The commodities boom of the past decade is starting to look its age. Abundant liquidity and the perception that commodities could be a ‘store of value’ pushed prices to record levels in many markets. But today, investors are rightly becoming nervous about the likely fall-out, once the Federal Reserve starts to wind down its stimulus programs. Markets may therefore start to reconnect with the fundamentals of supply and demand. And this could provide an unpleasant shock for unprepared investors.
Oil markets provide a good example of what may be in store. As Chart 1 shows, there were just four years in 1900-2003 when oil traded above $30/bbl. These were during the 1979-82 Iran crisis when OPEC operated a fixed low production ceiling.
Even in real terms ($2012) oil has similarly been below this level for 78% of the period (23 years). Only since 2004 has the $30/bbl level become a floor rather than a ceiling, as policymakers:
- Held interest rates below market levels in the run-up to the financial crisis of 2008, in an effort to support growth in housing and other markets
- After 2008, initiated successive waves of stimulus and liquidity programmes in an effort to support growth in the wider economy, when the promised swift rebound failed to materialise
This period has clearly been unique in history. Yet investors and companies are now dangerously complacent about the risks they will face once central bank liquidity ceases to be the key market driver and prices begin to revert to historic levels:
- Investors have ignored evidence of slow demand and low operating rates, and have instead come to assume that today’s unprecedentedly high levels have somehow become normal
- Companies have come to assume that oil prices can never fall, and so have failed to develop the necessary scenario analysis to help them survive a period of potentially extreme turbulence
Yet inventory levels in the U.S. recently have been at 80-year highs, whilst supply is back at 20-year highs and increasing rapidly thanks to the application of fracking techniques to potential oil reserves. Equally, demand growth is slowing fast under the influence of today’s high prices. Even more critical for the medium term is that populations in many major economies are now aging. So demand growth is set to slow for decades to come, and even may go negative.