Fundamentals of a commodity bull market

Originally published in the February 2007 issue

Markets appear to have cycles of approximately 18 to 25 years. They alternate between what is termed ‘stuff’ (real estate, raw materials, art, antiques and autos) and ‘paper’ (stocks and bonds).

The last full stuff cycle lasted from 1966 to 1982. During that time oil rallied from $2.90 per barrel to $28 per barrel; gold started at $35 an ounce and zoomed to $850 an ounce, and the average home in the US increased in value by 180%. Paper, meanwhile, was in the ‘dead zone’. The US GNP increased 330%. The Dow Jones Industrial Average went from 1000 in 1966 to 875 in 1982.

By 1982, the stuff cycle was coming to an end and the paper cycle began. Brokerage firms’ IPOs consisted of oil and gas partnerships and real estate deals. But by 1982, stuff was overbuilt, with over capacity and was over owned.

However, in 1982 paper was very cheap and under owned. The Business Week magazine cover reported ‘The Death of Equities’ and, as with magazine covers, heralded the end of a trend just as they announced it. The price earnings ratio of the Standard and Poor’s 500 was 7 and the public had only 14% of their assets in equities and equity mutual funds against a historical average of 25%.

By 1982, paper was emerging as the predominant market cycle and by 2000, the US GNP increased 170% and the DOW rallied from 875 to 11,700.

The public had 57% of their assets in equities and the PE ratio of the Standard and Poor’s 500 was over 30. The cover of Time magazine featured ‘The Committee to save the world – Greenspan, Summers and Ruben’, while brokerage firms were selling dot-coms with no earnings – ever. Paper was over priced and over owned.

During this period, stuff was in the ‘dead zone’. Oil declined from $28 to $20 a barrel, gold dropped from $850 an ounce to $280 an ounce and the average price of a home increased only 1% annually.

Spectacular stuff

But by 2000 the new stuff cycle was beginning to emerge. In my opinion, this will be the most spectacular stuff cycle in history, because this cycle includes the whole world, not just G-7 countries. The world has discovered capitalism and it’s sweeping the globe. Capitalism is easy to understand. It is nature on a balance sheet. The difference is, if you’re wrong, you go broke instead of being eaten. Today, 20 years of restrained and neglected stuff supply is being overwhelmed by prosperity-driven demand. Lead times to extract and process raw materials are measured in years. In the past 3 years Canada has committed $80 billion in infrastructure to production of the tar sands. The goal is to produce 3 million barrels a day by 2015. At $60, oil is a bargain liquid. It costs 10% less than bottled water, one third of the cost of milk, one fifth of the cost of beer and only 2% of the cost of Jack Daniels.

Phelps Dodge is planning to open a new copper mine in 2007 (it took 12 years of paper work to receive government approval). Currently, oil companies who search for oil at great risk earn 9 cents per gallon, while the US Government, at no risk, takes 51 cents per gallon. In the US, half of our energy problem is government regulations. The only place oil companies are allowed to drill for oil is next to a dry hole. The only place you can build a refinery is nowhere. In the US, we have more energy in the ground but the dip sticks are in Washington.

What price the bird of peace?

Peace put 2.5 billion people in the world labour market. India and China alone contain over 2 billion consumers. Suppose each of these 2 billion people consumes a mere quart of gasoline per week as their economies expand; that is an additional 1.7 million barrels a day, new demand that is sure to increase price.

Today, China is booming. Their national bird is the construction crane. Last year China’s factory floor produced 50% of the world’s cameras, 35% of the TVs and 30% of the refrigerators sold worldwide. In the last five years China went from exporting oil to becoming the second largest importer in the world, the US being the largest.

The Chinese will go from walking to bikes, from bikes to motorcycles and motorcycles to autos. They will need oil and gas, chemicals, forest products and metals. At 80 cents per hour they are deflating manufacturing costs, but as they become more successful, they will throw away their bicycles, buy motorcycles and eat better, increasing the demand for raw materials.

China and India are transforming their economies from poor agrarian nations to the newest industrial powers, replete with heavy industries, mass transportation and higher education. Rising from these giant new economies will come millions of new consumers, the very people who are already straining the natural resources of the earth. In 1900, the US started to industrialise. We were using one barrel of oil per person per year. By 1970, we were using 27 barrels per person. By 1950, Japan was starting to industrialise using 1 barrel per person but by 1970, they were using 17. In 1965, South Korea joined the fray. They were using one barrel per person per year and by 2000 they were using 17. Today, China uses 1.3 barrels per person per year and India uses .7. In 1950, Japan’s per capita income was 18% of the US; today it is 96%. In 1965, South Korea’s per capita income was 16% of the US; today it is 56%. India and China have 2.5 billion consumers; 9 times the US. The US uses 25% of the world’s energy; China and India use 2%. India and China have 280 people per car; the US has 2 people per car.

Changing demands

Third world real incomes are just beginning to rise to levels that create large demands for consumer goods. Between 1950 and 1970, Japan’s urban population increased 70%. Personal consumption increased 600%.

China currently is 40% urban, 60% rural. The US is 97% urban and 3% rural.

China has 20% of the world’s population and 7%of the world’s land. China’s grain imports willgrow from 14 million tons today to 57 million tons by 2020. During 2006, China approved building168 new power plants. McDonalds is building drive-through restaurants in China and meat consumption has tripled there in the past ten years. Demand is changing.

Today, 1 billion people consume two thirds of the world’s raw materials, 5.6 billion people consume the other third but they are becoming more successful. There is no need to connect the dots, they overlap.

The longer things remain stable, the more likely they are to become unstable. Demand for raw materials has increased. In many cases, the capacity to produce raw materials has declined dramatically in the last 20 years. Tops and bottoms are creatures of extreme. Before this stuff market is over, you will be able to see an oil drilling rig from every beach in the Gulf of Mexico and California. There will be a bounty on caribou and they will be digging a copper mine in Al Gore’s yard

Short term markets move for all sorts of reasons; government meddling, recessions and central bank manipulations, but in the long term, the fundamentals are in place for a raw materials (stuff) bull market. I believe raw materials will be one of the best investments for the next 10 to 15 years. As you climb the ladder of financial success, check to make sure it is leaning on the right wall.


Clyde C. Harrison is President and Director of Brookshire, a private Canadian company which designs, develops, markets and manages raw material based financial products for institutional, private and public investors.