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Resource prices are sliding for a simple reason – we have too much
The collapse in oil and commodity prices is freaking markets out. But it's not the end of the world, says John Stepek. It's just the normal market cycle playing out.
Oil and commodity prices are tanking now, but it's part of the normal cycle. They will bounce back.
Last night, my colleague Alex Williams and I were having a chat about the oil price and what's going on in the market.
Alex pulled up The Economist's (in)famous Drowning in oilcover story that marked the bottom of the 1990s oil crash. It's fascinating to read.
Much of the story could come from today's business pages: dramatic forecasts for how much further oil could fall; speculation about the demise of oil cartel Opec's influence; concerns about Saudi Arabia's economy. It's all in there.
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Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
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These things go in cycles it wasn't the end of the world then, and it isn't the end of the world now
What goes around, comes around that's key to understanding investment
Those are valid concerns. But right now, they're still not being borne out by the data.
Here's what I mean: the price of copper has halved from its 2011 peak. This is all about China, right? Well, maybe not.
Would it surprise you to know that Chinese copper consumption is still growing? Last year, HSBC reckons it grew by 1.8%, according to the FT. China last year "consumed almost the same amount of copper as the entire Western world". In 1990, it chewed up just 7% of the West's consumption.
China's demand may be growing more slowly. But it's growing from a much higher base. In terms of actual rolls of metal being bought, that 1.8% growth today equates to the same amount of extra copper as China bought a decade ago, when growth in demand was averaging closer to 12% a year.
As Goldman Sachs puts it: "Physical commodity demand shows no material deterioration from recent levels, even for metals in China".
In short, this is not a demand shock. Commodity and oil prices are tanking because producers have produced more than anyone wants right now.
This is logical. This is what happens when you have an industry that by its nature is forced to make decisions about how much money to invest today for an entirely unpredictable future perhaps five years hence (or even more).
No one can do that. It's just not possible. And although you can be sensible about it only investing when capital and labour prices are cheap, and holding back when experience and history suggests that you're closer to the top of the cycle than the bottom try doing that when you've a horde of shareholders looking at high resources prices and clamouring for you to take advantage.
So it makes perfect sense that commodity and oil prices are tanking now.
Because that's how markets work, generally: demand gets out of step with supply, and prices go up. That encourages producers to create more supply. Supply catches up and overshoots. Prices fall. Producers cut back.
Exuberance and profligacy, to despair and parsimony. Same deal every time.
The longer it takes for each of those stages to catch up with one another, the more cyclical the business. And there are very few industries with longer lead times than the resources business.
Anyway, that's a long way round of saying that smart investors should be looking through this. The bubble and bust in commodities is a sector-specific issue, and, unlike with subprime, it's not immediately obvious where the "transmission mechanism" lies to turn this into a global disaster scenario.
That's not to say that there isn't one. And we'll be looking in more detail at the underlying health of the global economy later in the week. But it's important to understand why commodities are popping now apart from anything else, it provides a better roadmap as to when the opportunities to invest will arise.
Alex will be looking at the oil sector in depth in the latest issue of MoneyWeek magazine, out on Friday. (If you're not already a subscriber, sign up now this is such an important topic right now, I think it's critical for any serious investor to understand what's actually going on seriously, make sure you read this).
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