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Commodity prices – simply put

I find it quite interesting that despite the fact that technology and apps were created to simplify our lives, many aspects of our lives remain extremely complicated, such as the reasons for valuations of certain investments.   

Since the commodity peak in 2010, platinum and copper prices are roughly 55% lower today, while oil and iron ore are a whopping 68% and 77% lower, respectively. Although lower prices (especially oil) are good for consumers in developed countries, it certainly isn’t good for commodity-producing countries such as South Africa.

This is also one of the main reasons for the 60% drop in the rand’s value over the same period, when compared to the US dollar, for example.

Many complicated reasons are offered as to why exactly these drops took place and many of them still leave us in the dark when it comes to what may happen to prices in the near future.  

Some argue that it is all part of a super cycle, while others blame China’s slowdown in economic growth for the massive decline in commodity prices. I have to point out that I seriously question the latter argument.

If we take an exclusive look at copper, for example, this argument doesn’t quite add up. The reason for this is simply that China’s copper demand around 2010 was 40% of the total worldwide copper demand.

If they (and this is highly unlikely) ceased the purchase of copper altogether, it would justify a drop of around 40% in price. The copper price, however, is closer to 60% lower than 2010 levels.   

But before I air my opinion in this regard, it is imperative that I quickly explain two terms: “correction” and “value”. As the word indicates, a correction is an event that occurs, the outcome of which is something being corrected or rectified. Dictionaries define value as something that is “fairly priced”.

So in theory, if the market, any asset class or commodity price survives a correction, it should be priced correctly and very close to a level where it offers us fair value.  

Returning to commodity prices, let’s go with the assumption that we have experienced super cycles and that the latest cycle – according to Bilge Erten and José Antonio Ocampo’s super cycle report released in 2012 – started in 1999, peaked in 2010 and is now in a declining phase.

According to this report, the last commodity super cycle took place between 1971 and 1999.  

The peak during the last cycle took place in 1973 and, just as now, was followed by the great correction.

If we go with the assumption that the correction was 100% successful during the last cycle and that the lowest point after the decline resulted in prices being “correct”, commodities should have been priced correctly by the end of 1975. But what would have been a fair annual increase thereafter?

Many may argue that commodities are becoming scarcer over time, and also that it is becoming more and more expensive to mine them, which would mean that an adjustment in excess of annual inflation would be needed.   

By taking a look at the International Monetary Fund’s All Commodity Price Index since 1975 and by adjusting it with world inflation only (by using the G7 largest average countries’ inflation rates), two things in the graph below left become very clear:  

1. Commodity prices have formed a giant bubble between 2005 and 2010. This was due to the massive growth in the Chinese economy, with 10.5% growth per year between 2002 and 2012 (the equivalent of a new economy the size of Sweden’s every year).  

2. More importantly: since December 2015, commodity prices have been priced fairly for the first time since the great correction of 2008, according to inflation adjustments.  

So will I buy every single commodity share that I can lay my hands on now? Probably not. Just as I wouldn’t convert all my foreign investments back to rands. Simply put, commodities shouldn’t be seen as the “bad boy” in investment portfolios forever.

From here on, it will slowly start to offer us value for money again.

* Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 28 January 2016 edition of finweek. Buy and download the magazine here.

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