It's time to be cautious on commodities

After a decade of rising prices, the commodity bull market has been embraced by the mainstream. But with high prices hurting global growth, and no sign of further money printing immediately ahead, it's time for investors to be cautious. John Stepek explains why.

Oil cartel Opec is meeting up tomorrow to discuss oil production quotas. It promises to be a fractious session.

One member, Libya, is in the midst of a civil war. That makes things complicated enough, as no one is sure who will be representing the country. But on top of that, some of Libya's fellow members, including Qatar and the United Arab Emirates, are backing the Libyan rebel contingent.

So the debate promises to be heated.

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And beyond the chaos of the Arab Spring', Opec has longer-term worries. With oil prices still sitting above $100 a barrel, it may seem that the cartel is sitting pretty in financial terms.

But in fact, Opec may be facing the biggest threat to its influence on the global energy market it has yet seen.

The best cure for high prices

Trying to control the price of anything centrally isn't as easy as it might seem. The market has a way of asserting its authority whether you like it or not.

Just ask Opec. Its members control around 40% of the world's oil. About the only commodity more important to modern existence is water, and the market in that is very restricted. So you would think they should be laughing.

But here's where it gets complicated. What's the right' price for oil? You might argue: "as much as you can get for it". The trouble is, if prices are too high, then two things happen.

Firstly, high oil prices hurt economic growth. You can already see this happening around the world, particularly here in Britain. We've just heard this morning that retail sales in May were down 2.1% on last year. "Households' disposable incomes continue to be squeezed by uncomfortably high inflation and low wage growth", said Stephen Robertson of the British Retail Consortium.

The airline industry is also being hammered. The International Air Transport Association (IATA) warned that carriers are set to make $4bn this year, less than half of what it initially estimated.

As prices rise, people consume less. Even demand for something as vital as oil isn't completely impervious to rising prices. So high prices do what they always do. They sow the seeds of lower prices in the future.

The golden age of natural gas

But there's a much bigger, longer-term risk for Opec. While prices remain high, Western consumer countries have every reason to find a substitute for oil. Or a substitute for Middle Eastern oil, at least.

And that day could be drawing closer. The International Energy Agency (IEA) reckons that we could be nearing a golden age' for natural gas, reports The Times this morning.

We've covered natural gas several times before in MoneyWeek magazine. Subscribers can read our most recent take on it here: The best bets on natural gas. Suffice to say, advances in technology and extraction techniques, added to the incentive of high oil prices, mean we can expect natural gas to grow in importance over the coming decades.

It's important to note that the IEA still expects demand for oil to continue to rise. But gas will have almost caught up with it, and overtaken coal as an energy source, by 2035.

The impact of substitution and innovation isn't just confined to the energy market. As Dylan Grice of Societe Generale has noted in the past, a bet on commodities is a "bet against human ingenuity".

Commodities look vulnerable

We have long backed the idea of a commodity supercycle. But the point is that it is a cycle. The notion of peak' resources has gone from being a fringe argument with some sensible warnings to heed, to being a mainstream we're all doomed' story.

We're not necessarily saying that commodity prices are in a bubble, or that we're on the verge of a massive crash. But as Lord Rothschild, who chairs one of Tim Price's favourite investment trusts, RIT Capital Partners (LSE: RCP) noted in the company's recent update: "After a decade of commodity leadership, a shift to a new regime is a possibility".

Given that RIT has long been invested in commodities, and has an excellent track record, it's worth paying attention. The trust is now turning its attention to "the attractive level of valuation of many quality companies", which we'd take to mean the sorts of defensive big blue-chips that we're fond of.

It's also becoming clearer that investors cannot rely on another bout of quantitative easing (money printing) to prop up the markets at the slightest wobble. Philadelphia Fed President Charles Plosser, who is on the Federal Reserve's interest rate-setting committee, has warned that "the hurdle rate for doing more [QE] is very high". In fact, "somewhat tighter monetary policy is possible by the end of the year We will have to begin exiting from our policies long before the unemployment rate is down to what people would like to have".

Tighter global monetary policy and a slowdown in demand all suggest that investors will have to be a lot more picky about which commodity plays they back. It's also worth looking ahead to what might help us to reduce our dependence on certain commodities. We have more on how to bet on human ingenuity in the next issue of MoneyWeek, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.

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.