Oliver's Insights

KEY POINTS

n Industrial commodity prices have risen substantially over the past few years, with many making record highs.
n Long speculative positions and very strong recent gains point to a correction, which may now be unfolding.
n However, strong underlying demand and constrained supply suggest the longer-term trend is still up.

THE COMMODITY BOOM

Over the past four years average prices for industrial commodities have more than doubled on the back of a cyclical recovery in global growth, strong structural demand from China and other emerging markets, and constrained supply. While there is much debate about what drives individual commodities at any point in time, it is clear that they have all moved up substantially.

Over the four years to January, the price of copper has risen 220%, aluminium 80%, nickel 150%, gold 100% and oil 250%. Over the past two years, coking coal prices have roughly doubled and iron ore is up about 70%.

However, after a particularly strong surge in the past few months, followed by a sharp fall back in the past few days, it is reasonable to wonder whether the commodity boom has run its course. Our analysis indicates it hasn’t.

Nominal metal prices have now surpassed their late 1980s highs. However, over the past 30 years metal prices have not kept up with general inflation. As a consequence, real metal prices (that is, nominal metal prices relative to general consumer prices) remain well below late 1980s levels.

The metal price index is an average of prices for metals such as copper, aluminium and zinc.
Source: Thomson Financial, AMP Capital Investors

This can be seen for example in the case of copper, where nominal prices are about record levels, but in real terms the copper price is below where it was in the late 1920s.

Our assessment remains that industrial commodity prices will continue to trend higher over the next decade or so. There are several reasons for this.

First, rapid industrialisation in China, India and other emerging markets means that global per capita metal consumption is now rising rapidly. Reflecting very low income levels, the penetration of consumer goods in China and India remains very low. For example, in China there are six cars per 1000 people compared to about 475 in the US, and the average Chinese person has 66 square feet of living space compared to 718 square feet for the average American.

As a result China and India currently use very low amounts of industrial commodities per person (see table below). However, the combination of rapid urbanisation, strong productivity growth, low costs and surging consumer demand will drive continued strong economic growth over the next decade or so. As these countries industrialise and income levels rise, their relatively low rates of per capita commodity consumption will rise rapidly. This will have a huge impact on global demand for commodities, reflecting the size of these economies (about 2.3 billion people in total).

ANNUAL COMMODITY CONSUMPTION PER PERSON
	Copper (lb)	Aluminium (kg)	Oil (bbl)
US	15.7	20.9	25.2
South Korea	37.6	20.5	17.5
China	4.9	4.2	2
India	<2.0	0.6	0.8
Source: Bank Credit Analyst, AMP Capital Investors

Second, the supply of commodities remains relatively constrained given the price surge we have seen. After a generation of weak prices, and consequently low returns on capital, this naturally led to a sharp fall in exploration and capital spending in the resources sector. Mining sector rationalisation has also contributed to the relatively constrained supply response this time around. Global mining investment still remains relatively low compared to past cycles.

Finally, global inflation has arguably now stopped falling. This is significant to the extent that falling inflation since the mid 1970s favoured financial assets over real assets, like commodities, that provide a hedge against inflation. With inflation having stabilised this should be positive for real assets, or at least leave them on a fairly equal footing to financial assets in terms of their attractiveness to investors.

With the easy gains behind us, momentum in commodity prices is likely to slow. However, strong structural demand from China and other emerging markets, combined with relatively constrained supply, suggests that the broad trend in commodity prices will remain up over the next decade or so.

SHORT-TERM CYCLE

Of course, there will always be a cycle. However, cyclical indicators for commodities right now are reasonable:

n Leading indicators of growth in industrialised countries appear to be picking up after a soft patch last year. This includes global measures of business confidence and the OECD’s Leading Indicator (which is a composite of economic variables that lead OECD economic growth) which is turning up (see the next chart).

n There is no sign of any imminent downturn in China or in other emerging markets.

n While growth in metal production has been strong over the past two years, stockpiles remain low (see the next chart). In fact, they are at levels normally associated with relatively high prices.

While cyclical conditions are generally favourable, industrial commodity prices are at high risk of a short-term correction though. After surging by 20–30% or so over the past few months, base metal and gold prices are very overextended in a technical sense and may have run ahead of fundamentals.

Investor sentiment is very bullish and speculators appear to have built up very long positions (although not in oil). What’s more, the growing investor interest in commodities via hedge funds and commodity-dedicated funds suggests that volatility is likely to increase. Falls in commodity prices in recent days suggests that a correction may now be unfolding.

CONCLUSIONS AND IMPLICATIONS

While industrial commodity prices are at risk of short-term correction (which appears to be under way) the longer-term outlook is positive. The solid longer-term outlook is underpinned by strong structural growth in China and other emerging markets and still-constrained supply.

While mining stocks appear to be undergoing a short-term correction the longer-term outlook for high industrial commodity prices suggests they should continue to provide relatively strong returns over the next year.

Continued longer-term strength in commodity prices indicates that the stimulus to the Australian economy from higher export prices is unlikely to end any time soon.