What’s driving commodities? Scarcity

Canadian investors are well versed in the volatility of commodity prices. Recent months have reinforced the connection between the value of industrial inputs and the returns of the stock market.

Less understood, however, is what is causing commodity volatility. There’s no question that macroeconomic shocks—such as the earthquake/tsunami in Japan and political turmoil in the Middle East and North Africa—play a large part in day-to-day shifts.

Some blame private speculators for spikes in everything from copper and iron to gold and grains. Others point to sovereign buyers, such as China, which is reportedly stockpiling commodities.

A more obvious, though seldom discussed, possibility is that commodity prices are rising because global supply is running low. As any high-school economics student can tell you, high demand and falling supply will generate higher prices.

Production of several key commodities could be on the verge of collapse, according to respected market commentator Jeremy Grantham, co-founder of global asset management firm GMO.

“The world is using up its natural resources at an alarming rate, and this has caused a permanent shift in their value,” Grantham wrote in the “summary of the summary” for his April quarterly letter.

“We all need to adjust our behaviour to this new environment. It would help if we did it quickly.”

Prior to 1800, the world’s human population was at the mercy of the environment, with famine frequently paring back our numbers. Since 1800, societies harnessed the power of hydrocarbons—initially coal, later petroleum and natural gas—to fuel a productivity explosion. This led to rapid growth in wealth and scientific advancements. Science allowed for the production of surplus harvests and gave humanity the ability to preserve food. A global population explosion followed.

But compound growth is not sustainable in perpetuity, Grantham points out.

“If we maintain our desperate focus on growth, we will run out of everything and crash. We must substitute qualitative growth for quantitative growth,” Grantham wrote. “But Mrs. Market is helping, and right now she is sending us the Mother of all price signals.”

For the 102 years ending in 2002, the prices of all important commodities—with the exception of oil—have been in decline, by an average of 70%. Since 2002, however, the entire decline was erased.

This is the “Mother of all price signals” Grantham refers to, and it points to a shift in long-term price trends.

“Statistically, most commodities are now so far away from their former downward trend that it makes it very probable that the old trend has changed—that there is, in fact, a paradigm shift—perhaps the most important economic event since the Industrial Revolution,” he wrote.

Chasing after this declining stream of metals, hydrocarbons and foodstuffs is an ever-growing global population that could reach 11 billion by 2050. Even low estimates place global population at eight billion.

The good news? Well, there isn’t any—at least for the long term.

“From now on, price pressure and shortages of resources will be a permanent feature of our lives,” he wrote. “This will increasingly slow down the growth rate of the developed and developing worlds and put a severe burden on poor countries.”

In the short term, however, the growing gap between supply and demand provides ample opportunity for profit. Commodity producers will see improved profits as prices continue to rise, but they will also be subject to increasing costs associated with prospecting and extraction. Companies that develop efficiency-enhancing technologies could be the big winners.