Commodities
Prepare for inflation and become poor
Author:
Leen Jason
26/3/2022
Introduction
As we all know, inflation is coming in and commodities prices are surging ridiculously due to several factors like the Ukraine-Russia war, ESG trend, increase of oil demand, etc.
However, before we analyze the factors that cause the spike in commodity prices, we must first understand what commodities itself is and what are the fundamentals of it.
What is a commodity?
Here is a snapshot from Google itself:
Commodities in layman’s terms are raw materials. Commodities are goods that are used as raw materials to create new products. In economic terms, it is called a basic product, which are inputs in the production of goods and services.
Types Of Commodities
There are a variety of commodities in the world, but they can be categorized into 4 main types.
4 main types of commodities:
- Agricultural
- Livestock & Meat
- Metals
- Energy
Almost all commodities are used to produce goods that we consume in our daily lives. I’m sure you need food to survive, transportation to travel, even your phones, furniture, house and other durable goods are all made up of commodities. This should give you an idea where everything around us is made up of commodities.
Why Does It Matter?
After learning about the nature of commodities and what they are, this begs the question “Why does it matter to me?” I am sure that you could care less about the increase in price of commodities since you are not a miner, farmer or even a manufacturer that produces goods using raw materials.
However, I would beg to differ and say that prices of commodities affect everyone in the world including consumers like you. This is because if the price of commodities increases, the cost of production goods in our daily lives increases as well, which leads to companies or firms passing down some cost to consumers in a form of price hike to protect their profit margin. Hence, this leads to what we all know as inflation.
The phenomenon that we are facing right now is called cost-push inflation.
What Caused All Of This?
Now we know how inflation affects us, we must understand the variables and factors that caused inflation and rise in prices of commodities. Let’s go back to the past and learn from history what caused the prices of commodities to rise. In the past 150 years, there have been 4 major price increases of commodities.
1890s – 1917
This was the age of Progressive Era, second Industrial Revolution and urbanization of the American Empire. What happened during this time were many political reforms, increased innovation and a growing population of cities in America, which led to building better infrastructure and a stronger economy. Better infrastructure for better connectivity, growth in population for the workforce, better technology like coal or oil-powered engines compared to steam, more factories being built and thus solidifying their position as the World’s Factory at that time.
Imperialism was growing with more wars like the Spanish-American War and WW1 happening, which created demand for production of weapons.
1930s – 1950s
This period of time is during the Great Depression. After coming out of the Great Depression in 1933, the USA had positioned itself as arguably the best supplier of weapon and steel manufacturers to the world. Hence, when the Great Depression ended, a signal of the economy recovering with the rise of demand from World War 2, USA had a huge advantage of pumping out production for weapons as they aren’t as involved in the war due to the long continental distance from the battles that took place.
Furthermore, post-war recovery was happening. The UK, Germany and Japan had huge plans for rebuilding destroyed infrastructure that was caused by the war and this pumped up the demand for steel, lumber and oil shot up first, followed with other commodities like livestock and agriculture as people are spending more money on everything in general as they have money and economic boom.
1960s – 1980s
The 1960s to 1980s had some major events. However, the most important ones are the oil shock in the 1970s that created an oil crisis, US-Vietnam war, the removal of the gold to dollar peg and the booming economy from the Land of the Rising Sun, Japan.
Oil shock happened in 1973 when the US decided to re-supply the military force of Israel. Arab-Israeli was happening and Arab OPEC members imposed an embargo on the USA for oil. This means the supply of oil has decreased and the demand is still high as people are using vehicles alot and need fuel for their daily lives.
The USA tried to stop communism from spreading in Vietnam and engaged in a long war. As we all know from the previous eras, when there is war, there is demand for weapons like bullets, guns, tanks, bombs, ships and etc.
1971 marked the greatest crime in the financial world in my opinion as the Gold Standard was removed by Richard Nixon to curb inflation and discourage people from converting US dollars to gold. This means your money is fully fiat and based on trust.
Other than that, Japan’s economy was rising and they were ramping up infrastructures. They grew so big that at one point, they were the 2nd biggest economy in the world. Japan was the World’s Factory at this point and this World’s Factory theme will be very crucial for anyone interested in economy, history and investing. It is an important concept on a macro level to generate ideas.
1990s – 2010s
Finally, the latest commodity boom that happened was mainly due to China. Yes, this is probably the most familiar story for people who are reading this as a lot of the progress of China and how it grew to the 2nd largest economy has been shared around on the internet. I can go on and on about the rise of The Red Dragon, but I will sum things up in the next paragraph into a few key points, but I encourage readers to go deeper about how China works and the upcoming Changing World Order by Ray Dalio. Please.
The rise of China can be simplified into a few key points:
- Policy reformations
- Implementing free market ideas
- Great utilization of strategic resources and joining WTO
These 3 are the major ones coupled with strong leaders. Policy reformations from Deng Xiaoping and it started off with 1979 agriculture reformation. Before this reformation the prices of crops were set by the government. This reformation allowed a certain number of crops to be traded in the free-market, which means farmers can set their own prices and get more profit. This means they can scale better and faster for farmers. Other than that, they finally understood the power of capitalism and applied it to their economy with some Chinese characteristics. Hence, becoming a World’s Factory.
They allocated 4 economic zones in the coastal area to attract foreign investors, boost economic exports and import technology into China. These 4 zones operate under a more free-market principle and grew ridiculously. Here is a picture of a famous city, Shenzhen.
From a backwater fishing village to a city dubbed as the City of the Future.
Super Cycles
The 4 major periods I had briefly explained have a term. They are called super cycles. Each of these super cycles had a long-term boom of commodity prices for more than 10 years each. You see, there is sort of a common theme in each of the previous cycles with some slight variation of context.
- Improving infrastructure
- Explosive demand for goods (Weapons, cars, fuel and etc.)
How do these factors affect prices of commodities? From history, we can see that it is mainly due to a huge sudden increase of demand with supply not catching up. This means that the increase of commodity prices is due to the imbalance of demand and supply of commodities.
The reason why it can last for quite some time is because of the nature of primary producers for commodities to be lagging behind demand, which means your supply will always be lagging if a huge demand ever comes. Supply will be lagging to stabilize price levels because if you think about it from a mining company perspective; as a mining company, you need to find a plot of land, explore for prospects, get the license, build the infrastructure, hire people and finally process the goods to be transported. It is a long process mainly for the upstream side to be set.
This Producer Price Index of All Commodities, shows the cost perspective from producers. A decent indicator of inflation too.
Furthermore, what happens in a supercycle is this. A commodity price starts to shoot up first and others would follow suit. However, some commodities will perform better than others because of the velocity and magnitude of demand being greater than others.
Moving Forward
What does this mean for ordinary folks like you and I? After reading through the context above, I am sure you know where I am going with this. One word. Inflation.
Why am I confident inflation will continue to happen at more than 3-4%? The latest CPI from the US government has already shown signs of inflation and I believe that inflation might have been understated too as they had changed their methods of calculating CPI
The CPI is calculated based on a basket of goods and services. If you want to calculate true inflation, just break down the price increase of goods and services that you specifically consume and that would be your own personal inflation, which is more accurate.
Let me tell you why I think inflation will happen at more than 3%, commodity prices will increase even further and the next super cycle is coming soon or may have even started.
Future Catalysts
First catalyst, US infrastructure bill. This means demand for construction and commodities in those sectors.
Second catalyst, China’s climate change commitments. They plan to peak carbon emissions in 2030 while ramping up their renewable energy right now and prepare to scale down carbon emissions in the future. China plans to be carbon neutral in 2060. Imagine the amount of renewable energy infrastructure needed to sustain a country at such a big scale.
Third catalyst, European Union’s Green Deal. They planned to shift away from traditional fossil fuel and slowly transition into renewable energies. I will just clump the rest of the world excluding China and USA into this renewable energy and carbon neutral trend. Most countries centered around achieving it by 2050. This is the Race to Net Zero.
Fourth catalyst, the electric vehicle trend. Later I will briefly explain why this is crucial.
Last catalyst in my mind, Ukraine-Russia war. I would not consider this as the same as the other catalysts listed above as it is mainly more on supply shock rather than a rising demand from structural changes to the world. This war had accelerated the super cycle by sending a supply shock in several commodities.
Let me give some brief rundown of how much these 2 countries export to the world.
Russia – 3rd largest oil producer in the world (11% of global), 1st palladium miner (40% of global, 1st largest wheat exporter (18% of global)
Others: Russia produces about 6% of the world’s aluminum, 7% of global nickel and accounts for about 8% of copper supplies, 10% of platinum 3rd in the world
Ukraine – 5th wheat exporter (7% global), 4th corn (15% global), and other agricultures and 5th iron ore (3% of global)
Another important product is sunflower oil, one of the main vegetable oils used for cooking. The two countries contribute about 80% of the world’s supply.
Personal Picks on Commodities:
From the 5 catalyst events above, a huge factor is the renewable energy trend and infrastructures needed for both EV and in general. The infrastructure bill is mainly for transportation, communications, utilities and cybersecurity. Why the renewable energy matter is because of the components that are needed to build it.
The trend that we are going is a world using electricity as they are renewable. The key commodity that popped up in my mind would be copper. Copper is arguably the most cost effective conductor in the world. Hence, anything that is electricity related would relate to copper and demand of copper will rise if the story I painted above plays out. Here are some pictures to show the importance of copper on everything discussed.
Next idea I have would be aluminum as it is tied with the renewable energy trend too. Aluminum has been a crucial part for transportation, electrical stuff and infrastructures in general. If you need to make the frames for transportations, cans, skyscrapers or solar panels, you can’t escape aluminum. This is because it is the 2nd most malleable metal and very lightweight. It is also the 2nd highest consumed metal by volume in the world. Almost every technological advancement, industrialization and urbanization can’t escape from the need of using aluminum.
Here are more pictures to paint my thoughts:
Finally, we have oil and gas. You may think that if the future is electric and renewable energy, what does oil and gas have to do with anything? In fact, it has to do with everything.
A quick fact for you, the majority of the products around us need oil. Also, the entire market of oil is bigger than all raw metal markets combined. That’s how big it is and how it affects us.
Furthermore, for the development of renewable energy, oil will be heavily needed. Currently, electric is mainly for vehicles on a smaller scale. What about transportations for the supply line like trucks, airplanes and ships? For the world to go round, we still need oil and gas, not just for energy but generally everything that needs to move.
The Ukraine-Russia war halted some oil flowing into the market, but there are ways Russia is selling it. I didn’t touch on the supply side much because even though there is a shortage now, commodities super cycle rely on demand more. I also foresee when endemic is becoming more present, we can see an increase in oil demand and may keep it around the high area.
Timing
Last but not least, there is some timing in play here. With the equities markets soaring and the majority of companies being overvalued, lots of investors are allocating them into other assets slowly especially with the interest rate hikes and macro factors in play. I believe that ‘growth’ stocks would consolidate in the next few years as compared to ‘value’ stocks. Perhaps commodities stocks are what we should be looking at right now.
The chart shows that during periods of deflation, stocks outperforms commodities and vice versa. The main reason is the fact that equities and commodities behave differently during the short term credit cycle. Stocks perform better in late recessions and early expansions while commodities overperform in late expansions and early recessions.
With the amount of money printed, excess liquidity and taking profit from growth stocks, I believe that institutions are eyeing commodities and commodities stocks too.
Moreover, we are quite low on the commodities to equities ratio, which may show that it is undervalued compared to equities. Combined with the catalyst described before with the undervaluation in general, I believe that there may be some potential upside.
Disclaimer: The information in this blog/article/post are just personal opinions of myself and do not in any way represent investment advice or stock recommendations. The content in this blog/article/post is just for educational/entertainment purposes only.
Information in this blog/article/post might not be applicable to all investors as it does not take into account the financial circumstances, investment goals, and risk tolerance of any specific investors. Risk is inherent to all investing, including the permanent loss of capital. Past performance does not equal future results. Speak to a professional financial advisor for financial advisory services.
Author Notes:
Well well well… Thanks for finishing my article once again. I hope that you enjoyed this article and gave you some insights into the world of commodities. Do take note that the scenarios discussed above may not play out well and are just my opinion. For commodities and super cycles in general, it will never repeat exactly as the context for the demand of commodities changes every era.
After writing and researching for an entire day, I must say, I’ve learnt a lot. However, the world is vast and there is much more to learn. There are so many sites, blogs, substacks, twitter threads, videos and podcasts nowadays that talk about finance, money and investing, Many resources out there. You just have to search for it and learn. I guess having the innate curiosity really helps to find joy in learning. Although I am imparting my knowledge and acting sort of a teacher, the road of learning never ends and I hope you can take this to heart as well. Once a teacher, forever a student.
Extra Links For Knowledge (A lot of these are references to generate this idea):
Inflation and Cost Passing
How CPI is counted differently
1890s – 1917
1930s – 1950s
1960s – 1980s
1990s – 2010s
Changing World Order by Ray Dalio, big fan of this guy way back and he gives lots of speeches/podcast
Some Books about China, Please Read Them!
Pax Sinica: Implications for the Indian Dawn
The Hundred-year Marathon: China’s Secret Strategy to Replace America As the Global Superpower
When China Rules the World : The End of the Western World and the Birth of a New Global Order