Common Commodities Misconception – by John Butler, Amphora
Commodities are the most basic economic goods, providing essential inputs into progressively more complex goods at advanced stages of production. Yet the economic mainstream generally fails to understand commodities, treating them as distinct from the processes whereby they are created and the processes they subsequently enable, when in fact they are an integral part of a dynamic, complex, adaptive economic system. A correct understanding of commodities is essential if we are to understand what their price signals are telling us about supply, demand, and economic activity generally. In this report, I offer some thoughts on longer-term commodity price trends, including the so-called ‘supercycle’. Is it over? Or has it a long way to run? The truth, in fact, is neither: There never was a ‘supercycle’ in the first place! I conclude with some thoughts on commodities investing and trading strategy, in particular how to take advantage of ‘overshooting’.
Commodities Misconception: Malthus And The Myth Of Scarcity
Common sense is a good place to start when thinking about the role that commodities play in an economy. As with all goods, they are limited in supply: there is not enough available to satisfy the potentially infinite needs and wants of consumers. Sure, some are more plentiful than others, but even those once thought essentially unlimited, say fresh water (or even fresh air!), might not be as unlimited as they once were.
The Reverend Thomas Malthus (1766-1834), a prominent classical economist, explored this concept of scarcity in some detail, in particular with respect to food production and consumption. He noted that farm production tended to grow linearly over time, yet populations tended to grow non-linearly. Eventually this would lead to demand outstripping supply, rising real food prices, and the impoverishment of the masses. A similar phenomenon is observed when bacteria are isolated inside a test tube with a limited food source: The bacteria grow exponentially until the food source becomes limited and access becomes restricted, at which time there will begin a precipitous decline and, in the end, a complete wipe-out of the entire population as the food source is depleted.
Malthus was entirely correct in his view, given his assumptions, as the test-tube example above demonstrates. In practice, however, his assumptions have been completely wrong. Indeed, the technological advances of the industrial revolution were already in full swing during his lifetime, but he failed to understand the role of technology and the associated division of labor and capital that was enabling, already during his own lifetime, a multifold increase in agricultural productivity.
Modern, neo-Malthusians sometimes retort that global population growth has now caught up with agricultural productivity to the point where food scarcity is again becoming an issue. There is some evidence for this claim. Food price inflation has been picking up in most parts of the world of late. But is this really due to scarcity? Or is it due to something else entirely?
Commodities Misconception: Understanding Price Inflation
When thinking about commodity price inflation, we naturally tend to think of this in terms of the dominant medium of exchange. In the US, this would be US dollars, although dollars are used around much of the world. In Japan, people think in yen terms; in the euro-area, in euro terms, etc. But while this is certainly conventional and convenient, when considering whether scarcity might be causing food price inflation, it can be horribly misleading. For example, food price inflation in Japan has soared over the past year. But is this due to scarcity? Or to the sharp devaluation of the yen that began in late 2012? Back in 2010-11, UK food price inflation was also unusually high. But was this due to scarcity, or to the sharp devaluation of sterling in 2008-9?
It should be obvious that currencies that experience sharp swings in their purchasing power serve as poor measures for benchmarking food price inflation and thus obscure its true cause. So which currency should we use?
The answer is… wait for it… None! NO currency can serve as a perfect measure of true food price inflation because all currencies are subject to swings in their purchasing power. These swings occur naturally, as currency supply and demand fluctuate, although most central banks purport to keep such swings to a minimum. (As we know, central banks in fact fail miserably to keep such swings to a minimum, but that dead horse has been flogged in many an Amphora Report.)
Here at Amphora, our entire investment philosophy and associated processes are based on the idea that the best way to understand commodity prices is to think of them in relative terms, that is, relative to each other, rather than to denominate their prices in currency terms. So if we want to find an answer to the question of what is behind food price inflation we should first get a sense of to what extent there has been relative food price inflation.
Let’s start by comparing the price of food to that of one of the key inputs in production: crude oil. Mechanised agriculture is powered primarily by petroleum products. Have food prices been rising relative to crude? No. How about metals? No. In fact, food prices have been sharply lagging the general price rise in commodities since the early 2000s.