By Jesse Colombo (This article is frequently updated)
In our age of incessant financial bubbles, it was only a matter of time before commodities experienced a bubble of their very own. Initially rising due the rapid development of China and other emerging markets, the price of nearly every commodity from wheat to uranium exploded during the past decade as hundreds of billions of dollars of capital entered commodities as the new “hot” investment destination. Terrorism, war in the Middle East, near-zero interest rates, quantitative easing and growing distrust of conventional investments have only served to bolster commodities’ newfound role as an investment. Now in its tenth year, the fate of the commodities boom (and now bubble) is inextricably tied to China’s teetering economic bubble, Western economies on the verge of another financial crisis and the vagaries of speculative capital flows.
The commodities boom and bubble was born at the start of the new millennium and just in time to fill the void created after the colossal 1990’s tech stock bubble burst. Commodities had been in a steady bear market since the early 1980’s and were virtually ignored by investors in favor of rapidly rising stocks. Energy products and precious metals started showing definite signs of life again in 1999, but the real commodities boom began in earnest in November 2001, just as the Federal Reserve’s aggressive interest rate cuts stopped the post-tech crash recession in its tracks.
Commodities prices, as measured by the Continuous Commodity Index (CCI), have risen a staggering 275% since the start of their bull market in November 2001, against a 25% increase in overall inflation as measured by the CPI. (There are many reasons to believe that the official CPI understates inflation. Click here for alternate inflation data.)
Chart Source: Barchart.com
Individual commodities have experienced even greater price increases (links contain charts):
Crude oil (WTI) is up 1,050%, gasoline 1,050%, heating oil 1,000%, gold 528%, silver 1130%, copper 666%, platinum 435%, palladium 443%, wheat 275%, corn 348%, soybeans 250%, oats 300%, sugar 600%, coffee 635%, cocoa 435%, orange juice 245%, cotton 650% and lean hogs 213%. (measured at the latest peak in mid-2011)
What is impressive about the commodities bull market is not just the magnitude of the price increases but also the sheer breadth of commodities involved, from Malaysian palm oil and rare earth metals to sulfuric acid and uranium, with virtually no commodity missing out on the bounty. While the late-2008 Global Financial Crisis resulted in a 48% plunge in commodities prices, they staged a quick and powerful recovery, rising 112% from the depths of the crisis to a mid-2011 peak that surpassed the prior 2008 peak by over 10%.
Like all bubbles, from the Roaring Twenties bubble to the Dot-com bubble, the 2000s commodities bubble started as a legitimate economic trend and devolved into a “hot money”-fueled speculative mania. An absolutely critical component of every bubble is a convincing underlying story with strong elements of truth in order to be believable in the minds of the otherwise intelligent and well-educated people who control market-moving quantities of capital. The elements of truth that are responsible for the justifiable or “non-bubble” portion of the commodities price boom are: underinvestment in natural resource productive capacity during the 1980s and 1990s, the 2000s U.S. Dollar bear market, the non-bubble portions of China, India and other emerging markets’ economic rise, population growth, climate change and extreme weather, geopolitical turmoil and the increased diversion of agricultural commodities for use in biofuels.
The commodities bear market and depressed prices of the 1980s and 1990s disincentivized investment in natural resource productive capacity, which lead to a fall in global active oil rig counts, sharply reduced mineral exploration expenditures and underinvestment in agriculture, while “productive equipment deteriorated, was cannibalized or scrapped while other capacity closed and/or depleted.” (source) As the saying goes, “the only cure for low prices, is low prices,” which result in decreasing production until prices rise again as excess supply diminishes and/or demand increases. After a long period of low prices and underinvestment, commodities demand may eventually overwhelm productive capacity, leading to a new phase of rising prices. Commodities can experience lengthy bullish cycles due to the long time that is required to develop productive capacity, such as the exploration and development of new mining projects.
Some legitimate portion of commodities’ prices increase since 2001 can certainly be explained by the aforementioned phenomenon, but it is also important to realize that “the only cure for high prices, is high prices” as high prices eventually encourage more supply to enter the market, pushing prices down again. Record-high commodities prices have led to ambitious plans such as Quebec, Canada’s $80 billion investment and decision to open its vast northern region to mining development – an area twice the size of France with an abundance of iron, nickel and copper ore deposits. A new study shows that China has an incredible amount of unexplored mineral resources, with only 36 percent of the country’s mineral deposits discovered so far, including iron and aluminum ores. Chinese geologists have recently discovered $100 billion in mineral deposits in their Tibet region alone, which are now commercially extractable due to recent infrastructure developments. Emerging market nations the world over are rapidly developing their natural resource production capacity, such as Indonesia, whose sharp increase in coal production capacity will help it lead global growth in thermal coal exports in the next decade.
Record food prices are incentivizing the planting of new farm fields, causing a global wheat supply glut to swell to its biggest in a decade. In addition to having an ample supply of food, the U.S. has enough idled farmland to represent a total area larger than the entire state of New York. While the rise of China is commonly cited as a reason for rising food prices, China has largely been able to meet its own demand for food and even become a significant food exporter. Chinese interests have also started to unlock Africa’s abundant undeveloped agricultural potential using modern farming techniques, part of an expected 70% increase in Chinese investment in African natural resource production capacity by 2015.
While many people have worried about Peak Oil, a theory which posits that the world is near a point of maximum oil output and the end of cheap oil, high oil prices have incentivized the development of a wide range of technologies that are helping the discovery and production of far more oil than originally estimated and helping to allay Peak Oil fears for the time being. New oil drilling technologies, such as horizontal drilling and hydraulic fracturing, are creating oil booms all across the United States, while unlocking a potential 2 trillion barrels of domestic U.S. oil. South America could also have up to 2 trillion barrels of oil, while Canada may have 2.4 trillion barrels, compared to just 1.2 trillion in the Middle East and north Africa. A recently discovered oil field under the South China Sea is estimated to hold enough oil and gas to be “the next Saudi Arabia.” Horizontal drilling and hydraulic fracturing have led to astounding advances in natural gas production, making accessible as much as 500 trillion cubic feet of natural gas in the Marcellus shale formation in West Virginia, Pennsylvania, and New York, now the largest producing natural gas field in the world. A conceivable bonanza of new gas shale fields will be discovered as the new drilling technologies spread globally, such as Royal Dutch Shell’s recent discovery in China, part of the country’s staggering 1,275 trillion cubic feet of untapped shale gas resources – by far the largest in the world. While global shale gas production is only in its very early stages, the record supply of new gas is already causing U.S. gas prices to plunge to multiyear lows, down 25% in 2011 alone.
Another legitimate contributor to the commodities boom is the rise of China and India’s economies from their extremely depressed 20th century levels thanks to successful economic reforms and embrace of modernization. A 9.5% 30-year economic growth rate in China and an 8% 10-year growth rate in India helped both economies leapfrog from being economic backwaters to the world’s 2nd and 8th largest economies, respectively, lifting hundreds of millions of people out of poverty in the process. China and India’s real estate development and infrastructure construction soared in the early 2000s, causing economic growth and the demand for raw materials to hit a powerful upward inflection point. China’s growth surge has been particularly raw materials- intensive due to their strategy of undertaking large numbers of ambitious infrastructure mega-projects to create economic growth.
The 2008 Global Financial Crisis caused China’s exports to plunge and, in defense, the Chinese government launched a massive $586 billion economic stimulus program that was primarily invested in public infrastructure projects, housing and rural development. Economic stimulus programs entail the creation (or “printing”) of new money for the purpose of investing in projects that create jobs and economic growth. The downside of creating new money is that it leads to inflation and, quite often, economic bubbles. China is caught up in a full-blown infrastructure construction bubble, which can be seen in charts of fixed asset investment (infrastructure) as a percentage of GDP as well as Chinese cement usage. While the Chinese government builds scores of excessively extravagant government buildings, entire uninhabited “ghost cities” are cropping up, as can be seen in satellite images. Even the world’s largest mall, the New South China Mall, has been 99% vacant since it opening in 2005 (link has an excellent video). China’s economic boom now thoroughly over-relies on fixed investment and construction, as there are now 70 billion sq. feet worth of buildings of all types under construction and enough new office space to give every person in China a 5’x5’ cubicle. China’s local governments have financed their ridiculously extravagant construction projects via a $1.7 trillion “subprime” credit bubble, of which $540 billion is likely bad debt, according to Moody’s. As with the disastrous U.S. housing bubble, real estate speculators or “flippers” have taken China by storm, such as the college student who flipped an astounding 680 apartment flats. A real warning sign is the fact that five of the world’s ten largest buildings are now under construction in China, as skyscraper construction is a historically reliable indicator of economic bubbles, having marked the tops of the Roaring Twenties bubble in 1929 and the Asian Tigers bubble in 1997. India and other emerging markets are also caught up in bubbles like China is.
China’s flurry of unsustainable bubble-induced construction and development has led to a corresponding and equally-unsustainable bubble in raw materials demand. How many more empty cities and malls can China continue to build? While the legitimate portions of India and China’s economic rise justifies some degree of commodities’ price boom, it is important to remember that the other massive portion of the commodities price increase can only last as long as China and India’s bubbles do. Even if China and India’s long-term economic growth theses remain intact, the same could be said about the U.S. in 1929 right before the Great Depression. When China and India’s economic bubbles pop, the commodities bubble is sure to crash along with them. (Click here to learn more about China’s bubble economy.)
One of the strongest drivers of the commodities bull market was the 40% decline in the U.S. Dollar’s exchange rate (chart) versus other major currencies since 2002 . (compare with the CCI Commodities Index) The U.S. Dollar is the world’s “reserve currency,” which means that internationally-traded commodities such as oil are priced in Dollars, causing commodities prices to rise when the Dollar falls against other currencies and vice versa. The U.S. Federal Reserve’s unprecedentedly aggressive interest rate cuts in 2001 and 2002, which were a response to the post-Dot Com Bubble recession and September 11 attacks, along with the rising federal budget deficit and trade deficit were the main reasons for the Dollar’s decline.
After a decade of declines, there are several reasons why the dollar’s bear market may be ending and even preparing to rise against other currencies and commodities. One of the main bullish factors for the dollar is the likely future unwinding of the U.S. dollar “carry trade,” which has arose since 2008 due to the Federal Reserve’s zero interest rate policy (ZIRP). In the dollar carry trade, banks and investors borrow large amounts of U.S. dollars at extremely low interest rates and exchange them for currencies of nations with high interest rates, profiting from the favorable interest rate differential. Key beneficiary currencies of the U.S. dollar carry trade have been the Canadian Dollar, Australian Dollar, Singapore Dollar, Brazilian Real and the currencies of many other emerging market and commodities-exporting nations. The U.S. dollar carry trade has led to full-blown economic bubbles in Canada, Australia and emerging market nations as speculative “hot money” seeks higher returns around the globe. Nouriel Roubini, the economist who famously predicted the 2007-2008 Global Financial Crisis, has said that carry trades were fueling “huge” bubbles in commodities and emerging markets, setting the stage for the next financial crisis. When the bubbles in China, Australia, Canada and emerging markets inevitably pop, the U.S. dollar carry trade will unwind as speculators cut exposure to falling foreign assets and currencies, repatriating the borrowed dollars back into the U.S. to settle their loans. The unwind of the carry trade and repatriation of dollars will cause the dollar to spike, while throwing commodities prices into a tailspin and exposing the U.S. economy to a strong risk of a deflationary economic crisis.
The strong likelihood of a European sovereign debt crisis escalation, such as Greece or other PIIGS nations defaulting or exiting the Euro, would lead to sharply reduced EU interest rates and other stimulative monetary measures, greatly weakening the Euro and causing the U.S. dollar to launch higher due to “flight to safety” capital flows. The U.S. dollar’s global reserve currency status led to it being the greatest beneficiary (chart) of “flight to safety” capital flows during the 2008 Global Financial Crisis, even though the U.S. was the epicenter of the crisis. An EU crisis escalation and falling Euro would strongly benefit the U.S. dollar which, while certainly not perfect, is seen as “the best looking of the ugly sisters.” The combination of an economic crisis and soaring U.S. dollar would cause commodities prices to plunge as in 2008, when commodities prices imploded by nearly half in a mere five months (chart).
From a trader’s standpoint, the U.S. dollar may be strongly poised to rise against other currencies simply because the anti-dollar, pro-commodities investment theme has become a “crowded trade” (1, 2) after a decade of success. Citigroup’s chief technical analyst posits that the dollar may stop weakening and enter a bull market for the first time since 1995, while a popular contrarian pundit, Charles Hugh Smith, makes a strong case for a possible 50% rise in the dollar.
While it is safe to assume that population growth and climate change have some degree of long-term impact on commodities prices, particularly food and energy prices, these factors have been present for a long time and do not satisfactorily explain the sharp increase in all commodities prices during this past decade. The global population growth rate has dropped significantly since the 1960s and has steadily dropped during the 2000s (chart).
Starting in the mid-2000s, increasingly large amounts of corn were diverted from traditional food and animal feed uses for conversion into fuel ethanol in an attempt to reduce the world’s reliance on crude oil. While the initial ramp-up of ethanol production caused a disruption in corn supplies and higher food commodity prices, a UN report later showed that biofuels have contributed far less to rising food prices than previously estimated and that overall food prices were expected to head down as farmers respond to higher prices by increasing production. Corn’s 50% drop from June to October 2008, as commodities investors abruptly pared their bets during the financial crisis, was further proof that corn ethanol demand was far less important of a driver of the food price surge than initially believed. In late 2011, as a response to the U.S. federal budget crisis and a widespread backlash against using “food for fuel,” Congress ended a 30-year tax subsidy for corn-based ethanol and ended a tariff on imported Brazilian ethanol. The ending of the corn ethanol subsidy is seen by some as a subtle scaling-back and de-emphasis of the U.S. government’s enthusiastic original push for the proliferation of corn-based ethanol usage.
Terrorism, War and Geopolitics
Terrorism, war in the Middle East and other geopolitical strife are popular reasons given for this past decade’s rising oil prices but, while there is a small degree of validity to this argument, it certainly does not explain why the most explosive portions of oil’s bull market occurred long after (chart) the invasions and peak intensity of battle in Afghanistan and Iraq from 2001 to 2004.
Inflation, or the erosion of a currency’s purchasing power, is one of the most common, but incorrect reasons proffered for commodities’ 2000s bull market. According to economics professor Randall Wray:
Commodities are not a good inflation hedge, and they never have been. If you go back over the past century, this 33-commodity basket has declined at a rate of over 1 percent per year, inflation adjusted. In other words, it’s always been a bad bet to buy commodities as an inflation hedge, but it’s become the conventional wisdom, and it is part of the explanation for the flows into commodities.
Throughout human history, commodities have undergone booms and busts – there is nothing unusual at all about that. The 2000s commodities boom, however, is an extreme anomaly according to economics professor Randall Wray:
Most of the press has focused on rising oil, corn, and gold prices. But, in fact, the boom has taken place across a wide range of commodities, and, indeed, is unprecedented in scope and size. According to an analysis by market strategist Frank Veneroso (2008d), over the course of the 20th century, there were only 13 instances in which the price of a single commodity rose by 500 percent or more. For example, the price of sugar rose 641 percent in 1920, and in the same year, the price of cotton rose 538 percent. In 1947, there was a commodities boom across three commodities: pork bellies (1,053 percent), soybean oil (797 percent), and soybeans (558 percent). During the Hunt brothers episode, in 1980, silver prices were driven up by 3,813 percent. Now, if we look at the current commodities boom, there are already eight commodities whose price rise had reached 500 percent or more by the end of June: heating oil (1,313 percent), nickel (1,273 percent), crude oil (1,205 percent), lead (870 percent), copper (606 percent), zinc (616 percent), tin (510 percent), and wheat (500 percent). Many other agricultural, energy, and metals commodities have also had large price hikes, albeit below that threshold (for the 25 commodities typically included in the indexes, the average price rise since 2003 has been 203 percent) (Masters and White 2008). There is no evidence of any other commodities price boom to match the current one in terms of scope.
The unprecedented aspects of the commodities boom and bubble are due to a relatively recent fundamental change in the commodities market – financialization, or the large-scale transformation of the commodities market into an investment asset class like stocks and bonds. Hundreds of billions of dollars of investment capital has been parked in the commodities market since the early 2000s as commodities have become seen as an effective way of diversifying traditional stock and bond portfolios as well as a way to bet on China and India’s economic development. Pension funds have become one of the largest sources of capital parked in long-term commodity investments ever since Congress essentially forced them to diversify into commodities by law. The tsunami of new investment capital flowing into the commodities market has been a major contributor to the boom in prices. In addition, the financialization of commodities paralleled the financialization of, and bubbles in, the US housing and mortgage markets.
The U.S. Commodity Futures Modernization Act of 2000 ushered in an explosive wave of financial innovation, particularly in the realm of commodities derivatives products:
…the market value of agriculture commodities derivatives grew from three quarters of a trillion in 2002 to more than $7.5 trillion in 2007, while the percentage of speculators among agriculture commodities traders grew from 15 to 60 percent. The total number of commodities derivatives traded globally increased more than five-fold between 2002 and 2008.
Another extremely important financial innovation in the 2000s was commodity ETFs (exchange traded funds), which allowed common investors and portfolio managers to invest in commodities through stock brokerage accounts without having to deal with risky commodity futures. Before commodity ETFs, conventional investors could only invest in commodity-related stocks, such as mining companies, which aren’t always perfectly correlated with the commodities that they produce. Commodity ETFs have allowed commodities investing to go mainstream, attracting hundreds of billions of dollars to the asset class. The very popular iShares Gold Trust (ticker: GLD) and Silver Trust (ticker: SLV), both of which have debuted within the last 7 years, have attracted $63.48 billion and $8.7 billion respectively. So much investment capital has flow into commodity ETFs in recent years, including $10 billion in 2011 (in the U.S.) , that some experts have warned that they “may be the next financial bubble."
As part of the recent trend of financialization, the commodities market has become increasingly dominated by big banks, hedge funds and other speculative participants. In the first quarter of 2011, commodities trading revenues at the top 10 investment banks, including Goldman Sachs and JP Morgan, increased 55%, while most other trading segments’ revenues decreased. Investment banks now dominate the oil trading market even more than big oil companies themselves and possibly use their published research to manipulate oil prices to their traders’ advantage, despite the conflict of interest. Speculative bets on rising oil prices have hit all-time highs in recent years, causing oil prices to rise in a self-fulfilling prophecy. According to newly-released Wikileaks cables, speculators, not supply and demand, were the main cause of the 2008 oil bubble when oil hit $147/barrel. Similarly, recent investment bank domination of the food commodities markets were one of the major contributors to the massive spike in food prices in 2007 and 2008.
One of the main catalysts for the second phase of the commodities bubble (2009-to-Present) was the launch of the Federal Reserve’s quantitative easing (QE) programs, which were portrayed as the Fed’s “last resort” tool to stimulate the recessionary economy after the Fed Funds rate was already dropped as low as possible. During a QE program, the Federal Reserve buys (with newly created money) U.S. Treasury or other debt securities from the bond market, removing the securities from the market altogether. The perceived intention of QE is to increase the money supply to stimulate lending and jumpstart the economy again, but more accurately, it is a way for the U.S. Federal government to refinance its debt at very low costs.
The announcement of QE in late 2008 and again in late 2010 launched an outbreak of worries that the Federal Reserve was recklessly “printing money” and that hyperinflation and a U.S. dollar crash were soon to follow. The poorly-understood QE programs caused both panicked and profit-motivated investors to bid up commodities prices in anticipation of a massive inflationary episode. The speculator-driven commodities price boom created a self-fulfilled prophecy as the public and even most financial professionals started to believe that the uptick in inflation was caused by a tsunami of newly-printed money finding a new home in commodities rather than speculative activity.
The reality of QE is quite the opposite of what the public perceives it to be – rather than sloshing boatloads of inflation-driving liquidity, the recipients of the Fed’s newly-created money (those who sold securities to the Fed, which are mainly banking institutions) aren’t lending money at all, to the Fed’s dismay, and certainly aren’t bidding up commodities either. Nearly all of the newly-created money has been parked with the Federal Reserve in the form of “excess reserves” that are earning .25% per year, which is seen as preferential to traditional lending in the high risk and low reward post-Global Financial Crisis banking environment. QE-driven inflation fears are largely based on hysteria rather than fact as QE doesn’t truly add new liquidity to the markets, as most people assume. In the end, what QE succeeded the most in doing was creating a bubble in inflation expectations and commodities prices.
While it is reasonable to assume that some portion of the 2000s commodities price boom is justified by factors such as rising global population and industrialization, it is also clear that China’s economic bubble and speculative “hot money” are driving a massive commodities bubble. A popping of China’s bubble and/or the next phase of the Western debt crisis will cause a sharp reduction in demand for raw materials, sending speculators bolting for the exits as commodities prices crash. The hundreds of billions of dollars parked in commodities investments will soon be forced to reckon with the old adage, “the only cure for high prices, is high prices.”
(Note: While I do expect fiat or “paper” currencies to ultimately fail and cause commodities prices to soar in nominal terms, a strong commodities demand-reducing, and thus commodities price-reducing, economic recession or depression is far more likely to occur before an episode of hyperinflation. For my personal portfolio, I will seek to invest in the commodities sector (as a safe-haven against currency failure) after such a reduction in economic and speculative commodities demand occurs.)
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