commodities had now entered a secular bear market?

Sometime during the first months of calendar 2008 global equity markets had fallen to more than 20% off their prior peaks. It was widely reported they were now in a secular bear market. Someone, somewhere must have thought hey, if a 20% fall for equities means they are now in a bear market, surely the same must apply to commodities!? And so it is that we are now hearing, and reading, that commodities have entered a secular bear market too.

This is incorrect. Commodities are by default much more volatile than other assets. They move up by 300%, than retreat 50%, and move up again. That’s what commodities do; it’s their inner nature. However, having said this, through a strange twist of synchronising circumstances, those who are reporting this “misinterpretation” are currently closer to the truth than those who are denying it. The universe certainly has its own sense of humour.

Confused? Read on. It’ll all become clearer.

Myth number one is a truth, but it is widely used in a manner that makes it a myth, and a dangerous one too: commodity prices will remain “Stronger For Longer”.

Let me take you back to the turn of the century, now a little over eight and a half years ago. Oil was priced at US$27 per barrel (it was at less than US$20 throughout most of the nineties), uranium was at US$9/lb and gold was at US$280/oz. Compare those prices with today’s prices of US$110, US$64.50 and US$789 respectively. Even though all prices for commodities have weakened significantly this year, and those three mentioned are certainly no exception, current prices are nevertheless still significantly above levels that were common only a few years ago.

If you look closely at the prices I mentioned above you’ll see that even if current prices would drop by 50% from their current levels (which are already significantly below peak prices recorded earlier this year or last year), all these commodities would still be significantly higher priced than eight years ago. This is the true meaning of “Stronger For Longer” – it does not mean the price of commodities goes up year after year. In fact, there is now a strong case that most commodities will be cheaper next year in comparison with prices recorded in the first half of this year, and many of them might again become cheaper in the year thereafter.

This has now brought a whole new dynamic to the sector: previously producers could get away with production interruptions and other operational problems, because commodity prices had embarked on a steep rising path, and thus the overriding effect was always still a positive one (as earnings and cash flow would still be boosted by higher product prices). Now that prices are declining, the overriding effect carries a negative bias: as product prices are falling, producers will need to come up with the goods. Not only will their production increases have to keep up with price declines for their products, but what about their bottom line and rising costs?

Investors might want to take all this into account when reviewing their investment portfolio and strategy. (The above mentioned commodities are only a few examples, but the same principle applies to all commodities).

Myth number two is that as the size of China’s economy grows, annual GDP growth of 8-9% in China next year will still be OK. From a demand perspective this should be similar to the 11%-plus figures recorded in the past, or so the reasoning goes.

China needs to create 10 million new jobs each year. To put this in perspective: this equals the size of the total population of Belgium; all royalty, infants and children, elderly and foreign passport holders in the country included. Every year again. Failure to do so might trigger social unrest and that is one thing Chinese authorities are trying to avoid at all costs. Economists estimate such a mandatory jobs creation requirement equals annual GDP growth of at least 9%. In other words: were GDP growth in China to slow down to 8% it would “feel like a recession”.

China has deliberately slowed down parts of the economy to improve overall air quality for the Olympics in Beijing, and to avoid embarassing accidents while the world is watching. The key question will be how fast things will be ramped up from September onwards? One thing appears certain though, and that is the focus of the country’s rulers is likely to shift towards supporting economic growth. This is one pillar underneath commodity bulls’ view that the sector remains poised for a swift come back towards the end of this year.

Personally, I am of the view that many a market commentator, and investment expert, is too narrowly focused on what happens in China. Yes, things might pick up in China, after an anticipated weak third quarter, but what is happening in the rest of the world? Previously, demand for commodities was coming from solidly growing developed economies plus rapidly growing emerging economies, China on top. Now two thirds of global GDP might already be in recession.

To put it in another way: China may have become more important than any other country on the globe for commodities in general, but China is hardly more important than all other countries combined.

I rest my case.

Myth number three: the price of crude oil can easily rise to US$200 per barrel, or higher, in the near term.

Here’s what I wrote in June: If the price of crude oil goes to US$150 per barrel, expect to see the ASX/S&P200 index at 4900 (at the time the index was closer to 5500). As it turned out, I was wrong. Oil only had to surge deep into the US$130s to push Australia’s major share market index below 5000. But I think the underlying message is clear: were crude oil to surge to the dizzying highs that have been mentioned over the past months, the world as we know it would come to a crashing end. And there will be no place to hide.

The highest forecast I have come across, thus far, is from Eric Sprott, CEO of Sprott Asset Management in Canada. He can see the price of a barrel of light sweet crude oil (also known as West Texan Intermediate) reach US$400 in the years ahead. In line with my prediction above, Sprott advises investors to go overweight sectors that should benefit from extremely high oil prices, including other forms of energy and gold (the ultimate inflation hedge). If you are a true believer in such a scenario you should sell everything else.

I disagree with Sprott on one point only: I think the world will crash as never before and ultimately this will drag the energy sector into oblivion along with all the other segments of the world economy that will have gone to hell first. In essence, we have already been going through such a scenario in mini-version since June. This is still ongoing. Peak oil has nothing to do with what’s happening in the oil market this year. Experts are increasingly coming to the conclusion that what has caused this year’s oil craze has been a temporary disconnect between processing, supply and demand of diesel. The Saudis are right: there never was a shortage of crude oil. The world just got a little crazy, that’s all.

Myth number four: fundamentals, not investors, move commodity prices. Of course, and fundamentals for all commodities, from soybeans to grains, to base metals, to energy, to precious metals have all, independently from each other, significantly deteriorated at the same time over the past few weeks. Hmm.

What I have noticed is that other experts have now started to incorporate financial investors as a key factor in their determination of the price direction for commodities. This week ANZ Senior Commodity Strategist Mark Pervan formulated it as follows: “The extent and speed of the declines [in commodity prices] has prompted us to downgrade our 2008-2010 prices forecasts between 10-25%, and again highlights that investment funds seem to dictate the short-term trading ranges for most commodities.” There you have it.

In case you still refuse to accept this as a fact: a recent global fund managers survey by Merrill Lynch showed fund managers started to withdraw, en masse, from commodity markets in June. Guess when prices started to decline?

While most stockbrokers, and market commentators, tend to focus solely on China to underpin their long term bullish view on commodities, I say the bull market for commodities since 2003 has as much been the creation of a long period of underinvestment in the industry; exceptionally low interest rates across the globe, but more specifically in the US; a significant decline in the US dollar; the opening up of financial and investment markets through new innovations and products; a sudden push into increased globalisation and international trade; and an almost unique synchronisation of economic growth across the major economies of the world.

Myth number five is “a weaker Australian dollar is to the benefit of resources companies in Australia”.

Let me guess: at first you’d be inclined to accept this as a given, correct? When the Aussie dollar embarked on a steep rising path over the past years, how many times did you hear this would hurt the bottom line of resources companies? There is a reason why you never heard about this, it is because the main reason behind the Aussie dollar’s strength was far more important: strong global growth and rising prices for commodities. With commodities posting price gains of 30% and more, who cared about whether the Australian dollar was posting gains of 15% and more against the US dollar?

Now the opposite is true: global economic growth is slowing and commodity prices are in decline. The declines have been much larger than the 10% or so value loss for the Australian dollar. What holds true in good times, equally applies in not so good times. The currency merely plays a mitigating role for Australia’s commodity exporters, as price movements for their products tend to be much larger than relative movements for the currency.

As such, the recent decline in the Aussie dollar compares with a 20%-plus decline for the price of copper and a 25% decline for the price of oil. There are exceptions, such as Iluka ((ILU)), whose costs are predominantly generated in Aussie dollars and whose bottom line is genuinely receiving some extra oxygen these days. But for most commodities exporters the golden rule is that the reason behind the movement of the Aussie dollar generally outweighs the currency movement in itself.

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