Key points
– The commodity super-cycle that started in the late 1990s is far from over.
– The combination of substantially higher absolute levels of demand and the increasing scarcity and rising cost of commodity production will force prices higher over the next 10 to 20 years.…….
ETF Securities Research
– The industrialisation, urbanisation and rising wealth of large population emerging market countries will continue to drive demand higher.
– Although much attention has focused on the likely reduction in the economic growth rates of China and India over the next 20 years, per capita incomes are expected to triple over the coming 20 years, driving substantial increases in per capita and absolute levels of consumption of a wide range of commodities.
– The long-term supply of most commodities will remain constrained due to their increasing scarcity and rising costs of production.
– Higher prices will encourage the more efficient use of the world’s scarce resources and incentivise the investment and innovation necessary to boost supply productivity.
Executive summary
The commodity super-cycle that started in the late 1990s is not over. The primary drivers of the super-cycle are a resource-intensive urbanisation and industrialisation process in large population emerging market countries and a rising cost of production for most commodities. These dynamics are still very much in force. While global economic growth is expected to moderate over the next ten years, rising per capita incomes in large population emerging market countries will drive increasing per capita consumption of a wide range of commodities leading to potentially massive increases in absolute demand for most commodities. Higher commodity prices will be necessary for supply to meet growing demand. Higher prices will incentivise the efficient use of the world’s scarce resources and the investment and innovation necessary to boost high cost exploration and supply productivity.
What is a commodity super-cycle?
The weakness in many commodity prices over the past year has led a number of commentators to call the end of the commodity super-cycle. Few, however, define what they mean by the commodity super-cycle. Many commentators are in fact referring to the near-term outlook for commodities rather than the longer-term trend that characterises a super-cycle. Most definitions of super-cycles refer to them as decades-long positive deviations from long-run trends, punctuated by the periodic booms and busts of smaller business cycles. Given the cyclical weakness of the global economy over the past few years, it is not surprising that some investors have confused a weakness in prices with an end to the super-cycle. However, as we argue here, the main fundamental underlying drivers of the super-cycle are still in force and should continue to drive price increases over the medium to long-term.
Looking at commodity prices over the very long-term we can see that there have been four major super-cycles over the past 160 years, with full cycles (e.g. from peak to peak) ranging between 30-40 years, and with amplitudes up to 20% higher or lower than the long-run trend1. We appear to be in the fourth super-cycle, which started in the late 1990s. Importantly, we see sharp deviations from the super-cycle trend as regular business-cycles cause short-term increases and contractions in prices. Cycles are not uniform in length or amplitude so it is not possible to use simple extrapolation of averages to determine when the next cycle will start or finish. Analysis of underlying fundamental price drivers is critical, as the world changes from generation to generation. We argue that the recent weakness in some commodity prices is related more to business-cycle fluctuations and short term commodity-specific supply fundamentals than a change in the structural fundamentals driving the commodity super-cycle.
What has led to the current super-cycle?
Resource-intensive economic growth in emerging markets, led by urbanisation, industrialisation, and a growth in global trade, has led to a secular rise in the demand for commodities. While these trends are exhibited across a number of emerging markets, China has epitomised them most extensively. Previous super-cycles were driven by the growth of the US (1870-1913) and post-war Japan (1946-1973).
Economic growth will continue to support emerging market demand for commodities
While the countries that are driving the current super-cycle will likely see lower growth rates in coming years as their economies mature, growth is expected to remain strong. Judging by the path of other Asian economies as they industrialised, China and India are still at very early stages of development.
According to OECD forecasts, Chinese and Indian per capita GDP will grow 6.4% and 5.6% per annum respectively between 2011 and 2030. While such growth rates would be a moderation from the 9.3% and 5.8% per annum respective growth rates between 1995 and 2011, per capita GDP will more than triple in China and nearly triple in India by 2030 on these forecasts.
Even if the composition of the economic growth in China does gradually change from being primarily investment-led to being consumption-led, the goods and services that China’s households demand will need commodity inputs. Offices, middle-class housing, roads, cars, trains and related infrastructure, airports, refrigerators, washing machines, computing devices and meat are all highly commodity intensive to produce.
Urbanisation to continue in China and India
China has only just reached an urbanisation rate of 50% and has plenty of room to match the developed world average of 80%. According to UN forecasts Chinese urbanisation rates will reach close to 70% by 2030 and will continue to rise even after that point.
The new Chinese Administration’s political desire to see urbanisation rates increase was demonstrated by the acceleration of a $6.4tn programme to bring 400 million people into cities over the coming ten years, down from 20 years under the original plan. Bringing more people into existing cities will require upgrading and developing even more infrastructure which will be resource-intensive. The government’s infrastructure, spending budget for 2013 has been increased by 9% over the 2012 target, with particularly large increases ear-marked for railway development 2 . As certain mega-cities hit their sustainable capacity, more satellite cities with strong transport connections to core cities need to be built, requiring further infrastructure spending.
Even though urbanisation has been slower in India than in China, its population growth is expected to be higher. According to UN forecasts, India’s population will be larger than that of China’s after 2020.
India’s higher population growth is likely to see it play a larger role in driving the commodity super-cycle over the coming decades.
Rising affluence will drive global consumption higher As the size of middle class populations in emerging market countries grows, so will their appetite to consume more finished goods. Global demand for the inputs to produce those goods will rise.
For example, passenger car ownership in emerging markets is a fraction of the car ownership in developed markets (Figure 5). As incomes rise, emerging market demand for cars will rise. If car ownership follows the path of more developed markets, using the OECD’s projections for per capita GDP growth, Chinese car ownership is likely to rise from 35 per 1000 people in 2011 to 200 per 1000 people by 20303. This almost six-fold increase would equate to creating the entire current passenger car stock of US and Germany put together in the span of 19 years. The demand for platinum, palladium, nickel, iron ore and other commodities that are used in the manufacture of cars will remain strong as will the demand for oil based products used as fuel.
Similarly, energy consumption per capita in emerging markets is only a fraction of the developed world equivalent. Admittedly, some countries like the US are outliers in its scale of energy consumption and it is hoped that other countries will not follow its path. Emerging markets are also likely to be more efficient than their developed counterparts were when they were at the same stage of development given the greater scarcity of energy resources and better technology today. However, given the larger populations of emerging markets, a relatively modest rise in per capita energy use will transform into a large absolute increase in global energy use.
According to BP forecasts, total energy demand will rise by almost half to 17bn oil equivalent tonnes by 2030 from 12bn oil equivalent tonnes in 2011, almost entirely driven by non-OECD countries. This is equivalent to over 3 years of OPEC’s entire current annual oil production.
As citizens of emerging market countries become more affluent, their diets are likely to become more meat-based. According to the OECD and Food and Agricultural Organisation (FAO) forecasts, meat consumption in non-OECD countries is likely to rise by over 10% from 25.7 kg per person in 2011 to 28.3 kg per capita in 2020. After a 5.6% rise by 2020, the absolute increase in meat consumption in OECD countries will also be large considering that richer countries currently consume 64.9 kg per person.
Meat production is resource intensive. For example, in the US it is estimated that it takes around 7 kg of grain feed to produce 1 kg of meat6. The higher resource intensity of meat production (compared to other foods in traditional emerging market diets), is likely to place a strain on land and water resources in these countries. Adding to these strains, municipal and industrial demand for water is likely to compete with agricultural irrigation. Some of the regions most at risk of water shortages are globally important agricultural centres.
Supply constraints will support prices over the longer term
At a time when supply across a number of commodities is increasing, it may be difficult to believe that supply will be constrained. Indeed it is unlikely that the structural over-supply in commodities like aluminium is going to reverse any time soon. However, over the medium term, it will be difficult for the supply of many commodities to keep up with demand.
For example, it will take a significant amount of time for other countries to replicate the success that the US has had in developing scalable shale gas and tight oil. Policy hurdles and environmental concerns are stopping many European countries from investing in shale technology. Lobbying pressure by US energy consumers has made it difficult for US energy companies to obtain the permits to export the glut of shale gas. Some attribute the current cheap gas supplies as a key catalyst behind the economic recovery in the US and there is little will to change this situation. Even when permits are issued, it will take time for importing countries to build the necessary infrastructure to vaporise gas condensates.
Some of countries that are closest to developing shale gas such as Saudi Arabia and Mexico are the least likely to want to depress energy prices, given their reliance on exporting crude oil.
While many OPEC countries have large proven reserves of crude oil, they have no interest in seeing prices fall. Norway, the only non-OPEC country in the list of top 10 net oil exporters other than Russia has less than 10 years of proven oil reserves (if it continues to produce oil at the current rate).
According to BPs forecasts (which assume that China will become significantly less energy intensive after 2020) world primary energy consumption will be 36% higher in 2030 than in 2011. In order to meet this demand, shale gas output would have to treble, tight oil will have to rise six-fold, renewable energy would have to treble. The investment needed to see this rise in high marginal cost alternative fuels will require increasing energy prices. In addition, there are serious questions about the sustainability of shale gas and oil supplies, given high depletion rates.
Even though OPEC countries have large proven reserves, new fields will have to be developed and even more fields will have to be discovered to meet demand according to the IEA (Figure 9). According to IEA forecasts US$19tn will have to be spent on oil and gas infrastructure to meet demand by 2035, with a further US$18tn on other energy infrastructure to support aggregate energy demand.
Platinum and palladium, which are mined in a limited number of countries, are in a supply deficit at the moment. Mining cost escalation (Figure 10) driven by rising energy, machinery and exploration outlays as well as labour constraints are likely to see platinum group metals remain in deficit for the foreseeable future.
Rising mining costs are not unique to platinum and palladium. For example, copper mining costs around the world have risen 30% between 2007 and 2012, mostly due to labour and fuel, but also due to declining ore grades according to CRU. Chile, which produces 30% of world copper output, has seen costs rise 60% over the same five-year period. As mining costs rise it becomes uneconomic for companies to produce and explore, keeping upward pressure on prices over the long-term.
Risks to the continuation of the super-cycle
One of the key risks to the continuation of the super-cycle is that China’s rapidly aging population could cut short its economic growth and therefore the rising affluence of its population. China’s one-child policy has led to a low fertility rate which will leave a small cohort of working age people to support the elderly. The UN projects an old-age dependency ratio8 of 24 in 2030 compared to a less developed region average of 12. However, playing to China’s favour (at least in the medium term) is that its working age population has very few children to support, leaving its total dependency ratio9 considerably lower than other emerging markets (45 in China versus a less developed region average of 53).
Although there is more to fear from having a larger older population to support than a larger younger population to support (the younger population eventually start to work and have lower medical expenses), China’s aggressive aging is counterbalanced by India’s relatively young population structure (India will have an old-age dependency ratio of only 12 in 2030). Indeed as China’s aged population drives a more consumption led economy, there will be further opportunities for India to utilise its younger population to produce goods and services to export to China. Given India’s relatively poor infrastructure, it will need to invest heavily to meet the demand needs of China.
Technological change always has the potential to disrupt the commodity super-cycle. For example aluminium was once more expensive than gold, but improvements in production techniques in the 1880s, soon made it one of the cheaper industrial metals. However, technological change is hard to predict and without any imminent new innovations (apart from the shale gas revolution already discussed), there are no clear disruptions on the horizon. Also technological change can work both ways. For example if new, cheaper methods of making finished goods were found, it could boost the demand for (and hence the price of) the commodity inputs used their manufacture.
Summary
– The drivers behind the decade-long positive deviations from long-run trends that characterise the commodity super-cycle are still in place.
– Most recent arguments for the death of the commodity super-cycle are focused on the short-term (one to two year) outlook for a few specific commodities. This is very different to providing evidence of a long term (10 year or more) structural price decline across all commodities.
– Even if the emerging market economies driving the rise in demand for commodities grow at a slower rate over the next decade, the absolute demand for commodities is likely to grow as these large population countries get richer.
– Emerging market countries are likely to continue to urbanise, increasing the infrastructure spending that has driven commodity demand and boosting the per capita spending on a wide range of typically middle-class commodity-intensive consumer goods.
– The supplies of many commodities are likely to remain constrained. The growing scarcity of resources combined with the rising cost of extraction mean that prices of many commodities will have to remain high to incentivise investment in extraction.
– While we acknowledge there are several risks to the continuation of the commodity super-cycle, with a derailment of the economic development of China and India being the stand-out risk, we believe that these risks are relatively low.
Source: ETFWorld.it
