Long Live The Commodity Super Cycle

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Long Live the Commodity Super Cycle

It is our view that demand for commodities will continue to be very strong and that the prices of most commodities have a very long way to go before they can insure adequate supply and some semblance of demand conservation. While many commodities have already risen to historic price levels, an interesting phenomenon has surfaced that suggests that prices have not reached high enough levels to achieve consistent supply. For example, crude oil prices have settled in at roughly four or five times the levels seen from 1992 through 2000, yet alternative energy sources, such as natural gas, solar and wind power, are still underutilized. In the food protein area, nearly historic high beef prices have failed to provide beef producers with a consistently profitable environment due to surging feed costs, spiraling regulation and other increases in production costs. Similarly, the U.S. dairy industry remains in the midst of a decade-long collapse because retail prices for milk, butter and cheese are rarely offering producers an acceptable profit in the face of rising. While we arent suggesting that all commodities will take on the status of rare earth metals, key commodities like grains, metals, energies and livestock are destined to become rarer in the future, and the cost to produce these commodities is sure to escalate. This in turn should ensure these commodities will continue to offer investment opportunities for at least another decade. The case for commodities continues to burn brightly, as evidenced by the growing volume of trade since the subprime crisis despite disappointing recoveries in mature economies. The total volume of commodities traded bottomed out quickly in 2009, the depths of the financial crisis, and then posted impressive gains in 2010 and 2011. In contrast, the total volume of stocks traded on the NYSE continued to fall in 2010 and 2011. Total money under management in commodities saw only a minor decline in 2008 (the first time since 2000), and from 2008 to September 2012, it posted a very impressive 63% gain!
325 300 275 250

Billion USD
225 200 175 150 125 100 75 50 25 0

08 10 09 Q 11 4 Q 11 1 Q 11 2 Q 11 3 Q 12 4 Q 12 1 Q 12 2 Q 3 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Source: barclayhedge.com
Energy A Leading Indicator of Commodity Demand

In the wake of the sub-prime crisis and then again in 2011, the commodity markets were besieged with predictions that the Commodity Super-Cycle was coming to an end. Some analysts even predicted that many commodities were poised for a multi-decade decline, as the damage to the world economy in 2008-2009 had brought forth a peak in demand. The commodity bears were further emboldened in 2011 when four additional, epic-type disasters, the Fukushima earthquake and tsunami, the threat of Greece defaulting, the U.S. debt debacle and talk of a Euro zone failure, weighed on the world economy. However, global energy demand, which we view as a leading indicator for overall world commodity demand,
314.3
350
328.3
334.7
337.1
375
Money Under Management In Managed Futures

continued to grow year on year through the sub-prime crisis and has moved beyond several previous peak demand plateaus. Instead of looking for energy demand to top out, the U.S. Energy Information Agency is forecasting it to grow an average of 1.6% per year out to 2035. responded as quickly and as convincingly without the market providing an incentive. Without lofty oil prices there would have been no incentive to develop Canadian tar sands, and the U.S. wouldnt be seeing its domestic oil production expand rapidly as it has from the Bakken formation in North Dakota and Montana.
600 550 500 450 400 350 300
World Total Primary Energy Consumption (Quadrillion Btu)

7.5
Production - Million Barrels / Day
Quarterly US Crude Oil Production vs. WTI Crude Price
140 126 112 98

USD / Barrel
7.2 6.9 6.6 6.3 6.0 5.7 5.4 5.1 4.8 4.5
84 70 56 42 28 14 0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Sources: EIA Internation Energy Statistics and International Energy Outlook 2011 (2012-2015 are Forecasts)
Source: EIA Short-Term Energy Outlook 2012Q3 2013Q4 are Forecasts
The Importance of Price Discovery

It takes a long time to shift entrenched commodity production practices. Those who stand against speculation in commodities think that long-term shortages can be recognized without signals from the marketplace, but what really boosts production or curtails demand better than higher prices? The notion that the world would eventually have to diversify away from petroleum-based energy would have gotten nowhere without the periodic energy flare ups in energy prices over the past 40 years. And while speculation can accentuate price movements, global oil production wouldnt have
In the grain markets, the speculative reaction to the 2012 drought may have accentuated the rise in grain prices, but without that early warning signal from the futures markets, the ethanol and livestock sectors might have burned through enough corn to result in a multi-year supply shortage. The sharp escalation of grain prices prompted an expansion of global grain planting area that was absolutely necessary to make up for the lost production in the U.S. Another example is the natural gas market. Stubbornly high natural gas prices during in the late 1990s ushered in an expansion in production. This eventually resulted in an excess supply. Subsequent speculation has driven natural gas prices down sharply, especially compared
19 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 01 20 0 20 2 03 20 0 20 4 0 20 5 0 20 6 0 20 7 0 20 8 0 20 9 1 20 0 1 20 1 1 20 2 13
US Production WTI Price

to other energy sources, and that in turn has hastened a the switch away from petroleum-based feed stocks to natural gas. Without the distinct price advantage, it would probably have taken decades for natural gas to become as important as it has for electricity generation. Given the size of the investment required to shift global energy sources, it would be folly to assume that some other mechanism, such as one supported by taxpayer money, could have achieved that transition. The U.S. government has already wasted billions in its attempt to speed up the transition to solar energy with little to show for it. Full-scale implementation of solar and other alternatives will probably only come from higher energy prices and the potential for significant profits for those developing the technology. beyond mere stockpiling and search for even more creative ways to commandeer foreign commodity supply: Saudi Arabia, Egypt, Kuwait and South Korea have leased lands in sub-Saharan Africa for growing crops. Russia has leased land in Ukraine for the same purposes. For some time China has been looking to Africa for mineral resources, but more recently it has been making significant investments in agricultural production there and elsewhere. Australia approved a Chinese companys bid for a giant cotton farm this past August. Ukraine agreed to a 3 billion dollar credit loan from China in order to purchase inputs to boost production to supply China with corn. Chinese investors are making headway on a 1,215 mile railroad investment for moving soybeans grown in Mato Grosso, Brazil to port. This is the first proposed project for that area in the last 100 years.
Government Involvement in Commodity Supply

Another artifact of the sharp escalation in commodity prices between 2005 and 2008 was that many countries began to build or expand strategic reserves. Initially, strategic reserves were limited to petroleum and gold, but countries like China, India and Russia have long maintained grain reserves as well. With its breakneck growth, China seems to have taken domestic stock-building to new heights. While individual governments (the U.S. included) see strategic reserves as a way to blunt shortages and avert rapid increased in prices, a global push to stockpile could lead to the need for even larger global production as more output is set aside for future use. In reality, historically high commodity prices and the 2012 drought have prompted many nations to move
Government involvement in commodities has at times created a wave of buying that has easily dwarfed the activities of largest funds and commercial traders. Speculator buying and selling can accentuate volatility and move the market, but without open and actively traded futures markets, there would be nothing to countervail the government buying. As they currently stand, active, deep and liquid futures markets are a formidable countervailing force to large governments, large funds and large producers. As with most situations in a capitalist market structure,

multiple buyers and multiple sellers are always preferred over backroom deals and under the table transactions. ically in the last decade. The use of these instruments as price insurance has been widely accepted as an essential for doing business for both producers and end users.
70 65 60 55
Million Metric Tonnes (MMT)
China Soybean - Net Imports / Exports

Net Imports
New Exchanges Mean More Opportunity

Exchanges have been popping up around the world as futures and options have grown more popular and producers and end users have become more sophisticated. Black Sea Wheat, Malaysia Palm Oil and Australia Wool are all examples of local markets that have benefited from the availability of futures trading. Local producers and global consumers can use these markets to hedge their price risk.
50 45 40 35 30 25 20 15 10 5 0 -5 -10 86 88
Net Exports
90
92
94
96
Most Recent: 62.75 As Of 12/11/2012
Crop Year Beginning
98
00
02
04
06
08
10
12
Source: USDA
Exchange Volume Trend

While total futures and option global volume may be down for 2012, the trend over the past five years has been very strong. The exchanges with some of the strongest growth include the Multi Commodity Exchange of India, Dalian Commodity exchange in China, the Shanghai Commodity Exchange and the Singapore Exchange. In the first half of 2012 the CME Group was still the volume leader with 1.55 trillion contracts traded, but there were four other exchanges with volume greater an 1 trillion contracts during that time frame and 17 exchanges around the globe with volume over 100 million.
IV. Ever-Increasing Relevance of Commodity Futures to Global Trade

Commodity futures have become increasingly important to the global economy as their role in helping companies reduce their risk from price volatility has grown. Futures and options are used by corporations to offset price risk for commodities. This leaves them in a better position to concentrate on their core businesses and is much more effective than relying upon luck to manage their input costs. Producers and end users of commodities are more involved than ever transferring risk to those who want to accept it. Open interest in options has expanded dramat-
Regulations
The events of the last several years have clearly put the futures industry on a fast track toward even more intense regulation, but the most significant development is the push toward insuring customer segmented funds. The

industry is considering the implementation of something similar to SIPC, the Securities Investors Protection Corporation. While fraud issues are tough to detect, removing the customer funds financial risk through the use of insurance would go a long way towards restoring confidence in the futures industry. Indeed, the combination of intense regulatory scrutiny and this type of financial backstop should finally bring commodities to an investment class standing. Tighter regulations should benefit the industry in the long run, especially since swap activity will now be monitored more effectively in the wake of swap trades becoming part of organized exchanges. This in turn means that those instruments will be regulated to the same extent as futures and options. With recent news that the Intercontinental Commodity Exchange was poised to purchase NYSE/EuroNext, it would appear that commodity markets are poised to take on a more dominant role than equities in the years ahead. Some economists think that the net result of the sub-prime crisis is an ongoing rotation from financial assets into physical assets, especially when one considers the lingering negative influence from record global debt levels. conservation of its somewhat dear natural resources. With rapid rise in the standards of living in China, Southeast Asia, India, the Middle East and Africa all a long way from running their ultimate course, interest and trade in commodities looks to be an entrenched trend.
Vegetable Oil - Major Consumers

33 30 27
Million Metric Tonnes (MMT)
30.584
24 21 18 15 12 9 6 3 0 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
13.067 17.994
Source: USDA Most Recent: As Of 12/11/2012
Crop Year Beginning

China India United States
Conclusion
Commodities have only just begun to receive the respect they have been denied over the last 50 years. In the past some parties have suggested that commodities shouldnt be an asset class because they were too critical to the global economy and they thought allowing investment and trade in commodities would result in inflated prices. In reality, commodity prices need to be free adjust rapidly in order to register concern about upcoming supply, to foster expanded production capacity through technology, and perhaps most importantly, to increase the worlds
Surging interest in commodities by investors and governments, increased volatility from weather issues and the ongoing expansion of global commodity production areas (beyond ideal production zones) probably means that the battle between supply and demand will at times burn white hot with severe shortages, ultimately giving way to temporary overabundance. In the end, one of the most positive results of the sub-prime crisis might be that the pause in global growth allowed for a minor catch up in supply for some commodities and that in turn could delay what we think will be an inevitable inflationary end game. Change is positive and necessary, especially when one considers that commodities are a critical component of the global economy. A recent Bloomberg survey

put global investor sentiment at its highest level in 18 months. That combined with the slow but sure progress in handling the travails in the Euro zone suggests that smoother economic waters lie ahead. In addition, Chinas economic outlook is beginning to improve having successfully navigated a transfer of national power, but more importantly having halted a tight monetary stance that had been place for almost 15 months. Therefore the worlds biggest physical commodity consumer should be expected to see a recovery in commodity demand. In the end, improving economic confidence, historically high global money supplies and no way out but forward from global debt loads could mean most central bankers will be forced to keep their foot on the gas in 2013. If so, commodity consumption trends, especially with the growth in China, India and Southeast Asia, should mean a continuation of the longer-term uptrend in commodity trading volumes and even higher commodity prices.
Insider Market Advisory

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Long Live The Commodity Super Cycle

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INDEPENDENT. OBJECTIVE. RELIABLE.