The raging (commodity) bull

So long as the global economy continues to expand, reports of the end of the bull market in commodities will remain greatly exaggerated.

December 8, 2014
by Michael Hlinka

From the December 2014 print edition

Many years ago, Mark Twain famously quipped: “The reports about my death have been greatly exaggerated”. These words came to mind recently as a number of different commodities sold off, bringing both the Canadian dollar and Toronto Stock Exchange down with it.

Oil, which had been hovering around $100 a barrel for most of the summer, dropped sharply during autumn. At the beginning of 2014, copper was $3.35 a pound and year-to-date it was down about 10 percent mid-way through November. All this got some folks wondering whether the bull market in commodities is over. Let me assure that it’s not—in fact, it has barely even started!

Before I go any further, one important caveat: I exclude gold from this discussion.  There’s a simple reason for that. Gold, as an investment, is a vote for the power of superstition, nothing more and not less. I had a high school teacher back in the day that quite correctly pointed out that mankind has been subject to superstitious impulses for a long time and that was unlikely to change in the future. I’ll grant that, but I can’t reasonably guess at the future demand for the shiny metal—it’s a total enigma to me.

However, what I can predict with a great deal of certainty is the need for products like oil and copper as the developing world continues to grow. A bit of simple arithmetic makes the point.

There are 35 million Canadians. We consume 64 barrels per day per 1,000 people.  There are 1.272 billion people in India. They consume fewer than three barrels per day per 1,000 people. A total of 2.24 million barrels of oil are consumed in Canada each day, while 3.8 million barrels of oil are consumed in India each day. Imagine if each Indian consumed even one-fifth of what the average Canadian does. That’s a surge of 12.5 million barrels of oil a day! As for copper, we’ve seen a clear trend in consumption over the past years. In 1980, about 10,000 metric tonnes were used globally and it was twice that amount last year. The growth has been steady and persistent: 2 percent compounded annually.

Let’s go back to Economics 101 and the relationship between supply and demand.  Everything else being equal (which almost never happens in this world) if there is an increase in demand, there will be an increase in price.

But markets are dynamic. As—and this was particularly true in the decade of the 00’s—producers understood that what was going on in countries like China, Brazil and India was real, that is, these nations were embracing pro-growth economic policies, allowing markets to do their magic. There was the understanding that lots of money could be made slaking the developing world’s thirst for commodities. A huge amount of investment made in the producing regions of the world, including Canada.

Economics 101 provides another important lesson. We know we want to invest in a copper mine when copper is $3.25 a pound, and there are two alternatives. Each will cost us $100 million—which is the extent of our budget. Mine one has X thousand pounds and the cost per pound to extract is $3, while mine two also has X thousand pounds, but the cost per pound to extract is $3.50. Mine one it is!

Several years go by. Demand for copper continues to increase. When copper is $3.25 per pound, we’re making an adequate return on investment with mine one.  We just can’t afford to produce at mine two unless the price goes up, and this will happen as the demand effect overwhelms the limited supply on the market.

I’m simplifying, of course, because the interplay is more complex. Large capital projects, like mines, are only brought on-stream when revenue minus expenses covers all costs, both the variable and fixed ones, and an adequate profit is anticipated. But once a mine is operational, if prices go down, operations will continue as long as the price received exceeds the variable costs of production.  This is one of the primary reasons why commodity markets are so volatile, swinging from boom to bust then back to boom soon thereafter.

And nothing goes up in a straight line. Over the past 50 years oil has been extremely volatile. In 1964, it averaged $3 per barrel. By 1980, it had spiked to $37.42. By 1998, it was below $12. Then we saw runaway prices peaking at an average of $91.17 last year. But here’s the important lesson: over 50 years, oil’s nominal price increase is around 7 percent—which matches nominal economic growth. And it’s no exaggeration to say that as long as the global economy continues to expand, that reports about the end of bull market in commodity prices are greatly exaggerated!

Toronto-based Michael Hlinka provides business commentary to CBC Radio One and a column syndicated across the CBC network.