PROFESSOR DIETER HELM, UNIVERSITY OF OXFORD
Commodities have had a good run. Despite the biggest economic crisis for half a century or more, commodities have marched ever upwards. The reasons might be many and various – from a flight to safety (gold) to Chinese demand (oil, copper and iron ore) – but the trends have been common. Now there has been a wobble. Does this mean the commodity super-cycle has come to an end?
As with every bull market, there are always those who claim “this time it is different”. To believe that commodity prices will go ever upwards, there needs to be a structural explanation. Something fundamental has to have changed, stopping the history of cycles repeating themselves. There are two such theories: firstly, that resources are finite and hence will inevitably run out – in the process driving up prices; and secondly, China.
The finite resources brigade holds esoteric ideas such as ‘peak oil’ and applies them more widely across commodities. It is all very simple: there is a finite amount of oil; we know how much and where it is – hence there is a maximum supply. If demand then keeps going up and supply is fixed, up goes the price. The same logic is applied to copper, iron ore and gold.
TECHNOLOGICAL ADVANCES MAKE RESOURCES LESS FINITE
The trouble with this argument is that almost everything that could be wrong with it is, in fact, wrong. Let’s start with oil. It has lots of substitutes – including gas and coal – and there are a host of other ways of providing energy to transport, industry and households.
As its price rises, people reach for these substitutes. Fossil fuels are present in massive quantities throughout the earth’s crust. The recent developments of shale technologies make any ‘peak’ for oil or gas a very remote constraint. Technologies make it possible to get more energy from fewer supplies. There is no obvious ‘peak’ any time soon.
The same sort of logic has been applied – with even less credibility – to a number of other commodities. Back in the 1970s, the famous ‘Club of Rome’ report predicted that the finite resources of the planet would lead to a general rise in commodity prices and that scarcity would limit economic growth possibilities. Yet nearly half a century later, there is no obvious physical lack of iron ore, copper, or even gold.
The fundamental mistake is to confuse a dubious physical claim with a very different economic one. Whether or not there are physical limits likely to bite any time soon (and this is unlikely), the impact of price is what matters. If the price of oil is very low, as between 1985-2000, the incentives to discover and develop new resources will be correspondingly low too. In time, the supply/demand gap closes and up goes the price – as it has since 2000.
Beyond, say, $70 per barrel, all sorts of new alternatives to OPEC’s oil become attractive – from offshore and tar sands, to the Arctic. Companies start looking, and surprise, surprise, they find lots of new reserves. In recent years there have been major conventional discoveries off East Africa, in the Black Sea, off Israel and Cyprus, to complement the shale oil and gas, themselves facilitated by technological developments, which a high oil price induces. Such a process of market responses to price rises has been witnessed across the commodities in the super-cycle.
DEMAND HAS BEEN FUELLED BY CHINA
The fundamentalists claim not only that physical supplies are limited, but also that demand will go ever upwards. Their ace card is China. Looking backwards, China has indeed played the key role in the super-cycle. From 1990, it has been growing at almost ten per cent per annum, more than doubling its economy every decade. It has been on an export- orientated, energy- and commodity- intensive growth path. The fundamentalists simply project this phenomenal growth into the future. The result is a wall of demand.
Quite a lot of this demand may materialise. But before we get carried away, there are two other possibilities that the commodity bulls need to keep in mind. The first is that it might not happen. There is nothing inevitable about perpetual economic growth at seven per cent per annum plus. China has its problems. It is still a Communist authoritarian state.
It has massive environmental problems and the Communist party could either turn inwards or aggressively outwards to preserve its grip on power. The economic policy framework – massive savings expropriated by the state – is not necessarily sustainable and its export markets may be challenged by lower-cost rivals and by the reshoring to the US of much of its heavy industry. China has a big energy cost disadvantage vis-à-vis the US.
But even if China does carry on growing, there is another price effect that the bulls ignore. Higher prices encourage research and development and a search for substitutes. The higher the fossil fuel price, the higher the incentive to develop new sources of energy. There is no reason to assume that energy is immune to technical change and there is a host of new technologies waiting in the wings.
That is true for many commodities.
A CONVENTIONAL CYCLE WITH A BUBBLE AT THE PEAK
The fundamentalist argument for a permanent super-cycle for commodities is therefore shot through with holes. That leaves more conventional cyclical explanations for what has happened – and for what might happen in the future.
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