Commodities: Boom or bust?

Commodities: Boom or bust?

The debate surrounding commodity prices has heated up in recent months. It’s not the first time this issue has captivated investors nor is it likely to be the last. In the past decade alone, the boom or bust question about commodities made headlines in 2000, 2002, 2006, 2008, 2009 and now again in 2011. For Canadian investors, with almost half of our market’s capitalization linked to two commodity-based sectors – energy and materials, it’s an important discussion.

Essentially the debate about commodity prices falls into two camps. The first one – Excessive demand for commodities is making them scarce, the sky’s the limit!, is favoured by the likes of Jeremy Grantham, Chief Investment Strategist at GMO LLC. The opposing view – As commodities get too expensive, human ingenuity will find another way – efficient markets rule!, can be found among economists such as Steve Horowitz, an economics professor at St. Lawrence University and Sean Corrigan, Chief Investment Strategist at Diapason Commodities Management as well as strategist Niels C. Jensen of London’s Absolute Return Partners LLP.

Scarcity will drive commodities higher

In his April 2011 letter to investors, Jeremy Grantham, describes what he believes is “one of the giant inflection point in economic history.” In his view, commodity prices have undergone a paradigm shift from a 100-year trend of declining prices, largely as a result of productivity improvements, to a sharp reversal. Beginning in 2002, this reversal erased the 100-year decline in commodity prices in just eight short years – the biggest price surge since World War II. According to Grantham, it’s accelerating demand from developing nations, such as India and China, that is driving this recent commodity price boom.

China’s seemingly insatiable consumption of commodities is key to Grantham’s analysis, citing consumption rates upwards of 40% of the world’s supply of key commodities, including lead (44.6%), steel (45.4%), coal (46.9%), iron ore (47.7% and cement (53.2%). He believes that resource shortages and price pressures will be a permanent fixture going forward.

Price pressures will spur ingenuity

According to Steve Horowitz, ever since the industrial revolution, people have been concerned about running out of resources. In his view, we aren’t running out of anything – price pressures will encourage more efficient resource use and spur on the development of substitutes. Steve cites the use of copper wire in the 1960s to expand telephone service throughout the United States. Prices for copper surged amid worries about scarcity but with the invention of fibre optic cable as a replacement for copper wire, these concerns soon disappeared.

Today, more than 60% of the world’s oil consumption is taken up by transportation (55 million barrels each day!). According to Niels Jensen, it will only take one or two of the alternative fuel technologies coming on board to dramatically alter this picture. He points to hybrid cars, such as Volkswagen’s new XL1, which drives an incredible 110 km per litre as part of the solution. Although not likely in the short or medium term, if every car in the U.S. could attain this level of fuel efficiency, about 7.5 million barrels of oil would be saved every day. In Niels’ view, significant reduction in oil consumption is only a matter of time.

Sean Corrigan is firmly in the “human ingenuity will save the day” camp, arguing against the notion that continued growth will overwhelm the planet. He points out that the world’s current population is the equivalent of 1,000 Hong Kongs, stating that if everyone lived in Hong Kong’s high-rise fashion, we’d only occupy a landmass the size of Cuba. Corrigan concedes that it will take tremendous technological advances to ensure we won’t wind up in a Blade Runner-style existence but he’s willing to put his faith in what he calls the best computer in the known universe– the human brain.

So what is an investor to do?

These conflicting and compelling arguments don’t change the fact that investors face a difficult choice. But at the risk of repeating ourselves, we aren’t fans of placing big bets, one way or the other. In the past, commodities have both burned and rewarded investors and there’s no reason to assume they won’t do so again. The Canadian market provides you with ample exposure to commodities. However, commodities represent less than 5% of Canada’s GDP, so their market capitalization overstates their impact on our economy. Manufacturing, which amounts to more than 15% of Canada’s GDP, is largely absent from our stock exchanges because it is either held in private hands or is a foreign-owned subsidiary. For access to the broad range of sectors that shape the Canadian and global economy, you need to be diversified beyond our domestic exchanges and home-based companies, incorporating prudent exposure to growth opportunities from around the world.

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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