Investors in commodities have done extraordinarily well in recent years. Gold has risen 117 per cent since its trough, copper 274 per cent and oil an amazing 560 per cent. The soaring share prices of oil and mining companies have reflected those higher values. Last year all the capital growth in the US stock market as a whole came from commodity stocks.
But the sell-off of metals and energy resources last week "stirred talk that the commodities bull run of recent years may be faltering, as the spectre of further (interest) rate rises causes growth to slow and reduces demand for raw materials," Kevin Morrison reported in the Financial Times.
So, has the boom come to an end?
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The pessimists believe so. And there are plenty of pessimists around. That's why great oil and natural gas companies like ExxonMobil and BP are trading on valuations of less than 11 times historic earnings, mining giants BHP Billiton and Rio Tinto on multiples below 13 times.
Those valuations reflect the predominant belief that their share prices will soon fall, as high commodity prices depress demand and encourage additional supplies. It's always been that way in the past, because natural resources have always been a boom-and-bust business.
Au contraire, the optimists argue. This is a boom that's going to run for a decade or more which makes producers of energy resources and metals cheap at current valuations. Kenneth Rogoff, professor of economics at Harvard, even goes so far as to forecast: "For at least the next 50 to 75 years, prices for many natural resources are headed up."
It really is different this time
Although world demand will fluctuate in line with the business cycle, it's also likely to keep growing faster than it has in the past. The emerging economies are at a development stage that generates disproportionate demand for natural resources.
In advanced economies like the US, growth creates little extra demand for such resources. Donald Coxe, chairman of Harris Investment Management, commented recently that Americans spend their marginal dollars "on household furnishings and decorating, video games, gambling, travel, healthcare, philanthropy, pornography and tort lawyers... Those pastimes don't create rising metal demand."
But high-growth emerging economies are increasingly driving global growth. They have "high metal intensity" as they build infrastructure, factories, communications networks and homes. And high energy intensity, too. "When Chinese and Indians progress from abject poverty to lower middle class status, they move into dwellings with indoor plumbing, electricity and basic appliances.
"Within a few years, as their wealth increases, they become car owners. So, at the margin, they become significant consumers of metals and energy." (In less than a decade, China has moved from being the world's 20th largest oil consumer to being the second biggest).
"As they become collectively wealthier, they acquire gold, silver and platinum jewellery, which are both consumption goods and investments."
Global demand is also being boosted by increasing investment and speculative activity. One indication of this is that investment in commodity index funds has risen from less than $30 billion to an estimated $80 billion currently, and is forecast to reach $140-150 billion by the end of next year.
However, it's not future demand growth that's at the core of the bulls' case for commodities it's that supplies are not going to increase enough to meet additional demand. For these reasons
...Most of the large unexploited reserves of minerals especially oil and gas are in political hot zones such as Russia, the Mideast, Africa and Latin America.
Some of them are closed to the international oil/mining giants, or impose
commercially unattractive terms. Others are high-risk Bolivia has defaulted on its natural gas contracts, Angola recently cancelled offshore exploration leases held by Western oil majors, reportedly planning to hand them to the Chinese.
...Environmentalism is making it increasingly difficult to exploit deposits in the advanced economies. It blocks new projects, or imposes expensive requirements such as purification of emissions, waste disposal, land restoration.
At the very least, it delays things, adding to capital costs. BHP Billiton's chief executive Chip Goodyear says it used to take five years to bring a greenfield mine into production now, because of environmental concerns, it takes eight to ten years.
...The long bear market was so painful that oil and mining companies lack the confidence to risk billions on investing in new projects. They don't know how much longer the good times will last. ExxonMobil isn't investing much more in exploration and development now, with oil at above $60 a barrel, than it was when oil was at $10.
Companies are sitting on something like $100 billion in cash that they prefer to keep in the money market or distribute to shareholders rather than spend on expanding capacity or buying up businesses with existing capacity.
...They're also worried about committing themselves to new projects based on uncertain tax rates. Britain (North Sea) and South Africa (Sasol) are the two most recent examples of governments seeking extra loot through special additional taxes, rather than encouraging companies to invest in expanding production.
Long wait till the bleeding stops
...And, Coxe points out, "the incentive structure for mining companies in today's stock market militates against undertaking projects that will involve pouring money into holes in the ground for a decade before the financial bleeding stops and the financial gush beings.
"With a p/e ratio of ten or so, you can't bet your company on something that won't begin to pay back for ten years." If you do, a cash-rich competitor will come along to buy out your shareholders looking for quick returns.
...The long bear market also gutted the industries of human resources. There's now a desperate shortage of experienced mine managers, engineers and geologists. The few newly-graduated geologists coming available are said to be usually keener on working for "the opposition" the environment lobbyists to shut down mines or prevent exploitation of energy resources, rather than working for companies seeking to expand production.
...Exploration and development costs are all surging because of shortage of drilling rigs and crews, and operators willing to work in isolated places with often unpleasant weather. Companies are finding the costs of new projects much higher than originally estimated, sometimes even doubling. And I'm not talking about millions, but about billions of dollars, of over-runs.
...One little-discussed reason why the oil majors are not doing enough exploration and development to replace their depleting reserves, Donald Coxe says, "is that during the 1990s Big Oil signed many deals with governments that gave the oil companies very favourable royalty arrangements, based on cheap oil. The governments' ownership rights to the field would rise in the (unlikely) event oil prices rose above certain levels, such as $35 and would rise sharply if oil went even higher."
With oil above $60, some big fields are no longer attractive for companies that would have to bear the exploration and development risks.
...In most businesses, rising prices stimulate production. But in mining, they often have the opposite effect. Coxe explains it well: "When metal prices are very low, companies tend to high-grade' their ore bodies, focusing on their most valuable ore; when metal prices are far above expectations, good mining practice dictates that companies widen their stopes and drifts, harvesting low-grade ore, and thereby extending the life of the mines." Lower grades mean lower output volumes.
Although the mainstream view is that high prices will encourage producers to bring many new projects on line increasing oil supplies, for example, by 14 to 16 million barrels a day within five to six years thus driving down prices, some analysts argue that this is "fantasy."
Because of continuing caution about massive, high-risk capital investments, as well as rising development costs, political risks and litigation risk, few of the new projects will get the go-ahead. Those that do, won't be in production until the next decade, and won't do much more than offset declining production from aging oilfields and mines.
What to do now
What investment lesson should be drawn from this?
Coxe advises: "Buy oil, gas and mining companies on the basis of lifespan of (their) unhedged reserves in the ground in politically-secure areas of the world."
I agree. If you don't already have a substantial share of your equity portfolio in energy resources, precious metals and base metals, do some switching into them now.
However, if you already have good holdings, don't be in a hurry to add to them. When there is a downturn in the business cycle, that should offer another opportunity to buy into natural resources.
By Martin Spring in On Target, a private newsletter on global strategy
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