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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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With a Collapse in Commodity Prices, What Happens Next?

This has to be a scary time for virtually all commodities investors, whether one is talking about investing in commodities directly or in commodities companies. From oil to aluminum, nearly all commodities are not just trading near multi-year lows, but multi-decade lows. Bloomberg recently noted that commodities are now trading at the same level they were at in the mid-1990s after a major run-up in the late 1990’s and throughout much of the new millennium.

This begs the question: ‘what will it take for commodities to recover?’

To get to the answer, one first has to understand two important things about commodities prices in recent years. First, in recent years and up to the present, China has been consuming the vast majority of commodities. As economics website the Visual Capitalist showed in a stark chart recently, despite making up only 20 percent of the world’s population and less than 15 percent of global GDP, China consumes 60 percent of all concrete, 49 percent of all coal, 46 percent of all steel, and 54 percent of all aluminum among other commodities. Related: Is Russia Plotting To Bring Down OPEC?

(Click to enlarge)

The point here is that China’s infrastructure boom has had a massive and unparalleled effect on global commodities demand. So much so, that China was able to temporarily offset the second important point about commodities – they have largely been declining in price not just for the last few years, but for decades. In current dollar terms – that is, non-inflation adjusted terms, commodity prices have often risen over the last century, but in real terms have generally fallen substantially over time. The 2000’s led many investors to forget this trend as numerous commodities rose rapidly in price. Related: Six Reasons Natural Gas Prices Are Staying Down

A 1998 study by the U.S. Department of the Interior and U.S. Geological Survey makes exactly this point. As technology has improved, the real (inflation-adjusted) cost of commodities has tended to fall over time. The 1998 survey tracks some commodities prices back more than a 100 years making that point.

Skeptics of this philosophy and those who see scarcity of resources as outweighing the power of technology might be tempted to argue that oil and natural gas are different than metals. And that’s true to some extent – they are different markets, after all.

But the economic forces underlying those markets are similar. Oil prices have largely been controlled by a cartel for the last half century. In the absence of that cartel, it’s likely that prices would have fallen. Now, thanks to fracking, OPEC is starting to lose control of oil prices, potentially leading to a prolonged period of price stagnation. The days of $100 per barrel oil may be gone for decades or longer. The same general theme holds true for other commodities from coal to steel.

But what could change this?

The world needs a new China – a country (or set of countries) with a massive population and an absurdly low level of technological development that is ready to move its economy forward. The only possible option that fulfills those criteria realistically is India. Related: BP Spells Out What’s Wrong With Big Oil In One Chart

India is just as large as China (and it will actually become larger in the next couple of decades), and it has a sufficiently low level of development such that an infrastructure boom might make sense. India’s economy has largely been held back by sclerotic and dysfunctional economic policies, but that might be starting to change under the new Prime Minister.

Nonetheless, even if India does not reform its economy and start to realize its full economic potential, not all commodities or energy investments have to be bad ones. It is true that commodities prices may remain under pressure for a long time to come. But for companies in the resources space from E&P firms to miners, commodity prices don’t matter – margins do. If costs of extraction come down and commodity prices do as well, a company can still earn a substantial profit. The key is taking advantage of new technologies to improve efficiency. The U.S. E&P fracking firms appear to be doing just that.

With that in mind, investors should start to look not only at the price of oil but at the cost that companies face to get it out of the ground. It’s likely that over the next year or so, that cost will fall enough that many oil firms will begin reporting a profit again, even at current oil prices. The commodities price shock has been rapid, and companies need time to adjust, but once they do, investors should return in droves.

By Michael McDonald of Oilprice.com

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  • Charles on February 13 2016 said:
    Good article! I think oil is in a prolonged slump with fits and bursts bouncing in the range of $40-$60 for the next 5 years approximately. The frackers and oil shale companies have a pile of debt that they will default on which will have some negative macro consequences for the banking and bond markets as they hurl this $200billion in debt. All of this demand from China has been financed with debt.......they too will have to write down several trillion in bad debt. So the demand won't be from China soon.....5 years plus. Who really trusts China ? They are still commie and untrust worthy and will continue to try and lie about their actual GDP growth and the health of the banking system. The dollar will remain the reserve currency even with all of our problems in the US we are still the best house on a bad block. Demand for dollars will rise as the global economy contracts driving the dollar up and commodities prices down. Central banks have already lost control of our economies in the west and Japan. There is a huge debt overhang globally and I think a large chunk of it will have to be written down...40%? Either way commodities won't rally until after2020.

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