Commodities: a bull or a bubble?

published 1 February 2007

This article was first published on 3/11/2006

We don't always agree with each other at MoneyWeek. Take commodities. John Stepek, with commodities bull Jim Rogers and most of us here at MoneyWeek, thinks we're still in the early stages of a long-term bull market. But Cris Sholto Heaton isn't so sure he thinks Morgan Stanley's Stephen Roach has a point when he says prices are in a bubble. Below, Cris and John explain their views and, for the believers, we add three solid stock tips

There's been endless talk over the last few years about the globalisation-led commodity supercycle and it's beginning to get boring. As Stephen Roach, managing director and chief economist at Morgan Stanley, says, it rather suggests that the commodities market is different: "it gives the false impression of a one-way market, where every dip is a buying opportunity. Yet commodities as a financial asset are as bubble-prone as any other investment." The point is that, say what you like about very long-term market cycles, the fact is that commodity markets are extremely sensitive to economic growth and that means, says Roach, we can expect a "broad and protracted downturn in most economically sensitive commodity markets, including oil". There are three parts to Roach's bear case, all of which make sense to me: China, the US housing bubble and the belief that commodity investors are getting carried away.

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Let's take China first. It's universally acknowledged that the country's vast demand for raw materials has been a crucial factor in the commodity bull run. But it's rarely stressed exactly how important China has been. "During the 2002-2005 period, China's share of the total growth in global consumption of industrial materials was off the charts; 48% for aluminium, 51% for copper, 110% for lead, 87% for nickel, 54% for steel, 86% for tin, 113% for zinc, and 30% for crude oil," says Roach. Without China's appetite, global demand for copper, zinc, nickel, cement and steel products would have fallen last year.

That's not a problem if China continues to gobble commodities at this kind of rate, but it's a huge problem if it doesn't. And there's every chance it may not. The Chinese authorities are keen to rebalance the economy from one heavily dependent on industrial investment and exports into one in which private domestic consumers play a much greater part. This means, says Roach, that they are tightening monetary policy and increasing controls on certain industry sectors with the goal of cutting annual GDP growth from 10%-plus to 7.5% over the next few years. That alone is likely to have a big impact on Chinese demand. At the same time, the authorities are aware that their current commodities usage level is unsustainable, which suggests, says Roach, that they will succeed in engineering a "well-publicised shift toward more efficient usage of energy and other commodities".

The final piece of the puzzle is the growing demand for commodity investments. Virtually every major institutional investor around the world now has a large and growing commodity department. One consequence of this is to make me rather wish I was a metals trader, not a journalist, but the other is that a huge amount of money has flooded into the sector; commodity trading advisers now manage more than $70bn in assets, more than three times the amount three years ago. This may sound like good news, but it isn't necessarily. Why? Because, as Roach observes, it "alters the character of commodity investments Among other things, it subjects the asset to the same cycles of fear and greed that have long been a part of financial market history."

A big part of the gain in commodity prices so far has been due to the influx of speculative money, which has pushed prices up beyond what can be justified by fundamentals. Of course, in the real world one can't strip out speculative effects and say what something's worth in pure supply and demand terms. But Richard Bernstein of Merrill Lynch, another commodities cynic, notes a discrepancy in commodity markets that may give us an idea of the scale of the problem. He calculates that commodities that are listed on futures (defined on page 48) exchanges and are thus most easily accessible to speculative money trade at a premium of around 60% to those that are only traded in physical markets (and which see little speculative buying).

As long as commodity funds are making good returns, this speculative money will be content to sit there, propping up prices. But if returns start to lag, it will be out of the market fast. We may be approaching the point at which investors lose patience; while commodity vehicles have produced stellar returns over the last five years, one-year returns are firmly in negative territory for most. If investors bail out en masse, prices will fall even more sharply than the fundamentals suggest. Commodities are in a classic speculative bubble, says Roach. "Asset bubbles arise when perfectly plausible fundamental stories are exaggerated From tulips to dotcom and now probably US residential property as well, the boom all too often begets the bust." To that list, he expects to add the commodities boom and, much as I hate to disagree with my colleagues, so do I.

Jim Rogers has a phenomenal record. He co-founded the Quantum Fund with George Soros in the 1960s and did so well that he retired at 37. In mid-1998, close to the height of the dotcom boom, he launched the Rogers International Commodity Index. His timing was impeccable. While most investors were watching their portfolios crumble as their tech stocks imploded, investors in real' things were seeing the start of a commodities boom. The index has returned around 17% a year since launch, outperforming rival indices from Goldman Sachs and Dow Jones-AIG, which have returned 13.9% and 11.8% respectively, according to Forbes. To me, all this suggests that his views and his views on the commodities market in particular should be taken very seriously.

So what does he think today? Well, to call Rogers a bit of a bull on commodities would be to call the Pope a bit of a Catholic. Despite recent setbacks, Rogers is still very upbeat on the overall outlook and very dismissive of non-believers. "Stephen Roach couldn't even spell commodities two years ago," he says. One of Rogers's main arguments is that the current cycle simply hasn't lasted long enough yet. He points out that the shortest commodity boom, starting in 1966, lasted for 15 years, while the longest, beginning in the depths of the Great Depression, lasted 23 years. That means the current supercycle, at less than seven years old, still has at least as long again to run, he reckons.

The key driver for all this is the rapid expansion of emerging giants, such as China and India. China's demand for raw materials to develop infrastructure for its rapidly urbanising population of 1.3 billion people has sent the price of base metals, such as copper and zinc not to mention energy resources, such as oil and coal soaring in recent years. The bears think this can't go on and they are, of course, right to point out that nothing moves in a straight line there will be short-term cycles inside the supercycle. But it's absurd to think that Chinese demand for commodities will stop growing. Analysts from Investec pointed out this week that in Asia we are currently seeing the biggest "citification" of humanity in history.

The urban population of China is set to rise from 530 million now to 875 million in 2030. To house these people, "almost 50 cities the size of Greater London will have to be built in just 20 years". This is a hugely materials-intensive stage of development and over the next decade is going to demand "massive construction" and energy usage. Note too that India's development lags China's by about ten years, so just as China's raw material demand starts to level in a decade or so, India's will start to kick off. Under these circumstances, it's hard to see how anyone can really be a medium- or long-term bear on hard commodity prices, particularly given the chronic underinvestment in the sector over the last 20 years and the consequent supply constraints.

But it's not just about building roads and skyscrapers. As a population moves to the city and a wealthy middle class develops, its diet tends to change and that means higher consumption of, and higher prices for, soft commodities. This is something we've been interested in at MoneyWeek for some time and it's also one of Rogers's main themes. Almost exactly a year ago, he told MoneyWeek: "If I could only buy one sector in November of 2005 it would be agriculture." His timing was as perfect as ever. In the past year, the price of everything from coffee to wheat has hit multi-year highs. This is a trend I see continuing for some time and, after even a cursory glance at the numbers, I can't see how anyone can disagree. The OECD estimates that beef consumption in countries such as China and India is set to rise by nearly a third by 2015. That's good news for grain prices. The typical Chinese diet can currently be sustained on less than 400kg of grain a year but a US-style diet, with its larger portions of meat products, requires more than 900kg. It takes a lot of grain to raise a chicken. No wonder global wheat stocks are now equal to less than ten weeks of consumption, their lowest on record.

But why hasn't supply caught up with demand yet? It's easy to understand why supply shortages in assets such as oil and copper develop so rapidly. Establishing a mine or drilling for oil is complicated and expensive and it's not until a shortage develops and prices rise that companies tend to start looking for fresh supplies. But surely, the bears argue, if demand for something like wheat rises, it's just a matter of planting up another couple of fields and waiting for a year?

"Agricultural commodities are much easier to produce, not least because of frequent crop cycles and industrialised farming methods," acknowledges another commodities bull, David Fuller of Fullermoney.com. However, it's not as easy as some might think modern farming is energy intensive and is vulnerable to adverse weather conditions. It's also worth remembering that farming is very water intensive and that fresh water is in increasingly short supply across the globe. A full two-thirds of all water used on the planet is already used for irrigation purposes. It takes between 2,000 and 5,000 litres to grow one kilogram of rice and about 11,000 litres to grow the feed for enough cow to make a quarter-pounder. So increasing pressure on the global water supply will only make it more difficult to expand the food supply to meet a growing population's needs, as indeed will the increasingly unpredictable weather conditions many think are related to global warming.

With all these threats to supply, it's no surprise that prices have soared. But the boom is far from over yet. Adjusted for inflation, most soft commodities are well below their all-time highs. Fuller points to an inflation-adjusted chart of the CRB index since 1961. "For this chart not to move substantially higher over the next 15 to 20 years, we would have to assume combinations of the following: severe global recessions, little emerging market growth, little inflation and a huge increase in the production of resources."

Long-term bull cycles aren't without downward trends. "Something always causes consolidations," says Rogers, "and some of them will be dramatic. It could go down 20%, 30%, 40%", but when the dust clears, "the bull market will still be there" and long-term holders will be making money. So how much longer does the bull have to run? "Call me in 2019," Rogers tells Forbes. "I will say sell commodities'. And you will laugh and giggle and say Commodities always go up. You are an old fool'."

The Chinese consume 13kg of dairy products per head each year, compared to a world average of 100kg, so there's lots of room for the dairy market to grow as living standards improve and diets change. That's good news for China Dairy, whose market positioning in the northwestern region of China is superior to its main competitors, Bright Dairy, Yili Industrial and Mengniu. A deal with one of the largest networks of cattle farms in the region of Shaanxi and Xinjiang means China Dairy now controls 60% of the area's raw milk supply. It's also benefited from problems at rival Bright Dairy, which has been losing market share after a quality control scandal last year damaged its reputation. Bright's net profit fell 40% in the first six months of 2006, while China Dairy's rose by 11%. China Dairy is expected to achieve a return on equity of more than 20% over the next three years.

Cresud is Argentina's largest publicly traded agri-commodities firm. It is controlled by successful manager Eduardo Elsztain. Farming activities include producing crops, beef-cattle and milk. Cresud has been adding to its herd in recent quarters and now owns about 88,000 heads of cattle. Cattle prices are up more than 50% since 2002 and should rise further as emerging countries move towards diets richer in protein. Its principal crops include wheat, corn, soybean and sunflower. Asian demand for soybeans remains high because soy protein is central to human and livestock diets, again pushing prices higher.

More importantly, Cresud is also the largest agricultural land owner in Argentina, with more than one million acres, and has significant commercial property interests in Buenos Aires. This makes the valuation rationale straightforward. The company owns more than $300m in commercial property and about $350m in farmland. Cresud also has $120m-$140m in cows, crops and cash. That translates into a value of approximately $750m or $770m against a market cap of $350m. And that's without considering the potential of its farming activities. At $15, the stock is too cheap.

This Canadian wheat pool has two main businesses. One is a retail business selling agricultural products such as seeds and fertilisers to farmers. Saskatchewan Wheat Pool has 100 stores located in three provinces across Canada's prairie. Dealing with the farmers' products is the second part of their business. It stores, cleans, sorts, dries, transports and sells them. This work is carried out by a network of high-tech grain elevators scattered across the prairie.

But here's the catch. The Saskatchewan Wheat Pool is not a direct play on crop prices. It's a play on the volumes sold, rather than prices. If the business of farming does well, the Wheat Pool does well. Times have been hard for Canadian prairie farmers. A three-year drought from 2001 to 2003 was followed by another poor season in 2004 when an untimely frost reduced the quality of the harvest, and that has pushed the price of the company down. However, with better harvests expected and reports of a long Australian drought doing the rounds (which will reduce competitive Australian exports), it's no wonder that the share price has since jumped close to 15% from its lows. Buy below $8.

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