labels: Investment - general
Is the commodity bull-run really over? news
25 August 2008

The recent decline in commodity prices seems to have caused much cheer in the global financial and forex markets as players seem to have written off the commodity bull run for now, says Vijay L Bhambwani, CEO,

I belong to the players who are on the other side of fence and believe that the long-term commodity bull run is far from over.

While the short term uptrend maybe have halted temporarily, it's too early to pop the champagne. I derive comfort from the fact that global investment stalwarts like Jim Rogers, Warren Buffet, Stephen Leeb and George Soros, among others, have been expressing similar views. Allow me to play the the devil's advocate.

Crude cil: One of the least understood commodites, unfortunately, is the hub around which other commodities will derive price discovery triggers in the near, medium and long term.

Analysts who have figured out equities fairly accurately, use their established techniques to forecast the price trends of oil. Unfortunately, such an approach - what works for equities, works for commodities - is doomed to failure.

The reason is simple.

The supply of equity shares of a company remain static in nature most of the time; increases sometimes due to rights, bonuses, follow on public offers and private or preferential allotments.

Rarely does the supply of a company's stock reduce by way of buybacks, whereas oil is a non-renewable, fast depleting and relatively demand-inelastic commodity.

Common laws of mathematics and economics tell us that increasing demand and diminishing supply means rising prices. Yet analysts call tops on black gold fairly frequently since the recent bull run started in 1999. Oil has been exhibiting a pattern of two steps forward and one step backwards, leaving the larger bullish trend intact.

Sure, with the impending general election in the US, there may be downward pressure as the federal governments attempts to curb inflation. But history has taught us that such short-term moves invariably fail to change the course of commodity trends sustainably. Similar trends were noticed between June 2006 and December 2006, but prices climbed up by 100 per cent within 15 months.

While the demand for fossil fuels is nearly insatiable, supply is dwindling, albeit slowly. OPEC supply is facing constraints as the ageing and hard-pressured reserves have been harnessed relentlessly. While enhanced recovery techniques are yielding higher number of barrels, the costs are spiraling equally rapidly.

Besides, as drilling companies dig deeper, the quality of the fuel harnessed becomes poorer, with higher sulphur content and saline (sour) crude being obtained.

The same corrodes the drilling infrastructure, is heavier and costlier to refine. It also contains higher tar content, gases that need separating, adding to the costs.

Some of the giant Saudi oil fields are yielding upto 30 per cent or 40 per cent water along with crude, are losing pressure and are being pump-primed by injecting water to maintain reservoir pressure.

The news from the former soviet union is not encouraging either. The chief of Lukoil, the Russian state oil corporatio, has indicated peak oil production and upto 10 per cent to 15 per cent decline in production every decade.

Mexico has hit peak oil and reservoir pressures are declining at the fastest clip in decades.

Kuwait, Iran and Indonesia have reported peak production plateaus and no new discoveries. That is the most worrying part - no new discoveries.

While the "magic" sands of Alberta in Canada are promising to yield millions of barrels, commercial production of mass-scale levels is years away, whereas the world needs oil every day. We are consuming a little over a 1,000 barrels per second worldwide. With riots due to inflation and food shortages, the world may just become a little less seamless than a decade ago.

Many Asian countries have refused to part with their agricultural output in the export market. Should the oil producing nations follow suit, a big oil shock could confront us. Theories of alternate fuels are way too optimistic as the capital costs involved in switch overs will be prohibitive for the Asian countries that are the very cause for the demand growth in the first place.

Even a relatively easier switch over to natural gas has been painful as the cost of gas has more than tripled in the last half a decade. And gas is a hydrocarbon fuel. Imagine the difficulty in switching over to radical alternate fuels.

While oil may decline, even below the triple-digit mark before the US elections, the run up that will follow the elections may be more brutal than anticipated.

Base metals: Ferrous metals, aluminium, nickel, zinc, tin and lead are not the immediate source of concern as much as copper is. The leading commodity research bureaus have revised the global copper reserves from 60 years to 30 years. Copper is known as the tin roof of the global economy, because it is used everywhere - electricity, plumbing, automobiles and electronics to name just a few.

The metal is running out so fast that consolidation has already started with BHP Billiton making a hostile bid for Rio Tinto. L N Mittal calls copper his next big opportunity as prices are expected to spike higher. While most analysts have been cheered by a temporary import halt by China due to the Olympics, the recent sessions have seen a vicious surge that promises to keep the bears on the edge of their seats.

Should crude prices surge, and / or economic news deteriorates and the dollar weakens, I expect an inflationary effect on this asset class over a period of time. Therefore, the expectation of cheaper base metals basket over sustained period of time appears to be excessively optimistic.

Precious metals: Gold has been a fairly accurate barometer of how smart money thinks of the world of today and tomorrow. Gold has moved up from $250 per  ounce to over $1,000 per ounce from 1999, the time the oil run started.

While oil zoomed eight times, gold has rallied only four times. The gold - oil ratio is extremely skewed at this point of time and one of them has to give in. To return to the mean, either gold goes to $1,500 per ounce or oil falls to $60 - $70 per barrel. The second scenario appears a little stretched.
Commerce students would deploy the Kelly's formula calculator and arrive at a "safe" price for gold at between $1,150 and $1,200 per ounce in the next six to eight quarters approximately. If gold were to appreciate, silver is sure to follow, though not in lock-step fashion. Ditto for platinum, which is 30 times rarer than gold but fetches only twice its value.

The gold - platinum ratio too is likely to undergo a revision in the coming decade or less as the rare commodity becomes dearer to mine. Silver is a combination of hedge and industrial commodity and is likely to be relatively steadier than gold, though may lag slightly overall.

Start looking at investing in precious metals, and not just for your children's weddings and spouse's ornaments, but as an investment asset class.

I would caution again, that commodity trends are slow to unfold and last many decades. Six to 12 months are equivalent to the blink of an eye, compared to equity markets where 12 months is long-term even by government standards.

While this may sound alarmist to some and opportunistic to bullion investors, I would caution that nothing is likely to happen as early as tomorrow. You can continue to enjoy your long drives and even postpone buying bullion for a few weeks or months. It's not the end of the world, yet.

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Is the commodity bull-run really over?