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.
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.
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).