Jeremy Grantham on Commodities
May 1, 2011
Jeremy Grantham's latest quarterly is an absolute masterpiece and focuses on an extremely important topic – the looming shortage of natural resources and the resulting rise in their prices. It is a long piece (18 pages) and I have summarised below what I believe to be the key points, but it is well worth your while to read the attached note in its entirety as this issue is likely to fundamentally alter our living standards over the next several decades. So without further ado:
- Accelerated demand from developing countries, particularly China, has caused a fundamental shift in the 100 year declining trend (-1.2% per year in real terms) of commodity prices which ended in 2002, and the price rise since has erased the entire 70% real decline!
- Current commodity prices are so far away from their previously declining trend, that this is very likely to be a paradigm shift, and is perhaps the most important event since the Industrial Revolution.
- Rapid compounded growth is not sustainable over a period of time, and we need to shift focus to quality of growth and income redistribution or we risk eventually running out of resources.
- From around 1800, the use of hydrocarbons has allowed for an explosion in the use of energy , food and economic growth leading to a dramatic increase in wealth and scientific progress.
- The surge population (from 800 million in 1800 to 7 billion and on the way to 8 billion), the ten-fold increase in wealth in developed countries and the explosive growth in developing countries, has rapidly utilized our finite resources of hydrocarbons and metals, fertilizers , land and water.
- Humans are adept at a great many things, but are not particularly good at dealing with long term horizon issues, deferring gratification, have generally poor math skills (in particular the inability understand the effects of compound growth) and are overly optimistic and overconfident. This makes it difficult to develop long-term policies to develop appropriate resource and oil policies.
- What has changed in recent years, compared to previous spurts in economic growths, is that China and India, with 2.5 billion people, have started to double their economies every 10 years (Britain took 100 years!) and this effect is seen most dramatically in the demand for resources.
- China, in particular, has had a dramatic impact on the usage of commodities, with its share of world consumption of commodities ranging from an incredible 53.5% (cement) and 47.7% (iron ore) to a more reasonable 10.3% (oil) when compared to its 9.4% share of world GDP! This is due to Its size, accelerated economic growth and its astonishingly (and unprecedented) high share of capital spending to GDP of 50%.
- The dramatic increases in commodity prices is best reflected by calculating the probability of reaching current prices versus the long term declining trend – iron ore has a 1 in 2.2 million chance its still on a declining trend, coal is at 1 in 48,000, copper is at 1 in 17,000, gold is at 1 in 210 and oil is at 1 in 160. It is far more likely that the trend has changed (just like oil did in 1974) than commodities being in a massive bubble which will deflate back to its declining trend.
- Oil was an exception to the 100 year declining trend in commodities, having been in an uptrend since 1974 – the year when the OPEC cartel was formed and 3 years after US oil production peaked.
- This paradigm shift was reflected in a doubling of the trend price of $16 to $35, and since 2003 the trend price seems to have doubled again to $75 (with a typically volatile range of $150 and $36 around this trend). Additionally, the cost of getting new oil has increased to $70-80 per barrel.
- Most paradigm shift arguments are optimistic, usually to justify higher bullish asset prices and in contrast to this particular paradigm shift which is actually very bad news and is a classic contrarian argument.
- Metals are also subjectto a compounded rise in demand, a declining resource quality and increasing cost of extraction – for example, since 1994 it requires 50% more of ore to extract a ton of copper, using energy at two to four times the former price.
- Agricultural commodities face a more subtle constraint in terms of declining yields and lower quality of available land - despite a five-fold increase in fertilizer use, the growth in crop yields has declined from 3.5% in the 1960s to 1.2% today, leaving a minimal safety margin given population growth at 1%.
- While agricultural prices may not have reached previous highs, they have doubled or tripled from their lows and increasing weather instability is a factor behind their price rise. However, better weather over the next 12 months is very likely which would result in sharply lower agricultural (and other) commodity prices.
- While increased speculation has had some impact on commodity prices, the effects of weather instability and, more importantly, a permanent shift in the underlying fundamentals are the major factors contributing to this paradigm shift in prices.
- A stumble by China over the next 12 months is a 1 in 4 likely event, and combined with better than expected weather (80% probability); it could cause a significant decline in commodity prices and maybe even a crash along the lines of the financial collapse. If it happens, it would present a second “once in a lifetime” buying opportunity in 3 years and should not be missed despite the usual bullish arguments which will reappear about inevitably declining raw material prices.
- To benefit from rising resource prices it would make sense to invest in good agricultural land, in fertilizer resources like potassium and potash, hydrocarbon reserves, metals and water.
- Given the high likelihood of a sharp fall in commodity prices next year, either due to good weather or a stumble in China, it would make sense to have a small position (say 1/4th of the eventual target size) in resources now and quadruple the position if we get a likely decline in prices.
- This paradigm shift in resource prices will relatively favour resource rich countries like the US – which has quality agricultural land, good water supply, rich hydrocarbon reserves and very large coal reserves. Countries which are energy efficient (like Japan) will also benefit. Poor countries with limited resources and little efficiency will suffer.
A fascinating note and provides ample food for thought to develop investment strategies to hopefully deal with this paradigm shift. A well-diversified portfolio in energy and metals stocks, water and other natural resource stocks, agricultural land, gold, nuclear energy stocks is likely to be a key distinguishing factor between below par returns and superior returns. As he suggests, getting some exposure today is critical in the event that resource prices continue their upward trend, and be ready (and brave!) if we do get a sharp fall or crash in commodity prices next year. An additional, and important, benefit of a portfolio weighted in natural resources is that it would provide the best hedge against high inflation in both emerging markets (already present) as well as the developed world (likely in a few more years).
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