Over the past 100 years, we have had four great commodity booms—World War I, World War II, the industrialization of Japan and the OPEC embargo, and the industrialization of China. Each of these followed a long period of demand stagnation and a lack of investment in new supply. As these new demand sources emerged, a similar series of “stages” unfolded:
- Stage 1: A new source of demand emerges that begins to put pressure on global supplies. Miners are slow to respond as years of low prices weigh on management’s desire to invest, while access to capital is constrained.
- Stage 2: Global supplies drop sharply in response to the new source of demand and a lack of investment in new supply. Management teams begin to greenlight new projects and the expansion of existing projects. Access to capital improves. This is the stage of maximum profitability for mining companies as prices are skyrocketing but operating costs (e.g., labour and equipment) remain low.
- Stage 3: Demand continues to grow driven not only by the new source of demand, but also by investment demand. Global supplies begin to catch up; however, because of long development times for new mines (typically 5–7 years) the “catch-up” is gradual at first. Profitability for mining companies begins to wane as costs start to rise sharply driven by competition for labour and rising input costs (governments also tend to begin seeking higher royalty rates in order to get their share of profits).
- Stage 4: Growth from the new demand source begins to slow as either the event that drove demand runs its course or because nothing can go straight up forever. Supply continues to ramp up as projects initiated years before come to market and capital continues to flow freely into the market. Prices collapse and profitability for the industry collapses with them. Balance sheets start to become an issue as funding projects that are partially completed absorbs cash flows.
- Stage 5: Supply now far exceeds demand and prices for most commodities drop below the costs of production for most supply sources. Capital flow ceases and companies shift into survival mode. Supply continues to grow for a time as projects started years before continue to reach completion. Investment in new projects all but ceases and higher cost projects are shut down. The industry essentially goes into hibernation until the next demand driver emerges.
The five stages of the commodity cycle
Source - RBC Wealth Management
Supply and demand tend to move through a 5-stage process.
The first four stages have tended to play out over the course of about a decade or more, while stage 5 has proven to be of a similar length (10–20 years).
In the throes of stage 5
After years of double-digit growth in GDP, the Chinese economy has downshifted. Exacerbating this, at least from the commodity complex’s point of view, has been the sharp mix shift in Chinese growth. The two main components of GDP are fixed asset investment and consumption. Consumption typically makes up about 50%–70% of growth, while investment typically comprises 20%–30%.
During the boom years, the Chinese economy turned this relationship on its ear as investment made up around 50% of GDP. This was the sweet spot for commodities as investment-driven GDP growth tends to be commodity-heavy.
Chinese economy: Industry shares of GDP
Source - China National Bureau of Statistics, RBC Wealth Management
The Chinese economy is gradually shifting toward services.
As Chinese fixed asset investment has slowed, most commodities have been left in a position of oversupply. Further, because this shift in Chinese growth appears to have caught many commodity companies by surprise, supplies are expected to grow over the next several years for most commodities.
All commodities are not created equal
It is important to note that while the rapid pace of Chinese industrialization has been responsible for the upshift in demand for most commodities over the past decade, not all have been impacted in the same way. Whereas China accounts for 40% or more of global demand for copper, aluminum, iron ore, zinc, nickel, and more than 50% of global demand for thermal and metallurgical coal, it accounts for less than 15% of global demand for oil.
Demand for energy, agricultural commodities, and wood products all tend to be driven by rising global population and consumer incomes rather than fixed asset investment. And they have their own unique supply-response cycles, which are mostly much shorter than for the industrial commodity complex. Thus, we would not expect all commodities to necessarily spend the next decade or so dealing with persistent supply/demand imbalances.
The majority of losses tend to occur in the first five or six years of the selloff ... typically followed by 5–15 years in which prices tend to stagnate.
The implications will differ from market to market
Commodity-heavy economies such as Australia and Canada will likely feel the pinch, although even here there will likely be significant variability. Australia is much more exposed to bulk commodities and base metals than is Canada, which is more oil and natural gas weighted. Conversely, economies like the U.S., which is a big net importer of most commodities, should enjoy the tailwind of lower prices for some time to come.
From an investment perspective, the majority of losses tend to occur in the first five or six years of the selloff; however, this has typically been followed by a period of 5–15 years in which prices tend to stagnate. To be sure, there are tradeable rallies during this period in “the doldrums,” but they tend not to be sustainable and often draw investors in during their latter stages. Most commodities peaked four or five years ago, so we may be approaching the end of the “sharp selloff” period and poised to enter the long period of consolidation.
In this new phase, most investors will likely find it challenging to “time the bottoms” and “know when to take a profit.” For commodity-heavy markets such as Canada, we would continue to advocate looking to diversify portfolios not only to non-commodity-linked sectors, but also to other markets.
In general terms, commodity cycles tend to follow five stages. The first four stages, which have historically been sparked by enormous demand drivers such as world wars or mass industrializations, tend to last one to two decades and are marked by demand outpacing supply. Stage 5 tends to last about as long as stages 1–4 and typically follows over-investment in supply and the culmination of the demand driver that sparked the supercycle.
The pace of China’s industrialization has clearly “come off the boil” and with that commodities have entered stage 5. If history is any guide, it may be the better part of a decade before supply/demand imbalances are resolved and a new demand driver emerges. Until then, we would approach the commodity complex with caution.