Rising Commodity Prices Hide Longer-Term Challenges
(Bloomberg View) -- As major economies continue to expand moderately, it's not surprising that commodity use is increasing and many prices are rising. The Bloomberg Commodity Index is up 20 percent since early 2016. Crude oil prices have more than doubled since bottoming in February 2016. The MSCI World Metals & Mining Index of equities has risen about 90 percent since the start of 2016, topping the 30 percent gain for the MSCI All Country World Index.
Yet the rosy outlook presented by financial markets masks challenges for commodity producers from a broader transition in the economy: A greater share of economic spending is on services and a declining portion of outlays is for goods. In 1947, 61.6 percent of U.S. personal consumption expenditures was devoted to goods and 38.4 percent to services. In 2017, those shares were 32.3 percent and 67.7 percent, respectively. The same dynamic is at work in emerging economies such as China. In the services sector, consultants use some commodities via computers, but the vast majority of the output is in analysis and experience. Among goods, in contrast, vehicles are largely composed of commodities such as steel, aluminum and rubber.
Slower economic growth in China is a concern to commodity producers and exporters worldwide, especially since that country uses 40 percent to 50 percent of global production of many mineral and agricultural products, according to data from the National Bureau of Statistics of China. In fact, the ups and downs of the commodities market since 2001 can be tied to China's decision to join the World Trade Organization at the end of that year. Although big miners of copper, coal and other raw materials collectively undertook new projects that cost $1 trillion in total to take advantage of demand from China, many producers failed to realize that China was not adding much to net global demand for commodities but rather absorbing more of the global total as manufacturing shifted there and to other developing countries from North America and Europe.
That became apparent during the recession that followed the financial crisis, when commodity prices collapsed. That left many commodity producers in sore shape with threatened bankruptcies. Capital spending budgets were axed, dividends were slashed or eliminated, and mines were mothballed. Prices have recovered from their lows, but the Thomson Reuters/Core Commodity CRB Index remains below its October 2000 level. Adjusted for producer price inflation, that index is down 31 percent over the 17-plus intervening years.
You might think that major commodity producers would use their profits to rebuild balance sheets while restraining capital spending. Instead, they are back to their old ways, apparently believing that the rebound in commodity demand and prices will last indefinitely.
Mining companies show confidence in further rises in commodity prices and their profits and growth in China by returning to capital spending. Outlays by major companies in the first half of 2017 were about one-quarter of the 2011-2012 boom levels, but could rise 30 percent in the second half of the year, the sharpest increase since 2012.
The cost of developing a major new copper mine can be $5 billion to $10 billion. But once those expenses are completed, the variable costs of mining and processing another ton of copper ore are small. Such economics encourage investment and expansion when profits are lush, often resulting in excess capacity and a drop in prices.
My analysis of commodity markets and their economics suggests seven strategies:
- Take advantage of current robust commodity markets.
- Don't count on long-term real commodity price rises. Since 1850, the inflation-adjusted CRB commodity price index has fallen 83.9 percent thanks to technological advances and substitutes that overcame perceived shortages.
- Watch the ultimate buyer of commodity-using products, especially North America and Europe, and put less emphasis on China and other commodity processors.
- Remember that shortages are temporary and overcome by human ingenuity and substitutes.
- Don't increase financial leverage to levels that will be embarrassing during the next commodity decline.
- Restrain costs.
- Keep plenty of cash and borrowing power in order to buy assets cheap in the next downturn.
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, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”
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