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Booming Commodity Prices, but...

In the past, I have frequently discussed long-term price cycles and observed, based on research carried out by economists such as Nikolai Kondratieff among many others, that these long waves last between 45 and 60 years, with each rising and declining price wave lasting around 22 to 30 years. These long price cycles are well supported by historical price statistics of the 19th and 20th centuries.

The last commodity rising price wave took place between the mid-1940s and January 1980, when gold and silver peaked at $ 850 and $ 50 respectively. Thereafter we had a persistently declining price wave, which most likely came to an end between 1999 and 2001 when most commodities bottomed out. I must point out that at that time commodity prices, adjusted for inflation, reached their lowest level in the history of capitalism (see figure below courtesy of Barry Bannister of Legg Mason).

But upon further consideration, while accepting the existence of long price waves for an index of commodities, I have also come to the conclusion that price waves for individual commodities tend to be of far shorter duration.

In addition, different commodities move up and down quite independently from each other.

If we look at sugar, for instance, we find that it peaked out in 1974 at 70 cents per pound, collapsed into late 1978, and then soared once again to a high in the summer of 1980. In other words, within less than ten years, sugar went through two huge price cycles before settling down for the next 20 years or so in a price range of between 2.5 cents and 16 cents.

I am mentioning this fact because investors should be aware that commodities can reach a new all-time high and subsequently new lows within a brief period of time, since during the price boom massive additional supplies are produced that later depress prices. Just look at the chart of Soybean prices below. The 1997 highs were followed by new lows in 2000!

Even if we assume that the long-term commodity price cycle did turn up in 2001, we should also be prepared to occasionally see 50% declines in the prices of individual commodities within a long-term up-cycle.

In other words, investors who are betting on commodity price increases due to the rising demand from China should be aware that significant downside volatility for individual commodities, even in the context of a long-term commodities bull market, is almost a certainty!

This isn't to say that commodity prices, certain of which have recently seen parabolic increases, will collapse right away. A friend of mine, Richard Strong, once took me to task for being bearish on the U.S. financial markets and asked me why, if Japanese stocks had been selling for 70 times earnings in 1989, the U.S. stock market couldn't reach similar valuations. Richard proved to be very much on the mark - the Nasdaq sold for even higher valuations in the spring of 2000 than Japanese equities had sold for in 1989. The same rationale could also be applied to the commodities markets.

We could therefore see prices of certain commodities double - or even treble - from their present levels in a speculative mania. This is not a forecast, but a warning to investors of the extremely volatile and short-term nature of bull markets in individual commodities.

There is one commodity, however, about which a very bullish long-term fundamental case can be made: crude oil.

Unless the entire Asian region goes into a lengthy recession/depression in the next few years, oil demand will undoubtedly continue to rise. Oil consumption in Asia, with its population of 3.6 billion people, is about 20 million barrels per day (by comparison, oil demand in the U.S. , with a population of 285 million, is 22 million barrels per day). Based on demand trends in the last ten years, Asia 's demand for oil is likely to double within the next six to 12 years. This Asian rise in demand, which compares to a total current global oil supply of 78 million barrels, will inevitably mean higher energy prices.

There is also the supply side of the equation to be considered. Recently, Matthew Simmons of Simmons & Company published a very interesting study on Saudi Arabian oil reserves. And while he kept short of forecasting a decline in Saudi oil production, he nevertheless questioned in his analysis the widely held assumption that Saudi Arabia is in a position to eaningfully increase its production of crude oil.

For instance, Simmons raised the possibility that Ghawar, Saudi Arabia's largest field, with a daily production of five million barrels (by far the largest in the world), could be past its best years. Moreover, based on the experience of declining production at other large oilfields in the world, Simmons' report suggests that Saudi Arabia's five super-giant oilfields will at some point (maybe sooner rather than later) also experience declining production.

The possibility of declining oil production isn't the only problem the Kingdom of Saudi Arabia is facing. Its population has almost quadrupled since 1970 and per-capita incomes have been in a steep downtrend since 1980. It has therefore become increasingly politically unstable and, in addition, its own oil consumption is rising rapidly. Rising oil demand is also common in other Middle Eastern countries whose combined population has increased in the last seven years by more than 40 million, and now numbers around 160 million people. (It is estimated that Middle Eastern countries could by 2015 have more people than the U.S.).

I may add that in 1956, Mr. King Hubbert predicted that U.S. oil production would peak out in the early 1970s. Hubbert was then widely criticized by some oil experts and economists, but in 1971 Hubbert's prediction came true. Hubbert's methods of oil reserve analysis now predict that a peak in world oil production will occur sometime between 2004 and 2008.

Now, given the certainty that oil demand in Asia and the Middle East will rise substantially (by around 20 million barrels per day over the next ten years or so) and the high probability that world oil production will peak out in the next few years, the fundamentals of crude oil as well as oil companies look very attractive.

What is more, unlike the seventies commodity bull run - when global oil demand was leveling off - the fact that the coming energy crisis will happen in an environment of rapidly growing demand from Asia means it could involve price increases of unimaginable proportions.

And of course, neither Mr. Greenspan, who should never have been Fed chairman in the first place, nor his lackey Mr. Bernanke will be able to do anything about these price increases! Moreover, if we look at the recent very substantial increase in practically all commodity prices and the behavior of the ISM Prices Paid Index, it strikes me that the CPI figures reported by the U.S. government statisticians cannot make any sense at all to anyone except Mr. Greenspan and Mr. Bernanke. In fact, I wouldn't be surprised if, one of these days, the bond market woke up to the fact that inflation is far higher than what U.S. CPI followers naively believe, or that bond prices could begin to discount higher inflation rates in the future and sell-off sharply. The figure below, courtesy of Robert Bertschi of Credit Swiss Private Banking indicates that the period directly ahead will be very important since there is a possibility that bonds have completed or are about to complete a major head and shoulders top traced out between late 2002 and now.

In general, however, I would most like to warn investors about short-term volatility in commodity prices - even in those with great fundamentals, such as the energy complex. Although it is true that commodity prices are likely to have begun a long wave-up cycle, which could last for a decade or more, cycles for individual commodities tend to be of far shorter duration. Indiscriminate buying of commodities that are in the midst of a parabolic rise purely on the China demand story, for example, may result in large losses.

Having made this point, however, the view that certain commodity prices may have become vulnerable in the near term doesn't change the resumption that a long-term (but volatile) commodity up-cycle began in 2001. The future for this sector would seem to me to be far more attractive than for financial assets, which tend to perform poorly when commodity price rise, such as was the case in the 1970s.

There is one more point that should be considered is the following. In the past, rising commodity prices have led to an up-turn of the historically well-documented War Cycle, as nations became concerned about sufficient supplies of vital resources. Thus, an increase in geopolitical tensions is only a matter of time - another negative for equities. Lastly, the period from late April to November has in the past only led to very modest gains for equities. A failure to better the recent March highs for equities in the next few weeks would confirm that we have again put a major top in place, from where markets could sell-off sharply in May/June.

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