There's much more shock and ore in the pipeline

Telegraph

By Tom Stevenson (Filed: 18/04/2006)

You may not realise it, but you are almost certainly taking a punt on one of the key investment questions of 2006: is the explosion in commodity prices the start of a sustainable super-cycle or a bubble waiting to burst?

Even if you have not joined the rush to ride the oil, gold and base metals bandwagon, your pension fund most likely has. Unprecedented amounts of retirement savings are flowing into the sector as money managers seek better returns and a diversification away from equities.

The Sainsbury's pension fund has bet 5pc of its £3.2bn fund on a continuing rise in prices. Hermes, manager of the UK's largest pension, recently launched a commodities fund into which it has invested £1bn of the £34bn it manages.

It is easy to see why investors should be attracted to the sector. Gold has broken through $600 an ounce for the first time since 1980, more than twice its level five years ago. The oil price has risen six-fold since 1999. Copper has tripled in six years while the prices of other base metals like nickel and zinc continue to hit new records.

With movements like these, it is no surprise that speculative investors have spotted an opportunity. Investment bank Macquarie estimates that $80bn was invested in commodity index funds in 2005, up from $55bn in 2004 and less than $30bn in 2003. Forecasts point to an inflow of up to $150bn a year by the end of 2007.

But this is about much more than mere speculation. All investment booms require a plausible story and with commodities it is an unusual combination of rising demand and constrained supply. The "super-cyclists" believe this will underpin a multi-year upswing.

Others caution that things are never "different this time". They argue that rising interest rates around the world, a slowdown in US consumption and growth in production will soon prick the bubble.

First, the bull case, most of which can be summarised by one word - China. The Asian dynamo's remarkable expansion in recent years means it dominates the growth in global demand for raw materials.

China makes 90pc of the world's toys, 50pc of its cameras and 70pc of photocopiers. It is estimated that 80pc of Wal-Mart's 6,000 suppliers are in China. The country has 130 cities with a population of more than 1m. Around 300m Chinese will move into new houses by 2020, all of which will require new plumbing, electricity and appliances. The mind-boggling statistics go on and on.

China is at a resource-intensive stage of its economic development. Post-industrial countries like those in Europe and North America use less base metal and one day China and India will too. But that day is a long way off.

The second part of the bull case is the supply side of the equation. In the past, commodity prices have followed a well-worn trajectory. As economic growth boosts demand, metal prices rise and producers respond by investing in new supply. Thanks to long lead times, this usually comes on stream just as interest rates rise to choke off inflation. Subdued demand and over-supply combine to slash prices.

This time really does look different in some key respects. Over the past couple of years producers have shied away from new developments, despite the surge in demand. Mining companies are more focused on returns than they were and they have seen share buybacks and acquisitions as lower risk ways of cashing in on rising prices.

After years of under-investment there is now a serious shortage of qualified workers and equipment, with Caterpillar, for example, warning that mining kit is sold out through 2007. Such is the shortage of big tyres, that machinery is routinely sold without them. There has also been a massive fall in metal discoveries over the past 25 years and, while there has been an uptick in exploration recently, it looks too little too late.

One last reason for thinking that commodity prices have further to go is the fact that in inflation-adjusted terms, they are not expensive. According to UBS, despite doubling in two years, base metal prices have only just broken through a 30-year down trend. On average they are less than half their real price in 1974. This is where veterans of the dotcom bubble get nervous. When investors start to talk of new paradigms and things being "different this time", it is usually the time to be most cautious.

Capital Economics argues that there has been a good reason for the real price declines over the past 50 years. Despite global consumption of steel and copper, for example, rising seven-fold over the period and aluminium nearly 30-fold, producers have always satisfied massively greater demand. There's plenty of ore in the ground.

It also believes that a shift in China away from investment towards consumption of goods and services will make its economy less commodity-intensive. This will compound an expected slow-down in the US economy and lower global growth next year, all of which should reduce the upward pressure on prices.

Finally, it says speculative demand, which has fuelled much of the recent boom could easily swing into reverse if prices start to fall.

In the short-run, prices do look frothy. But however plausible the bearish argument, the force is with commodities. Market trends continue long after prices have left fair value behind. So, super-cycle or bubble, don't count on this boom ending soon.

tom.stevenson@telegraph.co.uk


© Copyright of Telegraph Group Limited 2006. Terms & Conditions of reading.
Commercial information. Privacy and Cookie Policy. Disclaimer.