Commodities? Looks Rare.

Photo by Khamkéo Vilaysing on Unsplash

It is by now almost a sure thing that everyone has seen the pace of commodity price increases over the past months. This is the real economy now: not so much paper money chasing paper instruments, but the actual cost of “stuff” going through the roof. So much so that even if someone didn’t read a single page of the financial news, they would also feel the effects of these price increases – from the cost of food to the cost of fuel to the cost of electricity. In fact, we have, here in the UK, been duly notified that our utility bills are to be anything from 30-50% higher. 

When something is said to be “commoditised”, the word implies a rather derogatory tone, suggesting that said thing is now commonplace and undifferentiated, implying that there is very little value to it. Nothing special at all. 

As far as physical commodities are concerned, the prices in the status quo suggest they are anything but “of little value”: from oil to gas to metals to wheat to fertilisers, prices are at (or even through, in some cases) all-time highs. Indeed, these things that we have taken for granted over the past decade or so are now starting to become a bit of a rarity. And because these are (unlike other more esoteric financial instruments) very much staples of everyone’s everyday lives, elevated price levels very quickly become political issues. 

Inflation in the absolute sense, as well as the growing chorus of “OMG INFLATION IS SO HIGH GOVERNMENT PLEASE DO SOMETHING”, is leading to an extremely profound change in market regime. But even more important is the fact that the factors that drive that regime change are likely to be much more persistent than they have historically been. 

No surprise that all this comes as the payback for more than a decade of easy money.  

Turns out that if you wanted to have your cake and eat it, you actually had to buy two cakes – and here comes the bill. 

A change of seasons 

Let’s start with a thought about market regime: for the past decade, two forces have been in play. On one hand, the end of the commodity supercycle which characterised China’s rise into industrial supremacy came as the payback for excess investment in the prior cycle. The swashbuckling dealmaking in the commodity space (for those who still remember those days), during which millionaires (or even billionaires) were minted in droves as commodity assets of all sorts were bid at ludicrous prices (fuelled by aggressive debt financing) in a frenzy to feed the Chinese industrial machine, also gave birth to a broad assortment of small to mid-cap commodity names. Everyone was looking for the “next rising star”, IPOs were bought at ridiculous valuations, and every investor became an expert in metallurgy, geology or fractional distillation, amongst others. Ring a bell? 

Then it all came down, as the exuberance gave way to a decade-long slump. 

Such were the days when commodity price charts were heading from top left to bottom right, when anyone who wanted to trade any commodity stock was branded an old fart from a bygone era. EVERYTHING was in oversupply, and new projects were shelved or cancelled. Management teams who pursued aggressive growth strategies were promptly removed, replaced by new executives whose focus was to deleverage these companies into an environment of slowing top line growth, reversing the irrational exuberance of their predecessors. Assets were shed, debt was paid down, capex was reduced. 

The world of commodities was no longer the poster child for growth. It was the naughty kid that was now working to atone for its juvenile delinquency. There was no more growth, not in the commodities space at least. 

In its place came a new kid in town: tech. 

We all know the story very well: easy money, low capital return hurdles from low rates and a structural window of opportunity as many technologies that powered the internet came of age – these were some of the major factors (amongst many others) that catapulted tech into the limelight. Slowly but surely, recovering from the blighted reputation that tech had from the dot com bubble fallout, a new breed of tech champions which we now know so ubiquitously was born. 

The parallels with the commodity superstars of the prior decade are uncanny: instead of rare earths, industrial gases and oil sands, we now have SaaS, e-commerce and electric vehicles; add in acquisitions, FOMO, IPOs that have traded below their initial listing prices after an exuberant rush up, and the storyline can be easily replicated into a similar-sounding rhyme. 

Furthermore, we now see the straw breaking the camel’s back in real-time: inflation.  

One could almost go so far as to say that the presence of inflation itself should matter more than whether the Fed raises rates in response to it. Just this week we got the Feb 2022 CPI print in the US: a whopping 7.9% YoY, a number that puts US inflation WAY ahead of inflation numbers in traditionally “high” inflation markets. 

In contrast, Indonesia is clocking in YoY inflation of around 2%+, South Africa is clocking in at north of 5% and India is at 6%. US inflation is high, and politically there is serious pressure to “fix it”, arguably by hiking rates. For this reason, market participants cling on to every word uttered by the governors of the various Federal Reserve Bank branches, as well as those of Fed Chair Powell. 

Yet in the face of high inflation and negative real rates, the opportunity cost of long-dated future cashflows, which has till recently been low (with low nominal rates AND low inflation), remains high, whether or not the Fed says it is. Stripped of an environment supportive of “growth at any cost” since the opportunity cost of money was so low, the entire growth complex – all too familiar now with easy money – is having its juvenile delinquency cleanup moment. 

The tables are turning again. 

More than “just” commodities 

For one, the degree of necessity is at a completely different level. One could live without internet for a couple of days – it would probably be quite good for physical and mental health; but to live without food, fuel or electricity for a couple of days would be much more challenging.  

“But didn’t we learn in economics classes that higher prices bring on more suppliers?” 

Indeed, we did. But herein lies the problem: in contrast with our increasingly digital lifestyle, one does not simply “create” new supply of physical commodities by clicking a button.  

We already saw signs of this with silicon chips, the lack of which flowed through to an inability to produce everything from graphics cards to cars, leading to the spike in second-hand car prices: rather have a second-hand car than no car. Why couldn’t more supply come on? Because the world’s foundries were already operating at capacity, and the most cutting-edge chips come from TSMC whose books are filled to the brim with incoming orders. Even for TSMC, building a new plant takes at least 2-3 years to get it constructed, kitted out and brought online, not to mention the time it takes for production to hit its designed rate.  

Just as it isn’t the case that 9 women can give birth to a baby in a month, the same problem is now showing up in commodities. No matter how many companies make a decision to increase new supply, we’re still talking about 10-15 years to bring new capacity online, of which the first 5 years or so is negative in cashflow. From copper to iron ore to crude oil to potash to processed materials like petrochemicals or refined aluminium, the ramp-up cycles in these industries to bring on new supply – not to mention the challenge of finding and prospecting for them in the first place – are long. 

So, the bad news is that while higher prices are in play, it will take time for new supply to come into the market and bring the prices down.  

Furthermore, there’s more bad news: thanks to the past decade of focus on ESG factors etc, it’s not exactly the most ESG box-ticking decision to decide to start a new open-pit mine, or explore new undersea oil reserves. Governments, too, bending to popular demand, are becoming much more reticent to allow natural resources to be extracted and sold, as much because of the loss of value-add as it is because of the environmental impact. 

Ultimately, the conclusion is the same: supply will come, but not soon enough, and certainly much more slowly than in previous cycles for a variety of reasons. 

For those who do have access to supply, this could mean a windfall of higher prices and profits, with even the most populist governments being powerless against them when it comes to controlling prices. Should prices persist at current levels, perhaps higher long-term average prices for commodities could entice new supply to come on in the mid-long term. 

Another Econ 101 excerpt: When supply is inelastic, rising demand (and prices) lead to more than proportionate profit growth.  

That means potentially many, many years of supernormal profits thanks to elevated prices, earned by companies that have cleaned up the leverage on their balance sheet and streamlined their operations after a decade of austerity. 

Inflation: can’t stop, unless it all stops 

Short of an absolute cratering of global demand (i.e. a global recession), there seems to be little standing in the way of a long-term inflationary environment taking root. 

Again, whether rates go up or not doesn’t change the fact that inflation is present, and acutely so. All of this sets things up for a structural rotation in the opposite direction of this recent decade: away from long-dated growth names as the opportunity cost of time increases with inflation, and towards cash-generative, high ROE businesses, of which many commodity producers form a part. 

That doesn’t by any measure mean that we’re seeing the end of a “tech supercycle” per se, although perhaps it could be the end of the “growth at any cost” supercycle. One would imagine that solid, high margin, high pricing power tech businesses would make the cut too, even if they may be guilty by association with the outgoing trend. 

Whatever the case may turn out to be, two things are pretty clear to us: 1. inflation isn’t going to painlessly disappear; 2. It’s time to dust off the old playbooks from the previous decade because the market regime is changing pretty quickly. We’ve had a massive adjustment over the past few weeks and it will settle off the spike levels but there is a very good chance the shift has only just begun.