The Future of the Commodity Price Boom
With oil nearing $100 a barrel, and gold reaching highs not seen in two decades, many wonder how long this boom in commodities can last. Stefan Karlsson, writing for mises.org, helps explain this upward trend.
As late as 1999, oil was trading at $10 per barrel and gold at $250 per ounce, down from their nominal peaks in 1980 of $39 and $850, respectively. And that’s not even adjusted for the fact that the value of a dollar was a lot lower in 1999 than in 1980.
Many pundits at the time argued that prices would continue to go down. The Economist had a cover in March 1999 entitled "Drowning in Oil" where it argued that oil would continue to fall well below $10 per barrel. And gold was, of course, deemed a barbarous relic which would continue to fall in price as central banks continued to dump it.
That forecast from The Economist turned out to be one of the worst in economic history – on a par with Irving Fisher’s stock-market forecast in 1929 – because just a few weeks later the price of oil started a new upward trend. As this article is written, gold is trading at over $800 and oil is nearing $100.
The question facing us is, will commodity prices continue to boom in the foreseeable future…or are we at or near the end of the rising trend we’ve seen since 1999?
Jim Rogers, one of the world’s most successful professional investors, tries to answer this in his book, Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market, and as the title suggests his answer is that commodity prices will continue to rise.
Rogers is a bit biased on this issue as he manages a fund that invests in commodities, but that doesn’t mean he’s wrong. And as we shall see, Rogers presents powerful arguments for believing in a continued boom; the main shortcoming of the book is that he overlooks another powerful argument for commodities.
Rogers, unlike many other professional investors, such as his former partner George Soros, is a libertarian, but many libertarians seem to believe that it is somehow unlibertarian to believe that commodity prices will rise. This goes back to the old feud between the late Julian Simon and Paul Ehrlich. Ehrlich has long advocated a Malthusian view that the world would run out of commodities and that draconian population control measures must be implemented to avoid a disaster. Simon, on the other hand, argued that a larger population was the solution, not the problem, and that increased mining, recycling, more efficient use of resources, and other forms of technical innovations would ensure that we would never run out of commodities, but have them in abundance.
Based on this belief, he publicly challenged Ehrlich to a bet where he would win if the prices of a number of commodities of Ehrlich’s choosing were lower in 1990 than 1980. Simon won the bet, and this was taken by many as evidence that commodity prices were on a structural downward path, especially after adjusting for consumer price indexes. As Simon made this bet with a Malthusian, many now fear that rising commodity prices would somehow vindicate Malthusian advocates of government population control.
Jim Rogers is certainly not a Malthusian and he does not believe we are going to run out of commodities permanently or that commodity prices will always rise. Instead, he argues that commodity prices will go through 10- to 20-year cycles where commodity prices will first rise, then fall. In his book, he points to the experience of the last 100 years as evidence for his prediction. Between 1906 and 1923, the world saw a long commodity-price boom. Then between 1923 and 1933 commodity prices fell sharply, particularly during the last three years. After that, a strong commodity-price boom started that lasted a full 20 years, until 1953. There followed a 15-year downturn in commodity prices that lasted until 1968. Afterwards came the great commodity price boom of the 1970s, or more specifically 1968-1982 (1980 was the peak year for oil and gold). We saw the long commodity downturn between the early 1980s and 1999, followed finally by the commodity-price boom that we’re seeing right now.
Within these cycles, there are corrections, as we saw when oil fell back from $78 per barrel in August 2006 to $50 in January 2007. And there will certainly be more corrections within this boom.
Why do commodity prices move up and down in such decade-long cycles? Rogers’s answer is that, while commodity production and demand do in fact respond to price changes, there is a long time lag in most cases, particularly with regard to production.
There are many reasons for this. First, because commodity prices fluctuate so much, many producers want to wait and see if we’re really on an upward path before investing. But far more importantly, particularly in the cases of mining and drilling for oil and natural gas, it takes quite a while to find new sources; to determine whether or not mining or drilling is really economically viable; to overcome red tape and objections from government bureaucrats and environmentalists; and then finally to go very deep into the ground and actually extract it. Any of these things can take a decade or more.
The response time is a lot faster when it comes to individual food commodities, as is illustrated by the sharp increase in corn production in response to the sharp increase in corn prices following U.S. government subsidies of ethanol fuel produced with U.S. corn. However, while this caused corn prices to fall back somewhat, the prices of other farm products, such as wheat, then soared as the land previously used to grow other grains was diverted to growing corn.
We can also see how the substitution effect makes the price increases in some commodities contagious. Rising oil prices caused increased interest in alternative sources of fuel, such as corn-based ethanol, which of course helps bid up corn prices. Rising corn prices diverts farmland to the production of corn instead of other grains, which in turn helps bid up the prices of these other grains. Rising oil prices increase demand for nuclear power, something that helps bid up the price of uranium.
Similarly, it often takes time for substitutes to respond to prices. It usually takes years to install more fuel-efficient cars, not to mention how long it takes to finish nuclear power plants and wind-power installations, overcome objections from government bureaucrats and politicians, as well as those of environmentalists and the people living next door to these energy production facilities.
Later, however, when all these new mines and oil wells are finally fully operational, and when the fuel-efficient cars and new energy plants are put in place widely, then the commodity-price boom ends – and turns into a commodity-price bust. When the lagged effect of all of these factors all finally show up, the effect could be a dramatically long period of overcapacity when new mining and drilling are simply not economically viable, while gas-guzzling cars are increasingly affordable. But as there are so many production facilities in place, and as the marginal cost of production for these existing facilities is relatively low, then this situation could continue for quite a while, causing long periods of declining commodity prices. Until, of course, the mines and wells get depleted. Then we face undercapacity, which of course will precipitate a new commodity-price boom.
Rogers argues that the current commodity price boom is in part a result of how the declining commodity prices of the 1980s and 1990s caused low levels of investment in mining and drilling, which means that existing mines and wells got depleted. In the book, Rogers reviews the supply-and-demand situation for a number of different commodities – including oil, natural gas, gold, lead, sugar, and coffee – and comes to the conclusion that supply is simply not growing as fast as demand, and won’t do so for another few years, a period during which, therefore, the commodity-price rally will likely continue.
The other factor behind the commodity-price boom is the surge in demand from China, and to a lesser extent, India, and the rest of Asia. Rogers is very bullish on China and argues that it is inevitable that China will become the world’s dominant economic power. He devotes an entire chapter of the book to China, where he details the case for being bullish about China and also describes how the sharp increase in demand for commodities that comes with its continued industrialization and consumption will continue to push commodity prices upwards.
Rogers also argues that investors who want to reap the full benefits of the commodity-price rally should buy commodities outright rather than stocks of commodity producers. He presents statistics that show that stocks of commodity producers have generally not done as well as the real thing. The reason for this is that when you’re buying stocks of commodity producers you’re not just buying the commodity but a company too. And the company can in some cases be suffering from bad management or from political attacks. To the extent that commodity prices increase because government bureaucrats and other obstacles hold back production, holders of stocks of commodity producers could in fact lose.
Rogers generally argues his case in a very persuasive, lucid, and instructive way, so my overall assessment of the book is very positive. My main complaint is not so much what is in it, but rather what has been left out. The key factor in analyzing commodity-price movements that Rogers has left out is the strong influence of monetary policy on commodity prices. This is particularly puzzling since Rogers is in fact an advocate of hard money and has repeatedly condemned Bernanke for debasing the dollar and refers to him as "a nut" for cutting interest rates so much.
While monetarists and most other non-Austrians believe that money-supply increases will affect all prices simultaneously and proportionally, a more realistic Austrian approach recognizes that some prices will be bid up faster and higher by any money supply increase. Which prices will be bid up the most and the soonest depends in part on who the early receivers of money are and also on how flexible the prices are. While commodity prices traded on the market change from minute to minute – or even second to second – and often rise or fall by several percent (or tens of percent) within a day and between the days, the prices of regular finished goods in supermarkets generally don’t change very often. So as commodity prices are more flexible than the prices of regular finished goods, they, like stocks and bonds, can be expected to be affected more and faster by monetary trends than consumer prices will be.
There are also other reasons for believing monetary policy affects commodity prices disproportionately. If real interest rates fall, then the opportunity cost of holding commodities falls, making them more attractive. And if there is a fear that inflation could get out of hand, commodities could be viewed as being good inflation hedges.
Moreover, when the Fed inflates more than usual and lowers interest rates, this will drive down the foreign-exchange rate of the dollar, making commodities cheaper for foreigners, a factor that will help push up the dollar price of commodities.
While monetary policy isn’t everything, and the fundamental nonmonetary supply-and-demand factors that Rogers mentions are certainly very important too, we can see several instances where monetary policies have had a decisive effect on commodity trends. A key reason why commodity prices fell so much in 1929-33 was certainly the contraction of the money supply during that period. And it was hardly a coincidence that commodity prices started to boom after Roosevelt took America off the gold standard in 1933 and continued to boom during the coming 20 years of wars and massive inflation. And the commodity price boom of the 1970s was certainly helped by the highly inflationary policies of Arthur Burns. Similarly, a major factor in breaking that commodity price boom was the significant tightening of monetary policy implemented by Paul Volcker.
Indeed, the massive boom in commodity prices following the Fed’s rate cuts since August is another good example of the strong connection between monetary policy and commodity prices. Since mid-August, the Fed has lowered the discount rate 125 basis points and the federal funds rate by 75 basis points. The effect on commodity prices is very apparent, with the CRB Futures Index being up 15%, gold is up 20% and oil is up 35%.
The Fed’s likely continuation of its inflation in an attempt to solve the problems created by its previous inflation and the consequence that this will drive down the value of the dollar on foreign exchange markets will provide momentum for the commodity-price boom for some time. While Rogers’s book is good, it would have been even better had it also mentioned that key point.
Stefan M.I. Karlsson
for The Daily Reckoning
November 27, 2007
We’re in an airplane over the Irish Sea…
With no access to yesterday’s financial news, we’ll have to wait until we get to Waterford for an update.
In the meantime…
"Nothing technology promises ever works out as planned," said a participant at last night’s dinner. "Where is the paperless office? The whole idea of progress is a fraud. Life doesn’t really work that way. Secularism preaches that every step is a step forward. But it’s not true; half the time we are going backwards. Each generation and each person has to find their own way – anew."
Their way into Heaven, perhaps. But there’s no denying technological progress. Every new generation stands on the shoulders of the one that came before it.
We thought of the airplane. There was an invention that made a difference. And what a success! Scarcely a generation had passed since the first manned flight at Kitty Hawk, North Carolina, and the sky over London was full of planes – dropping bombs. Now, that’s progress.
And what of the Internet? It was supposed to allow us to stay at home and work. But now, we use the Internet to plan our trips and buy our airplane tickets.
Today, after much Internet conversation, your editor has gotten on a plane and come back to Ireland. He left London in the morning. He will return to London in the evening. By plane, of course; everywhere he goes he is leaving a carbon footprint as big as Sasquatch.
The more man gets; the more he wants. If he can communicate via Internet…or via airplane…he’ll do both. The Internet Revolution was supposed to reduce the demand for fossil fuel. Finally, man had conquered distance. You no longer needed to commute to the office…or half way around the globe. You could have your meeting, and do your work, without ever leaving home.
But what has happened? Now people work from the home…and the office! And still they travel. They want it all – bigger houses, more stuff, more vacations…and they want to work harder too.
But something went wrong with this model in America. In the last quarter of the last century, people worked harder than ever. What did it get them? Nothing. Nobody realized it, but they had reached an era of declining marginal utility of work.
Ah yes…dear reader, these fundamental laws and principles of economics have applications beyond what their discoverers expected. We know the principle applies to investing; you can only apply so much money to a project, after that the returns begin to fall off. Imagine yourself building a hotel, for example. You build a couple of rooms; maybe you’ll get 100% occupancy. So you add more and more rooms. There are only so many people who want hotel rooms…so occupancy rates – and your rate of return – fall. "Declining marginal utility," economists call it.
Well, no one ever thought the rule applied to the sweat of an entire nation. But since the ’70s, the average person in America has been working more and more hours…and actually getting less real benefit out of them. If you torture them enough, you can get numbers to say anything you want. Besides, they’re natural born liars; don’t trust them. Still, occasionally they tell you something interesting. And now they’re saying that the returns from labor have gone down.
This little factoid is as welcome as a flu sufferer on a crowded airplane. People turn their backs. What else can they do?
According to the theory, modern capitalism – especially in its dynamic American version…that is, served up with plenty of gadgets and new technology – is supposed to be making us rich. So strongly do people believe it that they ignore the evidence of their own balance sheets. So strongly do they believe it that they elect candidates who offer more of it. So strongly do they believe it that it that they spend their future wealth even before they make it. They are victims of their theories, dear reader.
Capitalism – at least as we define it – is merely a system where individuals are allowed to own things and decide amongst themselves what to do with them. It doesn’t necessarily get people what they want. But it usually gets them what they deserve.
That’s the problem, of course. America’s middle class won’t like what it gets.
*** Yesterday, the Dow dropped another 237 points. Gold held steady. The unstoppable force of inflation seemed to slow down. The immovable object of deflation didn’t budge.
And what of our ‘Trade of the Decade?’ "Sell stocks; buy gold," we said. That was when stocks had hit an all-time high…and gold had hit something close to an all-time low. At the end of the 20th century, it took 43 ounces of gold to buy the Dow stocks.
Well, as of yesterday, you could have bought the Dow for only 15 ounces.
So far, so good. We expect that we will eventually see the Dow and gold back on equal speaking terms – one to one…or close to it. So, we’ll hold our trade until the end of the decade. Let’s see what happens. The Dow could easily lose 30% – taking it down to 8,000…or maybe as low as 5,000.
Could gold ever sell for $5,000? Well, we don’t know…but hold onto your hats. Fasten your seat belts. Inflation and deflation still appear to be on collision course. The ride could be bumpy…and we’re holding on to the yellow metal, just in case. (You can get gold out of the ground…for less than a penny an ounce.
*** Last night’s repast was organized by our friend, the reverend Peter Mullen, rector of St. Michael’s Cornhill in The City. Peter is chaplain to the London Stock Exchange and an activist.
"Small groups of people, who are determined, intelligent and resourceful, can turn the course of history," he said. He did not mention the Bolshevik revolution. Or, how the neo-conservative putsch gained control of the Republican Party. Or the day the big bankers got together on Jekyll Island in order to sneak a central bank into America.
No, Peter is an optimist.
"We must do what we can to reverse what I call ‘secular terrorism,’" he said. "You know, this didn’t come from nowhere. A small group of intellectuals – notably Herbert Marcuse – got together. They said they needed to infiltrate our institutions and conduct a program of ‘secular terrorism.’ Marcuse used that expression. And that’s what they did. Now, we have a situation where it is practically illegal, in Britain, for a teacher to tell his class that he is a Christian. And God help you if you dare to suggest that one religion is better than another. Even our own priests and ministers don’t really believe in Christianity anymore. Many Church of England priests never even open the prayer book. They’re victims of secular terrorism; they no longer believe their own faith. Instead, they believe all religions are equal…and all ideas are equally valid."
We had a hard time concentrating. In front of us sat one of the most exquisite women we had ever seen. ‘Yes, there is a God,’ we said to ourselves. She had long red hair…and the kind of face you see on goddesses painted by Italian dreamers. She was probably in her 20’s…so innocent and so lovely. And when she spoke, the tones came out like dessert.
But what was she doing there? She was surrounded by middle-aged men, all of them grumping about the government, the intellectuals, the schools, art…finance…and all the other bad habits of our times…while recalling how much better things were 50 years ago. Her presence seemed so improbable, like a wedding cake in a machine shop. But it had a good effect on the old fellows. We sat up a little straighter and tucked in our shirts. Instead of yakking to one another with our typical boorish insouciance, we pulled in our stomachs and began making speeches. Now we had an audience…and a purpose.
"We are not the first to be in this position," began one Old Boy near us. "Since the days of Rome, we Christians have been a persecuted minority…not always…and not everywhere. But often. It’s part of what makes us what we are. We have to be willing to accept martyrdom. That’s what it’s all about."
"Are you volunteering?" asked another. "Perhaps we should nail you to the door of St. Michaels, and tell the police that Mr. Dawkins and some other unbelievers did it. Then, we would have a cause célèbre… ‘Remember old Alastair’ will be our war cry. Yes, I see the whole thing shaping up nicely. First, we will retake the Arts Club from the heathen…and then we’ll march on Westminster. Yes, it will be jolly fun…did anyone bring a hammer and some nails?"
The Daily Reckoning