The Key to the Commodity Boom

The Daily Reckoning PRESENTS: Since most commodities rose significantly in price over the last several years, the recent slide begs the questions: What does it all mean? Is the commodity boom over? Chris Mayer answers those questions – and more – below…

THE KEY TO THE COMMODITY BOOM

The market has knocked the stuffing out of many commodities of late. Crude oil is down 35% from its record high of $78.40 in July to a 19-month low as I write. The CRB Index of 19 commodities is off about 20% since May. The only commodities holding up seem to be in the agricultural markets (e.g., corn).

The key piece to understanding the commodity jigsaw puzzle lies in that ever-baffling and wondrous place, China, which never seems to stray far from our view. What happens there has a huge impact on commodities worldwide.

China is already the world’s largest consumer of copper, nickel and zinc. It is among the largest consumers of many other commodities, as well. But what’s really amazing is not so much the sheer quantity of commodities devoured… what is really staggering is the growth rate of such consumption – especially in the context of what the rest of the world is doing.

For example, from 2002-05, according to the International Monetary Fund, China alone accounted for 48% of the increased demand for aluminum. Take a look at the short table below, which shows the percentages for some other commodities, as well:

*Aluminum, 48%
*Copper, 51%
*Lead, 110%
*Nickel, 87%
*Steel, 54%
*Tin, 86%
*Zinc, 113%
*Oil, 30%

Think about that. Worldwide, when you look at the increased consumption of, say, steel, 54% of that increase came from China alone. In Wall Street fancy talk, they call that percentage the “commodity delta” – try dropping that in conversation at the next neighborhood barbecue. For lead and zinc, China’s increased consumption actually offset declines in the rest of the world. No single country has been as important to the commodity bull market as has the Middle Kingdom.

I traveled to China in late 2005, spending time seeing the sights around dusty Beijing in the north, exploring the crowded streets of Shanghai and marveling at the busy panorama in Hangzhou and Hong Kong. I also stopped off at a small village between Shanghai and Hangzhou – called Wuzhen – where I ate chicken feet and pigeon soup and saw another side of China away from the big cities. All along the way, I met with Chinese professionals and business people who helped me gain a better understanding of what was happening on the ground in China.

The whole experience made a big impact on me. Ever since, I can’t seem to stop talking about China. With good reason, I think. The emergence of China’s economy on the world stage may be the biggest investment story of our time. In 1990, China was the world’s 10th largest economy. Today, it is the fourth largest. That’s mind-boggling growth.

The implications of that cover just about everything I’ve written about over the past 12 months – from strained water resources and bustling agricultural markets to aging infrastructure and needed energy investment. These are long-term trends that will take years to play out.

It would be a mistake to say increased demand from China alone assures a rise in commodity prices. There are always many variables, but China is unmistakably a big one. If China went away, it would be like a fat guy getting out of a hot tub. The water level would plunge. Let me put it this way: It’s hard to imagine a continued bull market in commodities without China.

It would also be a mistake to assume that China’s growth rate stays at its hot pace of recent years. “Only stand high a long enough time,” the poet Robinson Jeffers wrote, “your lightning will come; that is what blunts the peaks of the redwoods.” There is plenty of potential for lightning – social unrest within China, political tiffs with the U.S. and other policy mishaps. (I found it interesting that 27 separate pieces of anti-China trade legislation have made their way to Congress since 2005.)

However, even a slower-growing China will still have a lot of sway in the market for commodities. China is still in the early innings of industrialization. It’s in the midst of a massive shift of population to the cities, the biggest the world has ever seen. Chinese officials expect more than 300 million Chinese farmers will migrate from rural areas to live in urban areas in the coming two decades.

As a result, China has big plans for investment in infrastructure – such as water and wastewater systems, power grids and much more. China will need a lot of steel, copper, energy, etc., to build all that stuff. For example, as Stephen Roach at Morgan Stanley notes, “There is an especially tight link between homebuilding and copper.” In the U.S., the average home contains 400 pounds of copper. We don’t have comparable numbers for China, but it seems reasonable to assume China’s numbers should be similar. It’s

possible, given that Chinese efficiency lags behind the U.S.’s, that China could require much more.

Nonetheless, we should expect commodity prices to fluctuate, sometimes sharply. Even in the last great commodities boom, from 1966-82, there were plenty of setbacks. And these commodities won’t all move together as each responds to the unique tugs and pulls of its market. We’re seeing some of this already with corn rallying hard amid a nasty decline in oil.

Regards,

Chris Mayer
for The Daily Reckoning
February 20, 2007

P.S. The winners during times like this, when prices take a big dip, are the investors-in- waiting. The recent downdraft provides a nice buying opportunity to pick up some quality commodity companies, if you can stomach the volatility.

Editor’s Note: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital and Crisis – formerly the Fleet Street Letter.

Down here in the tropics it is easy to lose interest in the financial markets. Against the bright sun…the waves crashing on the beach…the trees, flowers, monkeys…the price of the Dow or the dollar seems to fade away.

We fight against it, dear reader, on your behalf.

There is no question that the world is enjoying an unprecedented flood of liquidity. The question is ‘how durable is it?’ And the answer to that question is: We don’t know.

But while we have nothing but doubts about the future of the world financial markets, we have nothing but certainty as to what you should do in preparation for it. Because no matter how we look at it, we see much more to lose than to gain from further inflation of the liquidity bubble. The higher prices go, the further they will have to fall.

Yes, as long as liquidity continues to expand, you can make a fortune. Maybe you could flip paintings of the Trivial School…or leverage yen credits. There’s money to be made. But it feels like the last days of the Internet bubble of the late ’90s to us. Even then, you could have made a lot of money by starting up a dotcom and taking it public. The poor sods in the public markets would have bought the thing from you; they, too, were hoping to get rich. If you moved fast enough, you could have walked away with millions.

You just didn’t want to linger too long. Every bubble pops sooner or later. This liquidity bubble will explode too. We just don’t know when. If you’re feeling lucky…go ahead, see what you can get out of it. But if you’re not feeling so lucky…we urge caution.

Besides, what glory is there in profiting from a bubble? It is like learning that an ATM machine is on the blink. You rush over to see if you can score a few 20s before it gets fixed. Yes, it’s easy money…but what pleasure can you take in it? What did you do to earn it? And having said hello to the cash so casually, wouldn’t you expect to say ‘goodbye’ to it just as easily?

No, dear reader, it’s not worth it. You would be taking a big risk in order to get something that wouldn’t be worth having – easy money. It’s better to focus on protecting the money that is worth having…and making more.

How?

The first thing, of course, is to protect your income. If you are a real estate agent, for example, you might want to consider alternatives. Even if the residential property industry stabilizes, it will be at a level considerably lower than the peak. We read in yesterday’s news that the legal profession was already gearing up for the next stage.

“Lawyers ready for a boom in bankruptcy,” says the Chicago Tribune.

And if your business is selling granite countertops, perhaps a diversification is in order. Tombstones maybe.

Once your income stream is secure, look to your investments. Here, a pop in the liquidity bubble could do some real damage; stocks, bonds, real estate…they should all go down. We keep our ‘Crash Alert’ flag flying in recognition of the fact that they could not merely go down…but go down in a hurry.

And what seems to us most exposed is the dollar itself. The United States must finance nearly $3 billion worth of trade deficit every day of the week. That means, the foreigners must buy, net, $3 billion worth of U.S. dollar assets. Well, in December, the foreigners must have gotten a little sick of sending their money to the United States. Net inflows from foreigners were only $15 billion – about $75 billion short. Oops. If that continues, the dollar is doomed. And so are the other assets in which the dollar figures prominently – notably U.S. stocks and bonds.

How do you protect yourself? Gold is one way. While the dollar supply has been increasing at about 9% per year for the last 10 years, the quantity of gold increases only at 2%. You can do the math later. But the trend is clear; gold has some catching up to do. It rose 23% against dollars last year. So far this year, gold is up 4% against dollars – and not only dollars.

Now, for the news…

————–

Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis:

“The Japanese yen has really been on a yo-yo string the past few trading sessions. You see, the Bank of Japan meets this week, and that 4.8% GDP that posted last week should be the key master for the gate keeper… The Bank of Japan (BOJ).”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig

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And more thoughts:

*** Another way to protect yourself is to buy the currency that everyone else has sold – the yen. We do not suggest you become a currency speculator, but as we explained last week, much of the hot air in this liquidity bubble comes from borrowing yen at low interest rates, exchanging it for dollars, and using those dollars to buy financial assets. When the liquidity bubble stops expanding, however, a lot of speculators are going to be in line to exchange their dollars back into yen. The dollar will fall; the yen will rise. And yen-based assets, such as stocks listed on the Tokyo exchange, will rise too.

According to the Big Mac index, the yen was overvalued by 100% in 1995. Now, it is undervalued by 30%. The way the index works is simple. A Big Mac contains ingredients that are priced at world levels. So, you just compare prices to figure out which currency is overvalued or undervalued in terms of its purchasing power. Right now, the yen is a bargain…because people are so eager to sell it. The yen ‘carry trade,’ in which speculators borrow yen only to sell them, is said to be a trillion dollar business. Even if the game were merely reduced to half its present size, it would mean a lot of pressure off the yen…and on the dollar.

*** “Well…what’s going to happen to Nicaragua now that Danny Ortega is in power?”

We posed the question to our driver, making the long run from Managua down to the beach.

“Not too much. This is not like Venezuela. Ortega wants to control everything; but he doesn’t control very much. He only has the backing of about 40% of the legislature…not enough to give him full power. He doesn’t really control the military or the courts. And now tourism is the number one industry in Nicaragua. Where do the tourists come from? They come from America. I don’t think anyone is going to want to ruin that business.”

The plane from Houston was packed with tourists. This was a big change. When we first began coming down to Nicaragua, we were about the only tourists coming into the Managua airport. The other gringos were members of church groups who were coming down to help various charitable causes. Now, the whole plane was full of large, light-skinned people in t-shirts and shorts. There were still some Christian groups doing their good works. But most of the travelers seemed to be coming for fun.

*** “It is incredibly pretty down here,” said a visitor. “We were lucky to get out of New York. There was ice and snow all over the place. It took us an hour and a half to drive to LaGuardia…at only 30 mph. And we were very lucky. A lot of the flights were cancelled. But we got to Miami…and then got onto a full plane in Miami. And now here we are. This place is great. I’ve never seen beaches so empty…or so pretty for that matter.”

*** While home sales are down all over the United States, and the once booming London housing market has begun to fizzle out, a Bloomberg.com article showed that the place to invest in property is in…Iowa?

“Land in Iowa, the biggest U.S. producer of corn and home to the most ethanol plants, surpassed $5,000 an acre from a high of $4,200 a year ago, said Monty Meusch, 55, a vice president for Farmers national Co., a property broker and farmland manager in Omaha, Nebraska. A 200-acre Iowa farm increased 14 percent in a month when it sold for $5,7000 an acre in October, he said.”

Due to demand for corn-based ethanol, farmland from Iowa to Argentina is rising fast…and commodity gurus couldn’t be happier.

Hedge fund manager and Hot Commodities author, Jim Rogers said that because that the above normal temperatures our county has been seeing will hinder crops and has “advised purchasing farmland for at least a decade.

“‘Because of the disruptions, agricultural prices will go through the roof,’ he told reporters in Melbourne on Feb. 7. ‘ I am extremely bullish on agriculture.'”

In Argentina, the world’s second-largest exporter of corn, the cost of buying a corn farm has jumped 27 percent in the last year – but Chris Mayer, isn’t putting his money on farmland. Chris, who is traveling to Argentina today for a closer look at this story, thinks that the real investment opportunities lie at the back-end of the agricultural boom – with farming equipment.

“All this machinery that does the heavy lifting of planting and harvesting corn – tractors, plows, irrigation equipment – carries the brand names of many companies. This is where the true payday is – not in making the ethanol, but in selling the picks and shovels.”

[Ed. Note: More from Chris reporting from Argentina in the coming weeks. In the meantime, check out his latest essay, below…]