The Commodities Super Cycle and Precious Metals

David Guthrie - Tue 13 Mar, 2007

Economic cycles are best judged by history according to David Guthrie and says why he thinks there's more to come from commodities and why gold looks the pick of the metals...

You would have to have been living on a desert island
for quite a long time now not to be aware that
something has been going on in the world of
commodities. Oil increased in price sevenfold between
1999 and 2006. Copper did almost the same in 4 1/2
years from its low at the end of 2001. The precious
metals have also soared in this new decade. Now it’s
the turn of the grains, where wheat and particularly
corn have exploded higher on the US futures exchanges.

This has all given rise to much loose talk in
investment circles of a commodities super cycle which
will stretch several years into the future. But what do
people mean by a super cycle? Over the years some
economists have observed that there are phases of
economic activity, where waves of expansion and growth
are followed by slowdown and recession, and that these
phases can be quantified in terms of duration.

Kondratieff was probably the most famous exponent of
this approach in the 1920s, while in the US Dewey and
Dakin took up the theme in their book “Cycles – The
Science of Predictions” published in 1947. In both
cases, a long wave (or super cycle) is posited as
lasting between fifty and sixty years in which we move
from trough to peak to trough again. Within the long
wave there are deemed to be smaller waves, in which
activity ebbs and flows in briefer time periods. All of
these studies focused as much on the historical
analysis of commodity prices as on interest rates,
trade, inflation and the rest of the available
economic data.

The equivalent in the technical analysis of markets is
to be found in the wave theory of R.N. Elliott, in
which he breaks down the trends in bull and bear moves
into cycles that last from minutes through to decades.

Of course, the value of all these cycle studies lies in
their supposed predictive power. And here is where the
problems begin. Even as convinced a believer in the
commodity bull cycle as Jim Rogers points out that the
shortest boom lasted 15 years, while the longest lasted
23 years. His conclusion is that we have much further
to go, but don’t expect a great deal more precision
than that. Oh, and don’t forget that we’ll endure some
huge corrections along the way.

The Chancellor, Gordon Brown, has of course famously
had his own problems in this area: he laid great stress
on balancing the books over the course of the economic
cycle only to be forced to change the starting point of
the current cycle from 1999 to 1997 in order to meet
this “golden rule”.

In reality, all economic cycles and wave patterns are
best identified with the benefit of hindsight and
forcing current circumstances into some pre-ordained
mould will usually prove to be a pretty unrewarding
activity, and a dangerous forecasting mechanism.

What we can say is that there clearly are long-term
cycles and that they are driven by fundamental changes
in the world around us. Global wars, the industrial
revolution, major innovations in transport and
communications are just some of the factors that can
instigate long-lasting shifts in economic growth, that
in turn stimulate demand for commodities. Increased
demand drives prices higher while producers struggle to
increase the capacity to meet that demand. Ultimately,
prices peak when excess capacity has been developed –
the cycle is then completed when demand abates and
general surpluses force prices lower.

The big event of the moment is clearly China. I could
run through endless statistics indicating the dramatic
nature of the new industrial revolution that is taking
place there – its double digit annual growth rates, its
spectacular leap up the league tables to become the
world’s fourth largest economy and so on. In focusing
on China, we shouldn’t forget about India – it is the
second fastest growing major economy in the world, with
GDP growth up just under 10% - or Korea (up 5%) or
countless other booming countries. It’s just that the
sheer size and scale of everything Chinese makes it
stand out and suits it to the role of representing the
emerging market economic boom as a whole.

The staggering numbers on Chinese economic growth are
matched by equally impressive figures in relation to
its consumption of commodities. The International
Monetary Fund reports that its share of the overall
growth in global consumption of industrial commodities
between 2002 and 2005 was massive – 51% for copper, 48%
for aluminium, 110% for lead, 87% for nickel, 54% for
steel, 86% for tin, 113% for zinc, and 30% for crude
oil. On the subject of oil, the Energy Information
Administration (the US government’s provider of
official energy statistics) envisages a 47% increase in
global demand from 2003 to 2030, and that non-OECD Asia
(including China and India) will account for 43% of
that increase.

Frankly, all future projections are no more than
sophisticated guesswork, but what we can assume is that
unless the world economy really hits the buffers and we
are plunged into a global depression, the relentless
demand for industrial materials of all kinds from the
likes of China is set to continue.

We are still at the stage where supply is struggling to
match this huge increase in demand. If we take the
example of copper, only 12% of supply is generated by
recycling scrap, which means that 88% has to be mined
from the ground. Commissioning new mining production
inevitably takes years not months and in the lag we see
copper stockpiles around the world run down. Total
exchange inventories have fallen to under a quarter of
what they were four years ago, although this is above
the alarmingly low levels they reached in 2005. In
fact, the inventories held on the London Metal Exchange
and New York’s Comex market are as good a guide to
ongoing tightness as you are likely to get, and
until they rise significantly the current phase
will not be over.

Although we are in a generally fundamentally benign
environment for the base metals markets right now and
will remain so for the next 3-4 years in all
probability, this doesn’t of course mean that the
prices of these commodities will inexorably rise from
here. The dramatic rallies witnessed on futures markets
over the past few years have already discounted much of
the story. The news is well and truly in the price in
the case of copper: the steep parabolic rise,
culminating in the final doubling in price in the six
months to May 2006, has all the appearance of a
speculative bubble. We have already fallen from over
$4.00 per lb to a recent low of $2.40 on the Comex
exchange. That said, what had previously been a multi-
year price ceiling at around $1.60 per lb is still a
long way off and will probably prove a floor for the
foreseeable future.

As for the other base metals, aluminium peaked around
the same time as copper last year, and zinc has also
stalled for the time being; only lead, nickel and tin
are continuing the immediate surge higher.

Because it began its recent long-term rally at the same
time as copper and also peaked (for the moment) in May
of last year, it is tempting to put gold in the same
category as the base metal. Certainly the supply/demand
picture is similarly tight: mining produces around
2,500 tonnes per annum, while demand is running at
around 3,500 tonnes per annum. Scrap and central bank
sales make up the shortfall. However, there is one
crucial difference between the two metals, as the CEO
of the World Gold Council reminded us in the Financial
Times in early February: only 11% of gold demand comes
from the industrial and dental sector. This means that
89% of gold demand represents discretionary spending.

The jewellery business accounts for the lion’s share of
this, general investment demand the rest. Not
surprisingly, the appetite for gold jewellery is
strongest in those traditional regions – India, the
Middle East and East Asia – which are currently
booming. It shows no sign of abating and underpins the
market. What will put the icing on the cake and push
gold prices on through last year’s highs is the general
investment demand side of things. Low real interest
rates, persistent US dollar feebleness and the need for
asset diversification will continue to create an
attractive environment for speculation in the yellow
metal, while new mechanisms such as ETFs will make it
ever easier for the less sophisticated investor to
access the market.

Although gold has enjoyed a very good rally, nearly
trebling in price off its 1999 lows, it has not matched
the sevenfold move in copper, and the thing about these
major cycles is that they always overshoot in value
terms and end with a climactic bang, not a whimper.

In sum, unless the global economy hits the skids
dramatically, it is likely to take another 3-4 years
for supply to catch up with demand for industrial
commodities. This should put a floor under the price of
base metals and maintain a secular bullish environment,
even if some - like copper - may have discounted much
of this positive outlook already. Right now, the best
opportunities are in the precious metals, where gold
could easily top $1000 an ounce, and would need to
reach around $1700 an ounce to match the recent
performance of copper.

Regards

David Guthrie
For The Daily Reckoning 

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