It is over-simplification to say the world has been overwhelmed with too much oil and gas and inadequate drivers of demand for them over the last few years. Price movements of commodities are traditionally cyclic in nature, and have followed a multi-year boom-bust sinusoidal-type wave profile that dates back to the earliest days of humanity’s first phase of industrialization. These cycles are triggered historically by a catalyst that impacts the global demand for commodities, and drives prices up or down for decades. In physics the sine wave represents the oscillations in which the amplitude of the peaks and troughs are proportional to its displacement, over time.
To date, the sine curves of the commodity cycle have followed this trend. Is this set in stone? To know where we might go, it is important to understand where we’ve been. In this article we will review the factors involved in initiating the current commodity super cycle, the peak of which we crested in 2011. The fundamental question being, are there some extenuating factors that might short-circuit the depth of the projected trough. A trough, that if nothing changes could last for another decade.
The origins of the current super cycle
In 2011-ish we crested peak demand in the current cycle and began a period of contraction in commodity demand as the global economic system reacted to the market implosion and credit crisis of 2008. An implosion driven by the collapse of the U.S. housing bubble the year prior. Oil prices continued higher for several years on the potential for supply disruptions driven by unrest in the Middle East, and Africa, peaking in 2011. A war-fear premium, if you will. Oil prices then began to drift lower over the next several years, but remained high relative to their historical averages. The decision by OPEC in mid-2014 to maximize their market share took the war-fear premium out of oil and led to a multi-year collapse in pricing. A collapse that's only recently seen its low point, as once again OPEC+ (OPEC with the addition of Russia), made a fundamental course correction in its quest for market share.
The result of all of this has been the carnage of the last six, going on seven years that has decimated the global oil and gas industry. An industry that had borrowed and built its way to massive proportions on the notion that oil prices would remain above $100 forever. Particularly in the E&P sector among the Super Major International Oil Companies-IOC's, we've seen share prices fall as the expectations for growth in 2014 turned in discussions of obsolescence as a new wave of alternative forms of energy caught the public's imagination. To measure the extent of the decline, it’s useful to note that in 2008 oil and gas firms represented 15 percent of the S&P 500. Today they represent just 2.3 percent of this index.
Before we go further, let's define just what a Commodity Super Cycle is, and examine the origins of our current super cycle.
A commodity Super Cycle is characterized by the abrupt and lengthy rise of industrial commodities-oil, metals, livestock, agricultural, over time until prices rise toward a peak, and then cause a contraction toward the eventual trough. The rapid rise of China as the global manufacturer of nearly everything provided the spark or "catalyst" that initiated the current commodity Super Cycle. Beginning in the early 1990's China became the buyer of last resort of nearly all raw materials produced globally. If no one else wanted it, they did. What we learn from the graphic above is that these cycles come in waves and are initiated by a "shock" to the global supply system. Growth creates demand and supplies increase to meet that demand, driving up prices as this happens. When prices reach a certain multiple from a historical mean that varies from commodity to commodity demand shrinks, and suppliers are left with excess inventory. Prices crash until inventories shrink to modest levels, and the next inflection point is reached, be it war, technological or expansion of a sector's middle class. And, then a new cycle begins.
As discussed above, if the past is a guide, and it generally is in sine curves, we have conceivably another decade of decline before we bottom out and a new cycle begins. Perhaps this extended down cycle is not inevitable?
The Global population which drives all economic activity increases by ~80 mm annually. Every dozen years or so we have a billion new inhabitants of the earth. Plus in many areas of the world the middle class is expanding. Growth seems to be the base case for world economic activity, and should drive commodity prices higher. Will it?
What's different this time?
A difference might be that presently a number of new vectors are developing for a resumption of the increase of commodity demand.
India is likely to be one of the next recipients of the flow of global capital due to a number of factors-
- In 2030 it is projected to become the most populous nation on earth with 1.5 bn inhabitants, 50% of which are under 25-years of age, and 65% are under 35.
- Low wage rates compared to China. $148 per month vs $234 in China.
- A rising middle class that by 2030 will comprise 68% of the country and number in excess of a billion, allowing that are wide bands of income in what is considered middle class in that country.
- About 10% of India's middle class is considered highly educated. India currently exports many of their degreed class due to lack of employment opportunities at home. A scenario that could shift if outside capital does indeed begin to flow to India.
- Challenges include the diversity of tribes and native tongues spoken in India. Nearly a thousand variants of ethnicity and hundreds of mother tongues present a challenge to growth and communication within the country.
Nations of the ASEAN trading block present a lesser but still represent a significant and growing alternative to China with a population of 600 mm. Largely youthful in demographics and a common culture of seeking out higher education, these countries are already receiving new capital that might a few years ago have gone to China. The key challenge for ASEAN growth is the disparate linguistic differences and governmental structures ranging from legacy potentates mixed with democracy to communist with their attendant restrictions on individual liberty.
China's new middle class is six times larger than just a couple of decades ago. Numbering about 700 mm this is the largest single group of affluent consumers on the planet. China creates its own huge internal demand for goods and services.
Finally China remains a manufacturing powerhouse for decades if not perpetuity. A good part of the present conflict between the U.S. and China has to do with China's Belt and Road Initiative that seeks to propel their economy ahead of the U.S. What that means is they will fight tooth and claw to retain their export economy, while at the same time preparing to serve their internal middle class.
The essence of this argument is that with the multiplicity of causal agents listed above, and confronted by renewed global economic expansion, increasingly scarce commodities must begin a new Super Cycle.
Technological drivers: Infrastructure Spending, Electrification, and AI
There are factors that logically could influence the depth of the commodity cycle.
- There is a global push to modernize infrastructure in developing countries. Roads, bridges, cellular towers, mass transit, airports, dams, water projects, harbors, to name a few are being built or upgraded around the world, and in places that have been fairly primitive historically. This amounts to trillions of dollars of spending that will be focused on energy intensive construction, earth moving and heavy lifting type work that requires large energy expenditures to carry out. It is also worth noting that aging infrastructure in the U.S. and Europe much of which dates back to the early part of the last century, represents trillions of dollars of energy intensive capex that must be carried out to maintain our civilization.
- Electrification of everything is underway. Energy use will increase from population growth and from the change to robotic labor in factories, a shift to cleaner fuels for transportation, and growth of global middle classes. Source
What doesn't get a lot of press is that in order to generate electricity with the exception of a small but growing fraction generated by wind, and solar, and to a lesser degree by hydro sources, you have to burn something. The fuel to do that is mostly now, and is predicted to remain natural gas.
In the graphic above 'renewables' are credited with most of the increase in global electric generation. I think this is wildly optimistic and there are a lot of folks in California who might be starting to agree with me. When it’s 115 degrees outside, you don't care where your electricity comes from, you just want it to be there. That said, the current political push to decarbonize energy sources must be considered.
AI will transform the way the world works, and it’s a change that's only begun. In an OilPrice article a couple of months ago that featured an unlikely candidate for a writer whose primary expertise lies in the energy sector. It featured Microsoft, (MSFT), a company that until a few years ago, was primarily known for its suite of office productivity software. The reason it made the DDR was its entry into the cloud storage and applications space, and its five-year alliance with Halliburton, (HAL). I calculated that over the next five-years the MSFT Cloud platform, Azure could generate $50 bn in revenue. MSFT is not even the biggest in this space. Amazon, (AMZN) web services AWS is the market leader so far.
The cloud and AI are very abstract to most of us. The build-out of the hardware and data storage infrastructure necessary to sustain it will be an engineering undertaking the likes of which the world has never seen. Think of hectares and hectares of server storage warehouses, and the energy to run and cool them as they run, and you see that Lavoisier's constant still applies. There is no free lunch. Work that previously was done by hands, and backs will now be done by the brain, assisted with AI architecture. The rub is the energy required to do all of this work remains the same. That will require massive investments in energy sources of all types to sustain.
This has been a bit of futuristic prognosticating about things that might impact the current down slope of commodity demand. If history is a judge we have a long way to go before a new cycle begins. We often talk about what a catalyst for return to growth in the energy sector might look like. If any of the scenarios we’ve discussed here-in, come close to being correct as supplies drop from years of under-investment and demand increases from the global economic recovery, we may not have long to find out.
By David Messler for Oilprice.com
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