Monday, May 19, 2008

The commodity supercycle: myth or reality?
By Ron Mandel Since 2001, commodities have experienced a powerful bull market. Precious metals, base metals, coal, uranium, oil, natural gas, grains and potash have all gone up in price. The list goes on and on, and the price charts all look the same: they start somewhere on the bottom left, and move up to the top right-hand corner. With a powerful bull market now in its eighth year, some market commentators have asserted that this is a "commodity supercycle," a bull market like no other. Is the commodity supercycle for real, or is it just one more commodity bull market the likes of which we have seen before? One authority on the subject is Marius Kloppers, CEO of Melbourne- based BHP Billiton (BHP-N, BLT-L), the world's largest miner. BHP has made a pre-conditional merger offer to Rio Tinto (RTP-N, RIO-L), another mining giant, which was rejected. In an interview in The Wall Street Journal in late March, Kloppers compares the present commodity boom to those that occurred during the colonial age and after the Second World War. He says that the present boom is even bigger -- not only involving the industrialization of China, but also India and large parts of Southeast Asia. Kloppers says that new people are entering the modern industrial age, and with massive urbanization processes under way, commodity demand is strong. With such a bullish outlook, no wonder BHP is interested in Rio Tinto. Another upbeat view is expressed in a March report by McKinsey Global Institute, the economics research arm of management consultants McKinsey and Co. In a report entitled Preparing for China's Urban Billion, the McKinsey researchers make bold growth projections that, if accurate, would require prodigious amounts of commodities of all kinds. They say that 350 million people will be added to China's urban population by 2025 and that the population of China's cities will reach 1 billion by 2030. By 2025, there will be 221 Chinese cities with populations greater than 1 million, and of these, 23 cities will have populations greater than 5 million. This scale of urbanization will also require sizable investments in public transit, and the report estimates that up to 170 mass transit systems could be built, with up to 28,000 km of metro rail, three times the length of the Trans-Siberian railway. Five billion sq. metres of road will be paved, and 40 billion sq. metres of floor space will be built in 5 million buildings. Of these buildings, between 20,000 and 50,000 will be skyscrapers (buildings of at least 30 storeys). The McKinsey report projects that China's gross domestic product (GDP) will have grown fivefold by 2025. Vast amounts of energy will be required to power this expansion. The report says that between 700 and 900 gigawatts of new coalfired generating capacity will have to be installed between 2005 and 2025. Although the report does not connect these projections directly to the level of commodity demand, we can assume that if these staggering growth projections do materialize, they will spell

sustained high demand over the next 17 years for a broad spectrum of commodities such as base metals, steel, cement, construction materials, asphalt and energy. Another proponent of the bullish case for commodities is Frank Holmes, chief investment officer of San Antonio, Texas-based US Global Investors(GROW-Q), which projects commodity demand based on an infrastructure boom driven by globalization, urbanization and wealth creation. In a presentation entitled The infrastructure boom and its impact on commodities like gold, Holmes says that the world is in the midst of a megatrend in infrastructure build-out, which will require massive amounts of commodities. This is not limited to emerging economies: the U. S. requires an infrastructure investment of US$1.6 trillion. Even this amount is dwarfed by the worldwide (including U. S.) infrastructure spending over the years 2005 to 2030, which Holmes projects to reach a mind-boggling US$41 trillion, about three times the size of the U. S. GDP. Imagine what this could do to commodity demand. Population growth coupled with rising affluence and urbanization creates demand for all kinds of goods, in turn raising demand for commodities. Living standards in emerging economies still have a long way to catch up, with an average per capita GDP of US$5,000 compared with US$40,000 in developed countries. Holmes projects rising per capita consumption levels of oil, steel and electricity in emerging economies. A number of developing countries, including China, are creditor nations, and so have substantial financial reserves, putting them in a strong position to invest in development. Corporate balance sheets in emerging economies are also strong, carrying less debt than their counterparts in the developed G-7 countries. As an example of commodity demand this infrastructure boom implies, Holmes projects that the amount of copper that will be consumed during the 25 years from 2007 to 2032 will equal the entire amount of copper consumed throughout history until 2007. Contrast this strong demand with the lagging supplyside response, and the conclusion is that fundamentals are bullish for the red metal. Turning his attention to gold and oil, Holmes says that all the fundamentals point to continued strength in both commodities. Stephen Leeb is chief investment officer of Leeb Capital Management in New York City and coauthor of the books The Oil Factor: Protect yourself and profit from the coming energy crisis and The Coming Economic Collapse: How you can thrive when oil costs $200 a barrel. Leeb agrees with the commodity supercycle theory, but from a different perspective. He looks at the market from the energy angle, and specifically from the perspective of the oil market. According to Leeb, the price of energy, and especially oil, will continue to rise. Since mining is an energy intensive activity, it will become more and more costly, and rising costs will find their way into commodity prices. The bottom line: firm prices for mined commodities. Patricia Mohr, vice-president economics at Toronto-based Scotiabank (BNS-T, BNS-N) also believes that commodities are indeed in a supercycle. Mohr's economics department

compiles the Scotiabank commodity price index, and she points out that the index has registered three consecutive highs in January, February and March, despite a slowdown in the U. S. economy and slow commodity demand in the developed G-7 countries. Although prices of some commodities such as nickel, zinc and uranium have retreated, there are still a number of commodities with tight supply conditions such as oil, coking coal, copper, potash, sulphur and iron ore. Mohr says that commodity demand from emerging economies continues to be strong, so prices will remain firm. Although she acknowledges that base metal prices may come down to some extent as new supply hits the market, she believes that price levels will remain high. This is because commodity prices will have to be high enough to justify the development of new mines, or new mines won't be built. Therefore, Mohr concludes it is unlikely that commodity prices will come down to 1990s price levels. -- Next week: Part 2 of the Commodity Supercycle.