by Bill O’Grady & Mark Keller | PDF
Background and Summary
In this report, we use the term “commodities” to imply “hard assets.” In our definition, the latter is a commodity that requires multiple years to generate a supply response. This definition excludes agricultural commodities, which tend to create a supply response on an annual basis. That doesn’t mean all agricultural commodities have short-term supply responses. Coffee trees, for example, take three to four years to mature. But, once a tree is mature, a new crop occurs annually. Compare that to a mine which takes years from inception to producing ore. Even oil wells take about a year to drill (from pre-drilling work and actual drilling). Thus, a portfolio based on hard asset commodities will tend to have less supply volatility compared to soft asset commodities.
Secular markets are defined as long-term trends in an asset. There are both secular bear and bull markets. For example, a secular bull market in bonds is characterized by falling inflation expectations that trigger steady declines in interest rates. A secular bear market in bonds is caused by the opposite condition―rising inflation expectations which lead to consistently rising interest rates.
Commodity markets have secular cycles as well. Commodity demand is mostly a function of economic and population growth. Commodity supply comes from agriculture, ranching, mining, and drilling. In capitalist economies, technology usually acts to reduce demand and increase supply. Over time, we have seen consumption per unit fall for many commodities. Technology tends to reduce our per unit consumption; we get more output from consuming less commodities. Technology also enhances production. For example, agricultural technologies have improved production and reduced inputs. The impact of shale technology has revolutionized the oil and natural gas industry. Although globalization and trade can improve commodity demand, it also can make supplies more secure and lead to reduced inventories.
As a general rule, peace, stable economic growth, and orthodox monetary and fiscal policy tend to act as depressants on commodity prices. War, unusually strong economic growth, a breakdown in global order, and unorthodox policy are usually bullish for commodity prices.