Commodities: Bull cycle or bursting bubble?(ZT)

July 24, 2006
By Rob Brown

For almost a century, commodities have been a highly attractive asset category both in terms of return and diversification.

Between Dec. 31, 1914, and July 14, 2006, commodities delivered an average annual compound return of 5.7%, with a remarkably low correlation - 0.13 - to the Standard & Poor's 500 stock index, according to globalfinancialdata.com.

This suggests a superior relative position for commodities and supports their application in both conservative and aggressive portfolios.

Although commodities can offer higher returns and more powerful diversification benefits than housing, U.S. Treasury bonds and even precious metals, they

do go through very long-term secular environments characterized by extreme outperformance or underperformance.

No accident

These cycles aren't accidental or idiosyncratic. In fact, they are quite causal, having been driven by well-defined, long-term, fundamental structural forces.

The most recent long-term cycle reached a daily trough Jan. 30, 2002, and continues to set new all-time highs on a regular periodic basis. During this interval, commodities delivered a highly beneficial return of 102%.

But over the very recent stock market downdraft (May 11- June 13), commodities fell 9.2%. This pronounced commodity decline raised a surprising hue and cry among many advisers and investors that the bull market in commodities was over or, even worse, that commodities had become nothing more than another bubble waiting to trap unwary participants.

So the question of the moment has become: "Is this the end of an unfortunate commodity bubble or is it nothing more than the pause that refreshes?" The last several bull markets for commodities lasted between 10 and 23 years, and delivered returns ranging between 172% and 894%.

In a historical context, the current bull cycle is in its early stages, with plenty of room to run. Moreover, the weight of the fundamental evidence is uniquely in favor of significant further commodity price appreciation extending over many years into the future.

Let's review the evidence, beginning with the demand side of the equation.

Today, we find the world in an unparalleled position in which emerging countries from all regions are experiencing multidecade growth and prosperity cycles. During this era of rapidly emerging economic growth, these countries will develop voracious appetites spanning the entire range of agricultural, metal and energy commodities.

China provides an early example of this phenomenon. In May, its industrial production rose an astonishing 18% on a year-over-year basis, and that nation has become responsible for the overwhelming growth in global commodity demand.

Further compounding this rapidly escalating demand is Japan. For almost 15 years, Japan's economy lay dormant, recovering from two extreme bubbles in the equity and real estate markets, and the Japanese economy's unprecedented overreliance on export growth.

But now the Japanese economy has returned to economic vitality. One might ask, "Why would the return of Japan to economic vitality have an impact on commodity demand, given that it is just a single nation?"

First, it is the world's second-largest economy, and second, it meets virtually all its resource demands through imports.

The conclusion we can draw is that commodity demand will rise in a relatively uninterrupted fashion for the next 20 years.

Next, we should examine the supply side of the equation.

Commodities are explored for, developed, accessed, refined and delivered by for-profit corporations. Like any other business, they face increasing business costs as inflation rises.

If we examine commodity pricing after adjustment for inflation (in essence adjusting for rising costs of doing business over time), we find that commodity prices fell for more than 21 years. Specifically, for the 21-plus years running from Nov. 28, 1980, through Jan. 31, 2002, inflation-adjusted commodity prices fell by almost 30%.

The response by commodity producers to these falling prices was threefold.

First, many went out of business.

Second, those that remained in business reduced supply capacity.

Third, they stopped hiring for new technical expertise, which, with the passage of time, has resulted in a marked aging of the commodity industry employee base.

This is a highly significant development in that a large portion of the experience and talent base is nearing the point when it will permanently exit the industry - leaving numerous commodity producers searching for unavailable talent.

Demand up, supply down

Thus we face a unique period where demand is up and will continue to increase, while at the same time supply is down and will have a hard time responding.

Nevertheless, it has been suggested that prices will climb sufficiently to induce the introduction of new commodity supplies and capacity. But just how realistic is this assumption?

Of all the industry segments, commodities have the longest development cycle for bringing new supplies on tap - often such introductions take 10 or more years. Thus commodity bull cycles have a natural structural propensity to last for more than a decade.

Moreover, the duration of this development cycle for new capacities will be further lengthened for the following three potent reasons: dearth of talent and experience, the not-in-my-backyard phenomenon, and resource nationalism.

The first of these is an outgrowth of the 21 years of declining inflation-adjusted commodity prices referred to above. Today, the industry faces such a pronounced lack of talent and experience that many development projects are either not immediately executable or must be extended over far longer time frames than would otherwise be the case - giving the industry the time to stretch existing talent or to train new experts.

The NIMBY phenomenon is particularly real in the commodities industry.

To understand this issue, ask, "What is the likelihood that a new open-pit copper mine could ever be developed in the state of California?" Well, it will never happen.

NIMBY is a real and very genuine defining element that spans the vast majority of the developed nations in Australasia, Europe and North America.

For all practical purposes, the development of future commodity sources will be restricted to emerging nations - the sole meaningful exception will likely be the tar sands of Canada and certain isolated mining projects in that country.

The third impediment or delaying factor underlying the introduction of new commodity supplies falls under the heading of resource nationalism. The most recent examples of this are in South America and Russia.

Consider the recent actions of Bolivia, Venezuela and Ecuador. The three countries exemplify the world trend toward resource nationalism.

The pronounced extension of state control over commodity resources is significantly impeding essential investment in new - much less existing - supplies and production. This year alone, Bolivia has nationalized its energy business, Venezuela has doubled taxes on multinationals, and Ecuador has seized control of the largest energy company operating there, with further expropriation threatened.

Mexico, a critical oil producer, suffers from an analogous problem. Its constitutional restriction prohibiting foreign ownership or control of domestic energy assets has resulted in stagnation of investment and jeopardizes even the simple preservation of existing energy capacity.

Slowing the process

Russia, through its disassembly of Yukos Oil Co. in Moscow, has meaningfully slowed development throughout the country. Similar issues exist throughout the full range of emerging countries, including nationalization, taxation, expropriations, labor disruptions and resource terrorism.

Collectively, these issues force commodity producers to proceed more slowly and to demand far higher expected rates of return on new incremental projects before they will execute. As a result, new supply is far slower to develop - which serves to lengthen meaningfully the current commodity bull cycle.

The case is well established. The commodity bull remains intact and can be expected to run for another decade - but with the occasional temporary downdrafts.

Rob Brown is chief investment officer of Genworth Financial Asset Management in Encino, Calif.