Posted on July 8, 2008 by David Laidlaw
Even though we have no idea when prices will fall, it is apparent to us that there is a bubble in commodities across the board. Everyone knows by now that an emerging middle class in China, India and throughout the developing markets is demanding more and more resources as their incomes rise. This thesis spurred us to overweight the energy sector five years ago when we purchased such core holdings as Apache since at that time demand was growing faster than supply. From its low in 2000, oil has risen from $17/barrel to its current price of about $140/barrel. This climb represents an increase of over 8-fold during the last eight and one-half years.
Other commodities have risen as dramatically, but over condensed time frames. For example, agricultural fertilizers have spiked in the last couple of years. As late as 2003, potash (an agricultural fertilizer) was selling for about $80/tonne. Potash now trades for over $350/tonne. Agricultural commodities producers Mosaic and Potash of Saskatchewan now support combined market capitalizations of over $125 billion. Each of these stocks has increased over 4.5X during the last year and one-half.
The typical economic cycle of commodities is a boom/bust cycle that repeats itself over and over again. As demand rises, producers benefit from increased pricing and are initially cautious about increasing their production or exploration of the commodity in question. Producers have also been disciplined by periods during which they increased production only to see prices and profits fall dramatically. However, once prices rise for a sustained period of time, producers begin to ramp-up production. In many cases, it takes time for that production to come on line and introduce increased supplies into the market. During this phase, prices rise very quickly as demand and speculation fuel higher prices. Eventually, the producers work overtime to increase supplies since they believe high prices will persist. By the time this happens, consumers have changed their behavior to conserve and substitute away from the scarce commodity. This change in combination with increased production causes supplies to skyrocket in the face of decreasing demand. Prices then fall dramatically.
Of the agricultural fertilizer companies mentioned above, the two largest producers are now ramping up production and investing vast sums in exploration and production. A third company, Intrepid Potash, went public within the last year and is aggressively spending $125 million+ in capital projects with newly raised funds from its public offering. Assuredly, prices will fall for fertilizer, oil and every other “can’t miss” commodity as new supplies become available.