Commodities Boom Largely Due To Supply And Demand Imbalances Plus Inflation

Puru Saxena - Wed 22 Aug, 2007

We are witnessing a generational bull-market in all types of natural resources (energy, food and metals). This boom in commodities is largely due to supply and demand imbalances plus the ongoing monetary inflation, which is adding fuel to the fire. Today, the various central banks continue to pump money and credit into the system and combined with the rising per-capita consumption levels in Asia and Latin America, you can begin to understand why the prices of commodities are at record-highs.

We are witnessing a generational bull-market in all types
of natural resources (energy, food and metals). This boom
in commodities is largely due to supply and demand
imbalances plus the ongoing monetary inflation, which is
adding fuel to the fire.

Today, the various central banks continue to pump money
and credit into the system and combined with the rising
per-capita consumption levels in Asia and Latin America,
you can begin to understand why the prices of commodities
are at record-highs.

For sure, this sector has already risen considerably in
this bull-market, however I suspect that the uptrend will
continue for several more years. Firstly, back in 2001,
natural resources were the cheapest they had ever been in
the history of capitalism, so this advance has commenced
from a very depressed level. Secondly, when adjusted for
inflation (even via the bogus official CPI data which
understates the inflation menace), commodities remain
extremely cheap.

These days, some analysts are claiming that this bull-
market in commodities is solely due to monetary inflation
and that supply and demand imbalances have no influence
whatsoever. I tend to disagree with their assessment
because constant monetary inflation has been our reality
since the early 1970's when gold was removed from the
monetary system YET the prices of commodities (energy,
food and metals) declined significantly between 1980 and
2001. So, it is clear that the debasement of currencies
alone is not responsible for the ongoing surge in the
prices of commodities.

In order to have a lasting bull-market in any sector,
supply and demand must be out of whack. In the case of
natural resources today, demand is rising ferociously in
China and India whilst supply is struggling. Consider the
energy market as an example: At the beginning of this
decade, China and India combined used to consume roughly
8% of the world's oil and today they consume over 11%.

Now, to illustrate my point that supply and demand are
important factors, I would add that this rising demand
(regardless of monetary inflation) would not have
translated into a higher oil price IF there was an
endless supply of oil. In the current scenario however,
the oil price is rising because supplies are extremely
tight when compared to demand. In fact, I would argue
that humanity is staring "Peak Oil" in its face.

Today the average Chinese person consumes less that two
barrels of oil per year and the average Indian consumes
less than a barrel of oil per year whereas the average
American consumes 25 barrels per year. After reviewing
this data, you don't have to be a rocket-scientist to
figure out that demand for energy in Asia can only rise
in the future. And unless we can find a way to increase
supply, the price of oil will continue to appreciate.

If you have invested in commodities, you will be thrilled
to learn that apart from energy, the inventory levels of
other resources such as base metals or food are also
extremely depleted. And these stockpiles are low due to
the sudden and unexpected surge in demand brought about
by the rapid industrialisation and urbanisation of China,
India and parts of Latin America. A growing percentage of
the three billion people in the "emerging" economies are
now putting immense pressure on the planet's resources as
consumers, and the scramble to find more commodities is
on. Exploration activity, whether for metals or energy,
is at multi-year highs and I suspect that billions of
dollars will be spent in the years ahead as nations
desperately look for additional resources to feed demand.

It is interesting to note that after the brutal
correction in commodities last year, energy, food and
base metals have recovered, however the precious metals
have failed to rally. Moreover, if you compare the
performance of the various commodities over the past five
years, you will realise that industrial commodities (base
metals and energy) have outperformed the precious metals
by a wide margin. This was expected as the economic
activity has been very strong recently, and gold is a
counter-cyclical asset. No doubt, it has been frustrating
for investors to watch their gold holdings drift lower
for a year. Despite the recent underperformance, I
continue to believe that gold is also in a gigantic bull-
market, which has a long way to run.

You must understand that in the case of base metals
(copper, lead, zinc, nickel and tin), changes in
industrial demand, and physical supply cause prices to
rise or fall. However, when it comes to gold, investment
demand alone is the single most important factor that
can make or break a bull-market. And the investment
demand for gold is directly linked to the public's
inflation expectations.

If the masses are worried about future inflation, they
tend to convert their cash to gold as a store of value.
On the other hand, when the public is calm about
inflation, the reverse takes place.

Banks are in the business of lending paper currencies so
it is absolutely vital for their survival that the
public's confidence in the monetary system remains high
and that inflation expectations remain under control.

Every central banker knows that if the public really
understood the inflation problem, the monetary system
would come under strain. So far, the central banks have
done a fabulous job of managing the public's inflation
expectations. However, I am of the opinion that this is
about to change. As soon as the public realises that
inflation is much higher than the official CPI data, we
could see a stampede towards gold.

Recently, precious metals have drifted lower which is
typical at this time of the year. In fact, the wonderful
summer sale is on! Remember, corrections during a bull-
market are opportunities rather than a problem. Once this
consolidation is complete this summer, I expect precious
metals to soar towards the end of this year.

Regards,

Puru Saxena
For The Daily Reckoning

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