Commodities Drop Looks Secular, Not Cyclical

(Bloomberg Opinion) -- Any way you measure it, the market for commodities is suffering. The Bloomberg Commodity Index of 22 key raw materials ranging from oil to copper to soybeans has dropped about 10 percent since reaching an almost three-year high in May.  I’ve identified 10 forces that explain the weakness and why it will persist.

1. Slowing economic growth globally and a possible recession in the next year. Commodity producers seldom moderate supply to match weakness in demand, and commodity prices drop in recessionary climates.

Harbingers of a recession: Universally falling stocks, tighter Federal Reserve monetary policy, the soon-to-invert yield curve, weakening housing activity as mortgage rates rise, unsustainable corporate profit growth and soaring consumer confidence combined with lower savings rates. Globally, the Organization for Economic Cooperation and Development’s index of leading indicators is falling. Copper is an excellent gauge of worldwide economic activity since it’s used in almost all manufactured goods and has no price-constraining cartel on the supply side or legal restrictions on demand. Copper prices are down about 16 percent since June.

2. The strengthening dollar is increasing the local currency cost of commodity imports in developing as well as advanced economies, and I forecast the greenback, the world’s primary reserve currency, will continue to appreciate. Of my broad list of 45 commodities, 42 trade in U.S. dollars. High costs cut commodity demand and prices.

3. Chronic excess capacity exists among commodity producers. Fixed costs are high but variable costs low. A major new copper mine costs $5 billion to $10 billion to develop, but the variable costs of mining another ton of copper are small. So profits leap after demand and prices are high enough to cover fixed costs. This spurs investment and expansion since miners seem oblivious to the resulting excess capacity and falling prices it spawns.

4. Slowing growth in China is curbing commodity usage as GDP advances drop from double digits before 2007 to 5.8 percent in the third quarter. China’s planned shift from goods exports and infrastructure spending to domestic consumer spending is disruptive. Furthermore, 53 percent of GDP last year came from low commodity-intensive services, up from 34 percent in 1995.

China’s growth will slow further since its unemployed labor force is nearing exhaustion and because its emulation of Western technology, enhanced by stealing American technology or requiring tech transfers as the price of doing business in China, is over. China, like South Korea before it, is entering the “middle income trap.” Furthermore, China’s labor pool will shrink in future years as a result of her earlier one child-per-couple policy. The 15-to-64 year-old age group is set to fall from 1 billion in 2015 to 717 million in 2060.

5. As economies grow, proportionally less is spent on commodity-intensive goods and more on services.  You can drive only car one at a time, but spend almost unlimited funds on travel, recreation, education and other services. This is true for developed counties like the U.S. where outlays on services climbed from 39 percent in 1947 to 69 percent in 2017. It’s also true for emerging markets like China, where the services component of GDP rose from 34 percent in 1995 to 52 percent in 2017.

6. Globalization disrupts economic growth in the West to the detriment of commodities. In the last three decades, U.S. manufacturing employment plunged from 17 percent of total payrolls to 8.5 percent. Many of those displaced are flipping hamburgers, driving for Uber and employed in other low-paid jobs. The resulting stagnation of real wages has spawned disruptive populism as voters throw out centrist politicians in favor of the far right and extreme left. Furthermore, the deflationary climate sired by globalization has trained consumers to resist price increases, forcing many sellers to eat rising labor costs and pressure commodity producers.

7. The escalating trade wars disrupt economic growth and commodity demand as uncertain business people postpone capital outlays. Supply chains are also disrupted. Many American companies don’t export to China but depend on intermediate goods from that country. In President Donald Trump’s initial $50 billion round of tariffs, 53 percent were on intermediate imports from China and 50 percent of the impending $200 billion second round.

8. Mounting inventories depress commodity prices. Producers can’t be sure initially whether weakening demand is momentary or serious and don’t want to disrupt production. So inventories climb. After Trump’s tariffs curtailed exports of soybeans, stockpiles soared. Lack of pipelines to move oil has created a $6.75 per barrel discount for oil in Texas’ Permian Basin compared to West Texas Intermediate crude at $52 per barrel and excess inventories. Similarly, Western Canada Select oil from oil sands in Alberta is discounted $34 to WTI.

9. The realization that a peak in oil demand, not supply, is in the cards as rising supplies of natural gas and LNG as well as renewables replace oil (see my Oct. 12, 2018 column, “Oil Bulls and Perpetual Surpluses Don’t Mix”). Renewables such as hydro, wind and solar accounted for only 12.1 percent of electricity generation last year, but the IEA forecasts them to account for 56 percent of new generating capacity through 2025.

Due to conservation including more efficient vehicles, energy conservation per dollar of economic activity since 2017 declined by 43 percent in Canada, 61 percent in the U.S., 48 percent in Japan and 70 percent in the U.K.Mushrooming electric vehicle sales will slash crude demand since transportation accounts for about half of oil use and autos are around half of that, or 25 percent of the total.

10. Real commodity prices, or those after taking inflation into account, fall steadily in the long run as efficiency, substitute and human ingenuity consistently beat temporary shortages. Major wars cause only temporary spikes.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, a Registered Investment Advisor and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.

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