Commodities super-cycle: why you should invest

As economies recover following contractions and recessions, demand tends to balloon for commodities. These are, put simply, the raw materials we need to build things. Analysts at some of the big banks think this recovery could see many years of commodity prices driving higher, pushing them well above where they’ve trended in the past. In other words, the beginning of a new commodities super-cycle. Here we explore what this means.

So, what are commodities?

Before we define the commodities super-cycle, let’s begin at the beginning. Commodities are the raw materials we use to build things (we have a 45 second animation on them here). There are around 100. Some investors split them between hard and soft: hard being natural resources that require mining or extracting, such as gold or oil, and soft being agricultural or livestock, such as wheat and pork.

There’s a clearer way to look at them though, and that’s through the prism of four categories:

  • Agricultural – including sugar, coffee, orange juice, grains such as soybeans, rice, oats, cotton, timber, etc.
  • Livestock – animals such as cattle and pigs
  • Energy – different crudes, gas, etc
  • Metals – gold, copper, silver, and platinum

Who trades in commodities?

Numerous manufacturers of commodities buy and trade them directly, but investors also trade them in financial markets on specialised exchanges through contracts known as derivatives.

Direct trading goes back to 4000 bc, but in terms of modern exchanges for contracts, the first popped-up in 1848 in Chicago. It was to connect suppliers of commodities, mainly farmers, to buyers. They devised a system of bespoke contracts known as forwards, which agreed the delivery of certain amounts of the raw material for a particular price. You’ll hear these contract broadly referred to as derivatives – they derive their value from the commodity they represent.

What’s useful about derivatives is that if you no longer wanted part of the deal, you can sell your contract to someone else to fulfil. This ensures both stable supply of commodities and their prices.

When did savvy investors get involved?

Not long after.

They saw that you could speculate on the price of commodities using these contracts. An influx of investors led to the development of contracts that standardised terms of supply to make them easier to trade. You will have heard these names banded around in City lingo: futures, options and swaps. 

Nowadays, the big commodity exchanges today are CME and ICE. Investors like these assets because commodity prices can move differently to other financial assets like stocks and bonds. Hence, they provide diversification with hopefully uncorrelated returns to mainstream assets.

But they are also quite volatile – about 33% more so than shares.

What makes them sensitive to economic activity?

Well, the prices of raw materials are linked to the demand for global goods. As we continue to industrialise and modernise, you need lots of components to build stuff. So, depending on where we are in the economic cycle and the trends of particular industries, demand will change for certain commodities. Because supply cannot immediately match changing demand – i.e. you can’t just go out and quickly build a new mine if you need more iron ore – you’ll go through periods of undersupply, where prices rise, known as an upswing. But, eventually over time, new supply comes online and stabilises prices, before demand drops off at some point, leading to oversupply and falling prices for period of time, known as a downswing.

Generally, those four categories that I mentioned will have their own supply and demand dynamics and therefore won’t necessarily move in lock-step. Oil last peaked before the financial crisis; livestock – about 1975.

What is a commodities super-cycle?

When there is a big, unexpected, and persistent pick-up in the broad demand across commodities, so all four groups, with supply that isn’t likely to match that demand for a while. This means prices go above long-term trends for extended periods of time, even decades. Over the past 227 years, there have been 6 supercycles. 

The last was beginning 2000, when China’s economic growth roared as they built enormous new cities and infrastructure on a massive scale. Copper went from being $2k per ton in the 90s to $10k; oil from $20 / barrel to $140.

Why do commentators think we’re in a commodities super-cycle now?

Well, all four groups are above their long-term trend prices, and the thinking is that demand could balloon for a number of years for a number of reasons.

Firstly, we’re are tipping into a new economic cycle and a period of recovery which always comes with increased demand, particular as governments and central banks have piled money into the system to enable us to bounce-back much more quickly. 

But add to that, governments drawing up big infrastructure plans for long-term spending. Just look a Biden’s $2trn proposed infrastructure plan. And it includes a big focus on green areas such as renewable energy infrastructure and battery manufacturing. These activities use lots of different raw materials, including cobalt, lithium, and copper, to name but a few. 

What is more, commodities are seen as a bit of best against rising inflation, and with its prospect high for many reasons, plus governments not minding the idea that inflation will eat away at some of their enormous pandemic related debt piles, there’s demand in that sense too. 

Finally, undersupply is more likely for a while because the big commodity producers are sort of a bit too addicted to paying out lots of their profits, and haven’t been investing enough in new production. Why? Well, we could do a whole article on just this, but share prices and investors react well to strong dividends. These are operationally leveraged businesses and very cash generative. Income investors like them. More flock to the share if they pay strong dividends. Share prices are linked to executive remuneration. They get very rich and underinvestment becomes a thing.

Why might it not be a commodities super-cycle?

Well, demand is definitely falling off a cliff for some. Coal is horribly polluting, and oil will gradually become redundent as we de-carbonise and work towards 2050 and 2060 net zero goals. Even iron producers, which is the biggest mined commodity, say demand will drop as China’s growth cools. It simply cannot keep growing at a thunderous rate for ever. 

Back in the naughties, when China was supercharging the last supercycle, it was adding something like an economy the size of Spain every 4 weeks. The three I’ve just mentioned were big beneficiaries during that time. But, that said, I’m not convinced it’s drop offsets the enormous demand we’re seeing elsehwere.

Share on:
Marcus De Silva
Date published:
14 / 05 / 2021
Reading Time:
4 minutes