CMI Explains: Commodity Supercycle
Rising commodity prices are a prominent feature of the current market discussions as leading voices including Goldman Sachs and J.P. Morgan predict that global commodity markets may be entering into a ‘supercycle’. These views are helping to bolster an emerging narrative which predicts that serious inflation pressures, absent for decades in many economies, may make a return as economies bounce back from the coronavirus pandemic.
The term ‘supercycle’ has no fixed definition however it is broadly interpreted to describe a prolonged period of higher prices. In the past, these higher prices have been driven both supply and demand side pressures. Capital Economics identifies four such cycles over the past 120 years with primary drivers being recovery after each World War, the OPEC shock of the 1973, and the industrialization of China. Proponents of the notion of a nascent supercycle are yet to unify around a single driver with explanations stemming from both the demand and supply side.
Demand side explanations tend to center on the investment requirements to ‘green’ businesses and whole economies around the world, coupled with an expectation of surging demand for goods as the impact of the pandemic subsides and governments around the world continue to stimulate the recovery. This argument has significant strength as business and governments continue to announce billions more spending devoted to greening their affairs and targets for net zero are brought froward. Indeed, with the COP26 conference this November, pressure is building for further commitments. As vaccination accelerates, countries are beginning to pivot from direct support measures to focusing on stimulating a ‘green recovery’ meaning that these two demand side theories are deeply intertwined.
This global drive to invest in green infrastructure, will, in the long run, have winners and losers in the commodities markets. Significant amounts of investment are targeted at reducing demand for fossil fuels and derived commodities whilst technological advances which reduce the costs of substitutes will continue to pressure some commodity prices. However, in the shorter term, all this infrastructure needs building, something which will likely drive a short-term spike in consumption of energy from traditional sources. In addition, rapidly rising demand for the base materials to manufacture green infrastructure looks set to continue.
It is against this demand side picture of unilateral short-term gains and a more mixed long-term picture, that the supply side must be considered. Despite historically cheap money over the past decade, investment in commodity production, particularly in the energy sector, has generally been depressed, as forecasts of falling demand dominated. Exceptions lay in smaller sectors such as cobalt where excitement about a technological revolution has led to a desperate scramble to invest in the commodities which are predicted to provide the foundations for future goods.
Consultancy CRU forecast supply shortage of around 20% in copper and nickel markets by 2030 based on current projections highlighting serial underinvestment despite the positive outlook in many sectors. Further augmenting this underinvestment in some sectors, has been the increasing concern from both governments and investors about the ESG credentials of investments in the commodities sphere. Whilst the impact has been relatively small so far, rising interest rates and the continued extension of ESG considerations, to the extent that the Bank of England’s mandate has now been changed, indicate that financing new projects will continue to get harder, and more expensive.
Increasingly stringent environmental regulation is also set to increase costs for commodity producers. As countries seek to meet their own emission targets and raise revenue for the greening of their own activities, carbon taxes will likely be introduced. Indeed, there is growing momentum behind the notion of carbon border taxes, something expected to be pushed at this year’s G7 summit in June. These direct costs are in addition to the potential for barriers to developing sites as more and more areas gain special environment or cultural designations.
Vital to consider, is how regulation and taxation designed to decrease pollution will feed through from the energy sector into the broader commodity sphere. Extraction and refinement of metals and minerals, growth of crops and transportation of commodities are usually highly energy intensive activities. If effective energy prices (energy prices after accounting for related costs such as offset) rise, that will feed through the entire commodities sector.
Strong demand for metals and minerals central to the greening of the global economy will likely continue to support their prices into the medium term. Furthermore, increasing financing costs and difficulties in navigating the social and environmental complications of new extraction will likely continue to limit supply. In areas where the future demand is less clear, these regulatory and cost issues will compound a reluctance to invest in declining sectors. The case of oil is a unique one due to the dependence of the price on OPEC pricing decisions. This uncertainty is likely to continue to deter investment. Meanwhile, in the medium term, it is likely that increasing regulation and taxation will increase the effective energy price for firms, driving up energy reliant commodities such as aluminum. In the long term, however, once sufficient clean energy comes online, cheap energy may be the trigger for a significant decline in prices of many commodities.