“Holes in the Ground” – The End of the Commodity Super Cycle

Super Short Super Cycles

The commodity “super cycle” proved super short. The commodity “boom” is now officially a “bust”. So what happened?

The rise in commodity prices was driven by the confluence of a number of factors. Debt driven growth in major developed countries drove strong growth (both export and domestic) in emerging markets, such as China and India. This, in turn fuelled, demand for resources. In a virtuous cycle, the growth drove demand in major commodity producers, like Russia, the Gulf, Australia, Canada and South Africa, whose strongly growing economies fuelled further growth globally by way of increased consumption and investment.

The effect of increased demand on prices was exacerbated by decades of significant under investment in commodity infrastructure (mineral processing; refining; transport infrastructure (shipping, ports, pipelines) driven, in part, by low commodity prices.

The commodity boom was aided and abetted by investors, especially leveraged investors such as hedge funds. Hedge funds used commodities to bet on strong global growth and catch the updraft in emerging markets indirectly reducing problems of direct investment. Commodities also provide significant leverage making them more attractive to hedge funds.

Traditional investors also embraced commodity investments. Commodities were seen as a separate investment class with low correlation to traditional investments enabling investors to improve investment returns and reduce risk simultaneously.

The last factor was inflation. Rising commodity prices and strong growth fuelled rising prices. This encouraged further investment in commodities as a hedge against inflation. The higher prices went the greater the threat of inflation and the increasing flow of funds into commodities. The momentum was irresistible.

Reverse Gear

In 2008, each one of these factors went sharply into reverse. The global financial crisis (“GFC”) resulted in reduced availability and higher cost of debt affecting commodities through several channels. Leveraged investors were forced to liquidate their positions as leverage was reduced and investors redeemed capital. The reduction in debt also reduced global growth sharply and the demand for most resources.

The reversal was exacerbated by several factors. Rising prices and anticipation of higher demand had led to significant investment in certain commodities and infrastructure. The time needed to build capacity meant that this increase in supply coincided with reducing demand further pressuring prices.

The GFC also reduced cross border capital flows and global trade. The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than US$165 billion – 36% of the US$466 billion inflow in 2008 and only one fifth the record amount in 2007. The projected decline in capital flows is around 6 % of the combined gross domestic product of the emerging countries. This compares to a decline of approximately 3.5 % of combined GDP in the Asian financial crisis and 1.5% in the Latin American crisis.

Global trade is also declining. In late 2008, the World Bank forecast a fall in global trade volumes for the first time in over 25 years. The Baltic Dry Index, a measure of supply and demand for basic shipping materials, has fallen 90 % since mid 2008. Exports from Japan, Korea, Taiwan and China fell between 10% and 40% in late 2008 also signalling reduced demand for commodities.

Financing pressures also mean that it is increasingly difficult to finance trade. Some countries have had to resort to barter to obtain essential foodstuffs.

Self Harm

Resources companies compounded the problems by aggressive acquisitions that were sometimes debt financed. Expectations of strong global growth and demand, especially from China and other developing countries, encouraged leading firms in the steel, cement and mining industries to undertake ambitious acquisitions in 2006 and 2007.

For example, steelmaker ArcelorMittal undertook a cash-and-stock-financed merger. India’s Tata Steel completed a leveraged takeover of Anglo-Dutch Corus. France’s Lafarge, the world’s biggest cement producer, bought Orascom Cement of Egypt whilst its competitor Mexico’s Cemex purchased Rinker, a big Australian rival. Xstrata, the mining industry’s serial acquirer, entered into a number of debt financed acquisitions. Rio Tinto purchased Alcan increasing its leverage significantly.

Declining sales and cash flows, debt refinancing requirements, difficulties in selling assets and limited opportunities to raise equity to deleverage further complicates the commodity bust. Some companies are seeking state financial assistance to survive. For example, Corus has sought assistance from the British government

High oil prices also led to aggressive investments in alternative energy technologies that are not economic at lower prices further complicating the price cycle.

Commodities also proved to be yet another “crowded trade”. Investors had created highly correlated positions; for example, simultaneously increasing exposure to equities, resources companies, emerging markets, commodities and corporate credit spreads on mining companies. The trades were essentially the same “bet”. Correlation between investments has gone to near one in the GFC and the assumption of diversification has proved almost as elusive as the promise of the commodity super cycle.

Mark Twain once described a mine as “a hole in the ground with a liar standing next to it“. The end of the commodity price cycle has revealed that standing next to the liar is a crowd of hapless bankers, analysts and investors.

© 2009 Satyajit Das

Satyajit Das is a risk consultant and author of a number of key reference works on derivatives and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

9 Responses to "“Holes in the Ground” – The End of the Commodity Super Cycle"

  1. Guest   February 8, 2009 at 2:42 pm

    In short, a lot of stolen money looking for profit. This is news? That’s the problem with the so-called “analyses” on this ridiculous site. They state the obvious and what everybody already knows. This stuff is written by overeducated, undersophisticated technotypes. Glib robots. Tiresome. Time for these puppets to lose everything they have. Ha ha, monkeys.John Ryskamp

    • Guest   February 8, 2009 at 4:34 pm

      then why are you visiting the site, moron?

    • Payam   February 8, 2009 at 11:51 pm

      Here’s why you’re an idiot: Many idiots are still debating(and debated all throughout 2007 and 2008 before prices began to fall) that speculators had nothing to do with the rise in commodity prices. Satyajit Das is putting the nail in the coffin for those idiots.

    • Martin   February 15, 2009 at 3:03 pm

      Overeducated, eh?Well at least that’s one problem you’re not burdened by.

  2. Guest   February 8, 2009 at 10:38 pm

    Satyajit Das wrote a long time ago warning about the contagion that is on us now. I listened to him then and have my powder dry as a result. You can trust just about anything he writes.

  3. Guest   February 9, 2009 at 12:10 am

    The troubling part of this piece is that Mr. Das points out commodity prices increased because the previous cycle of low commodity prices inhibited investment in plant and equipment. From what I gathered reading the article the profits made from the latest cycle of high commodity prices ended up as loans to commodity purchasers instead of finally updating productive infrastructure. The core problem of deteriorating infrastructure remains unaddressed. Do any commodity producers take the long view?

  4. Anonymous   February 9, 2009 at 11:31 am

    it got cut short; cycles usually end with a big influx of supply from new investment. it did not happen this time and it will rebound in a big way. oil and gas are below marginal cost of production in many places. Its not if but when.

    • dave   February 10, 2009 at 3:55 pm

      I agree. The stage is being set for the next upcycle (2-5 yrs from now?)

  5. Steven Kopits   February 10, 2009 at 2:24 pm

    Some economists attribute approximately half of the current recession to high oil prices. Such prices resulted from substantial demand growth from China coupled with effectively zero supply response after Oct. 2004. If you have growing demand in one portion of the globe and flat supply, then the global economy must reallocate resources from slow growers (OECD countries) to fast growers (BRIC + ME), in principle. Check the stats and you’ll see it is also true in practice. Now how does that reallocation occur? One method may be by incremental transfer, ie, as the price goes up, the slow growers cede the resource to the fast growers. But that didn’t really happen with the US until 2008. So what’s another model? Perhaps a catastrophic event–a deep recession–which fundamentally reshapes energy usage. Perhaps that’s the re-allocation method.