It is certainly true that commodity prices have risen rapidly over the past year. The Economist Commodity Index has risen by 19.2% in dollar terms. Metals did even better with a rise of 43.6% over the same period.
Naturally funds which invest in natural resource comp
anies benefited as a result. Perhaps the most striking example is the Merrill Lynch Gold & General fund which has long been the best performer over three years in the entire universe of funds sold in Britain.
But before switching the bulk of their assets to natural resources funds it is important for investors to take a closer look at the commodities market. For the idea that prices are bound to rise strongly over the medium to longer term is open to question.
Most obviously it can be argued that rising commodity prices are at least partly a result of the weaker dollar. In euro terms the Economist Commodity Index actually fell by 2.5% over the past year. And in both yen and sterling terms the rise was only about 5%.
Oldest mistake
However, there are more fundamental reasons to question the assumption that the “China effect” will provide a permanent boost to commodity prices. It is simply a new version of one of the oldest and most pervasive mistakes in economics. Underlying the argument is the false assumption that demand is likely to rise rapidly while supply will be restricted by natural factors.
Such reasoning was first popularised by Reverend Thomas Malthus (1766-1834) in his Essay On The Principle Of Population which was first published in 1798. Malthus argued that population grows geometrically while food supply grows arithmetically. In other words population growth was likely to far outstrip the supply of food. So if population was allowed to grow unchecked he saw a future of disease, famine and war.
With the benefit of over two centuries of hindsight – and despite the remaining problems in the world - it should be clear that Malthus was wrong. The world’s population is much larger than during Malthus’s time and yet on average people are far better fed and healthier than 200 years ago. For instance, during Malthus’s lifetime the average English person only lived till their late thirties.
Malthus grossly underestimated human ingenuity. In particular he had little faith in the ability of human beings to learn to produce more efficiently. Agricultural yields – the amount of food that can be produced in a given area of land – have risen far faster than population. It has therefore proved possible to have a much larger population that is also better fed.
Many of today’s commodity bulls reproduce Malthus’s arguments in a new form. Their focus is on fuel and metals rather than food. But they also argue that natural limits – in this case the amount of resources available – will put a brake on supply. Only today’s natural resource investors hope to benefit financially from rising prices.
Confuse limits
Such arguments confuse natural limits (the absolute amount of a commodity that is available on earth) with social limits (the amount that is profitable to extract at any given time). Although this may seem like a pedantic distinction it is of enormous importance. Failure to understand it that has led to numerous alarmist predictions since Malthus’s time about resources running out.
The point can be understood more clearly by taking a specific example. Back in 1982 world proven crude oil reserves were 696 billion barrels according to the Organisation of Petroleum Exporting Countries (Opec). Yet in 2002, after 20 more years of use, global reserves had risen to 1,067 billion barrels.
Essentially oil companies do not go looking for extra reserves until they believe it will be profitable to extract them. As Bjorn Lomborg, a noted critic of environmentalism, has argued the conventional argument is like someone glancing at their fridge and saying to themselves: “Oh, you’ve only got food for three days. In four days you will die of starvation” (The Skeptical Environmentalist, Cambridge University Press 2001, p125). In reality, when the person gets close to running out of food he will go to the supermarket to get more.
In relation to oil there are numerous ways in which the supply could be extended in the future. On top of conventional supplies the amount of shale oil – extracted from sand and rock – is 1,000 times greater than normal reserves. Although it is expensive to extract at present it is likely to become cheaper over time. In addition, energy intensity – the amount of energy use per unit of GDP – is improving. America’s Energy Information Administration recently estimated that it is falling at an annual rate of 1.5%. Even if oil does run short there is always the possibility of switching to new forms of energy such as fuel cell technology or nuclear fusion. It is impossible to say for sure how the problem will be resolved but, judging from history, it looks likely that new forms of energy will be found as old ones are used up.
Metals untapped
What is true for oil is also true for metals. Vast supplies of most metals remain untapped. For instance, it is estimated that there are 8 million tons of gold dissolved in seawater compared with only 100,000 tons quarried so far in human history. There are also substantial amounts of already-processed gold sitting in bank vaults and the precious metal, unlike fuel, can be recycled.
As a result of human ingenuity the “China effect” on commodity prices could be short-lived. If it becomes profitable to develop new sources of raw materials it is likely to happen. Firms will race to supply China’s growing demand for natural resources. As new sources of supply are found then prices could well fall. Human ingenuity will have won once again.
This article first appeared in the January 19th issue of Fund Strategy.
