The surge in commodity prices has abated, perhaps temporarily. But for advisors and investors looking long-term, the question remains – what role do commodities play in the asset allocation for long-term investors?
Tim Bond and Nicholas Snowdon of Barclay’s Capital provide part of the answer in their study, “For richer, for poorer,” which appeared in Barclay’s Capital 2008 Equity Gilt Study.
For many commodities, demand is outstripping supply at an accelerating pace. With scarcity becoming a real possibility in 20 or 30 years, investors can benefit from long-term imbalances.
In his recent article, Craig Israelsen documented the benefit offered by diversification with commodities. Bond and Snowdon provide compelling data that commodities will be the driving force in world economies over the next several decades.
Over the last 35 years, commodities have fared poorly, generally breaking-even against inflation. Below is the inflation-adjusted data for several major physical commodities, as well as oil:
Underlying poor commodity performance over this time period has been a general balance between supply and demand. Commodity prices increases led to new investment and technology advances, spurring additional exploration, increasing supplies and driving prices down. But Bond and Snowdon claim that “the yield from exploration efforts is in decline, a condition compatible with the idea that the most easily exploitable and fruitful raw material deposits have either already been exhausted or are already in production.”
Global demand, fueled primarily by China and India, is on a pace to outstrip supply for many key commodities, leading to escalating prices and irreversible damage to the ecosystem. In their words, “as the world becomes richer, so the world becomes poorer.” Unrestrained economic growth is pushing up against physical limitations, and we are seeing the effects in CO2 levels, falling fish stocks, increase desertification and the shrinkage in tropical forests.
Global population increased from 2.5 billion in 1950 to 6.7 billion currently, and is projected to be 9.2 billion within 30 years. World Bank data indicates that, from 1960 to 2004, inflation-adjusted consumption per capita for middle and upper income economies grew by more than 200%, and by 60% for lower income economies. Bond and Snowdon conclude that “human demands on the earth’s resources have risen by four to five times in just 50 years. Unsurprisingly, signs of stress are beginning to proliferate.”
The World Oil Markets
The growth of the Chinese economy has been accompanied by a surge in per capita demand for several key commodities. Bond and Snowdon document the growth in per capita consumption for four key commodities since 1970:
China has been responsible for 50% of the increase in global primary energy demand since 2000. As a result, China has now passed the US as the world’s largest emitter of CO2, which Bond and Snowdon assert is a “direct result of rising per capita income and consumption.”
To put this growth in perspective, U.S. per capita energy consumption is now roughly seven times that in China and India. If Chinese and Indian per capita energy consumption rises to the level of the US, the oil consumption from these two countries alone would be 160 mbd (million barrels per day), approximately twice today’s global oil consumption (of 85 mbd). This would deplete the world’s proven oil reserves in just 15 years.
But even a modest increase in oil demand does not appear feasible. IEA data shows that even if Chinese and Indian demands rise to levels well below those seen in developed economies, world oil demand will increase 55% over the next 23 years. The oil industry would need to invest $5.4 trillion (in constant prices) to keep pace with demand. Most of this supply will come from OPEC, increasing their market share from 42% to 52%, and would, according to Bond and Snowdon, “clearly increase the cartel’s ability to extract higher rents from oil production,” provided OPEC can manage increase supply fast enough.
Bond and Snowdon cite data suggesting an oil crunch could come sooner. Today, total spare production is approximately 1.5 mbd, perilously close to estimates of increased demand for 2008, which range from 1.6 to 2 mbd. Ability to meet this and projected 2009 demand hinges on non-OPEC supply, “a sector that has consistently disappointed supply expectations,” and a lack of supply disruptions (i.e., natural disasters or project delays). Bond and Snowdon say “the oil market has reached a juncture at which the supply-demand balance is starting to teeter on the brink of a crunch.”
The cause of the imbalance is the depletion of non-OPEC (US, UK, Norway, and Mexican) supply, increased demand from developing economies (primarily China and India), and the increased cost of capital equipment and labor required for exploration and mining. Taking into consideration projected CO2 emissions, Bond and Snowdon say the “current hydrocarbon dependency is not a feasible path” if per capita consumption continues at its current pace in developed economies.
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