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SUPER CYCLE OR SUPER CORRECTION?

We live in an uncertain world. This has been more than amply proven by developments in the commodities world over the last two years. Prices of most commodities have gone up by far more than anybody anticipated, or could have anticipated. The best example is oil where prices over $50 a barrel are no longer pipe dreams (pun intended!) in the eyes of the Opec chieftains. There is no expectation that oil prices will ever go back to even $40 a barrel. The same is the case with metals, coals, other energy prices etc.

 uper-cyclists argue the future will be fundamentally different
• Correctionists believe the natural order in commodity prices will be restored

How has this price spike happened so suddenly? On the demand side, unexpectedly strong demand has continued in China, the US economy has shown strength, and so have other Asian countries, including India. On the supply side, there have been no real additions to capacity in most commodities over the last several years. So, when demand stayed strong longer than people thought it would, most commodities suddenly were in deficit. And commodities being commodities, even a small change in the demand-supply dynamic can lead to big shifts in prices.

The million dollar question now is whether these high prices will remain at current levels, whether they will drop, or will they tend to even higher levels. There are two schools of thought in this regard, and unfortunately, they appear equally persuasive in their arguments.

The first, and I shall call them the Super-cyclists, argue forcefully that the past is no predictor of the future which will be fundamentally different for a variety of reasons. The reasons are that natural resources are limited and there is only so much that one can take out of the ground, that demand will remain strong with high growth rates in China being supplemented by growth in India, and with the US needing a cyclical upgrading of its infrastructure. They also point to the generally robust global growth and lack of mineral exploration providing not only a floor to current prices, but arguing for a future spike in the entire commodity cycle. They claim that while we have reached a higher price level, given the increasing supply side shortages in the future, this is no more than the base camp on the path of higher prices going forward.

The Correctionists argue that commodities are called commodities for a reason. Prices go up and then extra supply kicks in, demand drops and before you know it, there are surpluses and everybody is cutting costs to meet their volume targets. This school believes that prices have been unsustainably high for a longish period of time and that it is inevitable that as global growth slows down, the natural order in commodity prices will be restored. Even Chinese demand will be sated one day (it is mostly replacement demand as manufacturing migrates there from other countries), India being mostly a services economy will never provide the same kicker, and the US with its spiralling budget deficits simply does not have the capability to do anything about its infrastructure needs going forward. The rest of the world, i.e., the European Union and Japan are in the throes of a major shake-out in manufacturing and have too many problems of their own to provide any impetus to the growth momentum.

Who is one to believe? The Correctionists are right to a point. Cycles exist because some people are bullish even at the top and others are pessimistic even in the troughs. It is, therefore, natural to have alarmist reports (even from reputed agencies like Goldman Sachs) warning of super spikes in commodity prices even in today’s high price environment. On the other hand, if one is bullish about India’s growth and that of other emerging market countries’ in general, then higher plateaus in commodity prices appear eminently feasible.

For corporates that have exposure to commodities, a view is obviously important as future plans will depend upon it. For India as a whole, apart from oil, is mostly neutral in commodity exposure. But both for corporates and for the country as a whole, backward integration where feasible, remains the best way of insulating against price spikes. Does that mean then that I am a Super-cyclist? Not at all, but it does pay to be prudent particularly in volatile times.

 
Source: The Financial Express