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.

160119-oil

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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Within months of that story being written, the oil price had bottomed out.

What's the point?

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).

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.