The old regime of falling commodity prices has ended | Outlook Business
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Perspective

The old regime of falling commodity prices has ended
A mixed outcome is in store for commodities with prices for some rising and others falling 

Jeremy Grantham

After every historical major rally in commodity prices, there has been the predictable reaction whereby capacity is increased. Given the uncertainties of guessing other firms’ expansion plans, the usual result is a period of excess capacity and weaker prices as everyone expands simultaneously. The 2000 to 2008 price rally was the biggest in history, above even World War II. It was, therefore, not surprising that the reflex this time was the mother of all expansions and excess capacity. This was further exaggerated by a sustained slowdown in demand from China, which is still playing through. The most dramatic example of this was in China’s use of coal, which had grown from 4% of world use in 1970 to 8% in 1988 and to 50% in 2013, the world’s most remarkable expansion in the use of anything since time began. And yet this remarkable surge was followed in 2014 by a reduction in China’s use of coal! And that in a year in which China was still growing at over 6%.

So, how profound was this supply surge and price decline? The graph (see: Still way over trend) shows our original index, which is made up of 33 important commodities equally weighted to avoid the data being overwhelmed by oil, which constitutes around 50% of all tradable value in commodities. You can see that although the average price has declined handsomely, it has only given back about one-third of the preceding great price surge.

Still way over trend

Assuming no global depression, we are unlikely to return to the declining

price trend of the 100-year period ending in 2000

 

And now, with a further sell-off in commodities following China’s recent mini stock bust, the reaction phase may be more or less complete. Projects have been cancelled and capital spending plans in general have been savaged. Investment attitudes are extremely negative, which is, as always, a requirement for change.

Wall Street Journal carried a headline on July 21, 2015 saying, “Investors Flee Commodities.” Promising. From now on it seems likely that prices will be more mixed, with some rising as others continue to fall. What seems extremely unlikely, assuming we have no global depression, is a return to the declining price trend of the 100-year period ending in 2000.

In agriculture, we also had a global sell-off following three consecutive years in which extremely hostile grain-growing weather had driven prices to panic levels of triple and quadruple their previous lows.

Good, unused arable land was scarce, but most of what could be thrown into battle was. And, as I suggested three years ago, investors should have counted on less bad weather inevitably arriving, perhaps even above-average conditions, which for the last two years has occurred. Yet although grain prices are way down (approximately -40%) from their panic shortage highs of 2011, they are still way up (approximately +70%) from their 2000 lows. And bad weather will be back: it has been bad here, there, and everywhere recently (California’s drought, notably) except for major grain-growing areas. All in all I am still very confident, unfortunately, that the old regime of irregularly falling commodity prices is gone forever. 

A further change in my thinking on resource availability has to do with their occurrence in the Earth’s crust (see: Ground reality). I will no longer worry about the three important commodities that are relatively plentiful: bauxite (aluminum) at 8.2%, iron ore at 5.6%, and potash (potassium) at 2.1%. Even though a relatively plentiful supply in the Earth’s crust does not absolutely guarantee long-term cheap resources – e.g., aluminum is more about the electricity cost to extract it – life is too short to focus on anything but the biggest threats to our well-being. For instance, why worry about the critical-to-life potassium when phosphorus, equally critical, is one-twentieth as common! Similarly, chrome, nickel, zinc, copper, lead, and tin added together are not nearly 1% of iron ore’s occurrence. 

Ground reality

There is no risk of paucity for important commodities as

they are abundantly available 

Among commodities, oil has been king and still is. For a while longer. Oil has driven our civilisation to where it is today. It created the surplus in our economic system that allowed for scientific research and rapid growth. Now, as we are running out of oil that is cheap to recover, the economic system is becoming stressed and growth is slowing. 

A penny drops 

I hope you will remember the exhibit (More than just buffer.) It is used by all peak oilers. It really does show what we might call the first derivative negative. If we keep on pumping more than we find, we will certainly run out of cheap oil. Eventually. But this data is also unsatisfactory.

Given this exhibit, how is it possible that since 1982 (the first year we pumped more than we found) global reserve life has risen by 60%, despite oil demand growing by 1.5% a year? (Which dichotomy has led the bulls to ignore all negative data and assume that somehow we will always have enough oil.) Well, this is why. When the original giant Saudi fields were being discovered, the first oil volunteered to bubble to the surface virtually free of cost. Why bother to expensively tease out more with so many new fields being discovered?

The ultimately cheap recovery rate was only about 15% of the oil that was there, but who cared? By 1982, the US production, for a while the largest in the world, had famously peaked out (in 1970) so there was a modestly growing interest globally in capturing more, and recovery rates had risen to around 20% (all numbers here are rounded).

And what are the recovery rates today? Now, in comparison, we torture oil fields with expensive and energy-intensive secondary and tertiary recovery tricks: compressed CO2, water under pressure, high-pressure steam, and, I suppose the ultimate torture, fracking — shocking and fracturing the rock with the encouragement of water, sand, ceramic beads, and an often secret mix of toxic and non-toxic chemicals, a process that is considerably more expensive than actually drilling the original well. With these efforts (and excluding fracking) we now aim for 60% recovery, with a new outlier from Statoil in the North Sea aspiring to 70%. What this means is that all of the oil fields ever discovered could now yield three times the oil originally counted on, as recovery has risen from 20 to 60%. To keep the math simple, this is about equal to a 3.5% a year compounded increase in reserves since 1982. With demand only growing at 1.5% a year, rising recovery rates have increased recoverable reserves to 50 times current global production, up from 32 times in 1982. Not bad. In fact, reserve life would have slightly increased with no new finds at all since 1982.

More than just buffer

Rising recovery rates have increased recoverable reserves to

50 times current global production

But, here is the problem. The cost rises exponentially as one moves up the recovery curve, and somewhere between 75 and 85% recovery we are unlikely to be able to afford the cost. In fact, the energy required to recapture more starts to overtake the energy produced. Checkmate. A move from 60% recovery to 80% (to be friendly) in the next 35 years would represent a 33% increase, or about 0.9% a year. This is obviously a big step down from the previous 3.5% a year, but it is still good news and bad news. The bad news for oil bulls is that this recovery game, which we might call the second derivative negative to production, is playing itself out quite fast. The good news is that with slower global growth and more emphasis on energy efficiency and a probability of some carbon tax increases, global oil demand may settle down to around 1% a year for the next 10 to 15 years.

At that level of increase in demand, even modest continued increases in recovery rates will keep us in oil even if no new oil is found for the next 15 years. However, here’s the snag: Increased recovery rates will take steadily increasing prices, which we may or may not be able to afford. And if these price rises occur, they will act as a continuous drag on global growth rates. Beyond 15 years, the resource and environmental news gets better because cheaper electric vehicles and changes in environmental policy will enable steady decreases in oil demand, and the remarkable insight of Sheik Yamani, Saudi Arabia’s oil minister, three decades ago will prove to be right: We will not run out of oil any more than the Stone Age ran out of stone – we will simply find better fuels. 

Bad news on tar sands 

No one took in my main point in an earlier quarterly regarding the pipelining of tar sands. The point was that while tar sands oil may not leak any more than regular crude, when it does, diluted bitumen, as it is called, releases poisonous benzene gas and sinks if it hits water, unlike crude, and costs over 10 times more to clean up. 

There is now another good reason to hope tar sands stay where nature put them and that we skip the XL pipeline. In a recent detailed study, 1 of 30 important global oils (different by type and location) looked at how much carbon dioxide is created at every stage, including, in the case of tar sands, the loss of arboreal forest, which occurs before squeezing and heating the sands begins. The study measured the differentials in refining and transportation all the way to end-use. We had all heard that products from tar sands caused only 10 or 12% more CO2 to be released than from regular oil, and I for one twitched sceptically, having an image of their colossal operations, which look like they chew energy relentlessly. Well, it turns out that when burned, because their products are on average heavier than those from lighter, more typical oils, they do release only 10 or 12% more CO2 than average. But that only counts when burning the product. When clearing the forest, squeezing out the oil, shipping and refining, and all of the other activities are included, tar sands products release fully 40% more CO2 than the median oil in the study! 

Now, the economy is going to need to use as much oil as it can safely use during the transition to renewables. To use unnecessarily CO2-intensive products and thereby limit our safe allotment is just bad for the economy, needlessly risky for the environment, and benefits only the principal players in the tar sands business. A leading producer of tar sands, Koch Industries, has enormous influence with Congress, so there will be relentless effort exerted to back what is for all the rest of us a truly sub-optimal use of a resource that is currently vital to our economy but extremely dangerous cumulatively to our environment.

Edited excerpts from the GMO June quarterly letter

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