For decades, investors largely ignored the commodities segment. They can no longer afford to. Demographic changes are stoking demand and the supply bottleneck will keep commodity prices high.

 

 

The last few years saw a breathtaking roller-coaster ride for raw materials. After a steep crash at the end of 2008, a new high-altitude in price records was achieved in 2010. What is behind this development?  And, beyond the horizon of the current economic situation, what are the most important drivers for prices of raw materials in the future?

 

Demographics are a significant factor. A growing world population and increasing wealth in emerging markets mean that the current structural shortages are by no means a short-term phenomenon. The increase in world population is slowing and, at the end of the 21st century, could even begin to fall. However, in between it is expected that the global population will increase by 2.5 billion during the next 50 years—an increase of about 40%.

 

The demand for commodities is not only increasing quantitatively because of the rising world population—there is also “qualitative” growth. According to estimates by the World Bank, by 2050 per capita income will increase about twice as fast in countries with low incomes as in OECD countries. For example, in the period from 1999 to 2009 real disposable per capita income in Asia rose by 90%. With higher prosperity, consumption becomes more raw-material-intensive.

 

Another important aspect is that affluence increases demand. Countries that have managed to strengthen their industrial bases now need significantly more commodities than before.

 

China, with its large population, is extremely hungry for resources, and its citizens are now among the largest consumers in the world of many commodities (see chart). The per capita consumption of copper, aluminum and steel increased threefold over the last 10 years. The energy demand of the largest country in Asia also explains one-third of the rise in worldwide demand for oil in the last years. China imports about four million barrels of oil per day (equivalent to approximately 13% of OPEC production) and is now the second-biggest importer of oil. In 1993, oil imports into China were zero. The country is the fifth-largest oil producer in the world, but this is not enough to meet pent-up demand.

 

 

A few general numbers give an insight: the average German today uses 542 kg of steel per year, while annual per capita consumption in China is only 342 kg. An American uses 23 barrels of oil per year (over 4,000 liters), while in Mexico per capita consumption is just over seven barrels per annum, and in China about two.

 

The role of infrastructure as a driver of economic activity, and consequently, of demand, is also often underestimated. Growing markets have transportation requirements, such as roads, waterways, railways and buildings, as well as facilities to ensure the supply of water and electricity. They also need commodities—and this is boosting demand.

 

The OECD estimates that in the period 2003-2030, China alone will have to invest about $2 trillion in power plants for electricity generation and distribution. At present the country already invests approximately 20% of its gross domestic product in infrastructure. However, even developed countries have work to do. In the years to come, the OECD expects the U.S. and Canada to invest around $1.8 trillion in their electricity infrastructure—not much less than China. This means that even if commodities are subject to cyclical fluctuations, the sustainable drivers we have discussed could ensure long-term demand for commodities maintains its pace even beyond financial crisis.

 

And the supply side? Long-term rising demand is coupled with the fact that few new capacities have emerged on the production side during the last few years. Partially, this was because in the 1980s and early 1990s “too much” was being invested in new capacity that was more efficient and less expensive. It took several years for this excess supply to be soaked up.

 

This was reinforced by severe economic crises in Asia and Russia. During this time, the inflation-adjusted prices of many commodities reached their lowest levels in over 100 years in the mid-1990s. Additionally, when the high-tech bubble began to inflate, it made more economic sense to invest in information technology rather than search for new sources of raw materials. At the same time, natural resources are becoming scarcer, or access to them is becoming more difficult and more expensive. Although exploration expenditures of companies increased significantly from 2002 to 2009, most investments (2009: 41%) were made at the locations of known deposits or in exploring in the immediate vicinity of already developed reserves (27%). Only 32% of expenditures for exploration went to discover completely new reserves—so far with relatively little success.

 

A similar phenomenon has been observed in oil production, where the development of new reserves is becoming increasingly difficult and expensive. While new technologies allow for deep-sea drilling at depths of more than 4,000 meters, almost no major oil fields have been discovered in recent years, with the exception off the coast of Brazil (“Tupi”). This is located in extremely deep water under layers of hard rock and salt, making it very difficult and expensive to develop. The sinking of Deepwater Horizon and the subsequent oil spill in the Gulf of Mexico in 2010 have shown that significant risks are associated with deep-water drilling. Meanwhile, the major reserves discovered in the middle of the last century, primarily in the North Sea and off the coast of North America, have peaked and are drying out. This means that scarcer supplies are working in tandem with declining output by the oil companies.

 

And even if new sources of commodities were found in the near future, it generally takes four to eight years to bring these to market. Lengthy approval processes, infrastructure development in remote regions and specific new technical challenges are among the most-cited reasons for the long lead time for mining projects. Skilled labor is also frequently difficult to come by. Who would have chosen to study mining instead of marketing in the late 1990s?

 

Finally, there are often political obstacles to the expansion of commodity production. Even in the agricultural sector, the supply of livestock and food cannot be expanded at will. With the rapid urbanization of the world’s population—in 2007, for the first time in history, more people lived in cities than in rural areas—the amount of arable land has decreased. Simultaneously, the shift in agricultural production to biofuels from food has increased competition for land.

 

Commodity production can scarcely keep up with the dynamic development in global demand. The supply bottleneck could remain a sustainable driver of higher commodity prices for the foreseeable future. This applies to energy, to commodities in general and agricultural products in particular: these resources are becoming scarcer—and this is a megatrend.

 

 

Past performance is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts are inherently limited and should not be relied upon as an indicator of future results.

 

A Word about Risk: Equity portfolios are subject to the basic stock market risk that a particular security or securities in general, may decrease in value. Concentrating investments in individual countries or regions may add additional risk and additional volatility compared to a geographically diversified portfolio. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments

 

©2011 Allianz Global Investors Distributors LLC, 1345 Avenue of the Americas, New York NY, 10105-4800, www.allianzinvestors.com.

 

 

 

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