The Future of Commodity Markets Part 1: Market Evolution
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
The World’s Grocery Store Is Not Going Away
Chapter 28, written by Hunter Holzhauer, is the final chapter of the book and covers the future of commodity markets. It is a big chapter, so I am splitting it into three parts. This first part focuses on market growth and the excess supply problem.
The chapter opens with a quote from Deloitte’s Global Mining leader: “Just as, during the super cycle, people imagined prices would go up forever, people now imagine the market will never recover. Neither extreme represents the truth.” That sets the tone nicely. Commodity markets are cyclical. They always have been. But the cycles are getting longer.
The big picture: commodity derivatives volumes grew more than 20 percent between 2005 and 2015, with trading volume increasing 26 percent in 2015 alone. More than 4.3 billion contracts were traded, surpassing single stock options as the most traded class of derivatives. The growth came mainly from China and the broader Asia Pacific region (55 percent), with the Americas at 28 percent and Europe/Middle East/Africa at 16 percent.
U.S. Growth: The Shale Revolution
The U.S. energy story is remarkable. During the 2007-2009 recession, the United States was net importing over 2 million barrels of refined oil products per day. Just five years later, it became a net exporter of about 1.2 million barrels a day. The Energy Information Administration expected the U.S. to become a net exporter of all energy products as early as 2019 if prices stayed high. This represents a radical shift for a country that had been a steady net energy importer since the 1950s.
Employment data confirms the trend. Between 2005 and 2014, several commodity industries were among America’s 25 most-thriving sectors: support activities for mining (97 percent growth), oil and gas pipeline construction (90 percent growth), copper/nickel/lead/zinc mining (76 percent growth), and soybean farming (112 percent growth). The agriculture numbers were even stronger, with dry pea and bean farming growing 117 percent.
Interestingly, almost no commodity industries showed up on the list of dying industries. The one exception was the U.S. cotton industry, hurt by outsourcing of fabric production.
The Excess Supply Problem
But global growth and U.S. shale success do not tell the whole story. The commodity market faces a serious oversupply problem, and a lot of it traces back to one country: China.
China’s shift from an investment-led to a consumer-led economy reduced global demand for infrastructure materials. That created too much capacity across metals, energy, and agricultural products. In a 2016 KPMG survey of 80 commodity market professionals, 70 percent expressed concern about low commodity prices. The biggest worries were low global prices (21 percent) and weak economic growth (18 percent).
The oversupply has cascading effects. Shrinking margins push traders toward riskier, more complex deals with higher capital requirements. As traders abandon less profitable markets, liquidity dries up and the probability of price spikes increases.
The one silver lining of excess capacity: the energy market can shrug off supply shocks in the short term. The entire globe, from the U.S. to China to Russia, is overstocked with energy commodities.
Changing Strategies
Traders are adapting to the oversupply in interesting ways. Companies that used to borrow or lease their assets are now buying them outright to secure stable demand. These acquisitions range from coal mines to storage terminals to gasoline retail chains. The goal is to lock down long-term supply contracts, commonly called “structural shorts.” If you own the end-user asset, you have guaranteed demand for the commodity you trade.
The Steel Story
The excess capacity problem hits hardest in steel. More than 45 million tonnes of global steelmaking capacity were shut down or idled in 2015. China is responsible for roughly 40 percent of global steel demand, which makes it a double-edged sword: it is both reducing demand and flooding the market with cheap steel.
Steel capacity essentially doubled since the turn of the millennium. It was ramped up in the early 2000s to meet global demand for infrastructure in emerging markets. Then the 2007-2009 recession cooled demand. Despite falling demand, the OECD projected steel capacity would continue increasing from 2.16 billion to 2.36 billion tonnes between 2013 and 2017. Why? Government interventions, mainly through subsidies for inefficient facilities and approvals for new ones. Asia alone was expected to add 143 million tonnes of capacity, almost three times the growth for the rest of the world combined.
In a PWC survey of 37 metals industry CEOs, 84 percent planned to cut costs. Nearly half were worried about declining commodity prices and rising energy costs. Access to affordable capital was a growing concern.
Population Growth: The Long-Term Bullish Case
If the short-term picture looks grim, the long-term case for commodities is much more optimistic. The UN projects the global population will grow from 7.3 billion in 2015 to 8.5 billion by 2030, 9.7 billion by 2050, and 11.2 billion by 2100. Most of this growth will happen in Africa and Asia.
More people means more demand for base metals (infrastructure), energy (electricity and transportation), and agricultural products (food). Emerging markets will play an even larger role in commodity demand going forward.
Climate Change: Winners and Losers
Climate change is creating both threats and opportunities. Natural gas is winning as coal regulations tighten. Even with a temporary reprieve from changing U.S. political winds, the long-term trajectory favors cleaner energy sources.
New commodities are emerging: fracking materials, recyclable building supplies, and potable water. Fresh water makes up only 2.5 percent of the world’s water supply, and more than three-quarters of that is trapped in glaciers. Without major advances in desalination technology, drinking water could become one of the most important commodities of the future.
Even Wall Street is getting into green energy. Citi won the 2015 “Emissions House of the Year” award for structuring a 13.5-year clean energy deal with Facebook, involving a 204-megawatt wind farm, a $212 million construction loan, and $219 million in tax equity financing with Berkshire Hathaway Energy.
My Take
This first part of Chapter 28 paints a picture of a market in transition. The short-term outlook is challenging: oversupply, weak demand from China, and shrinking margins. But the long-term fundamentals (population growth, emerging market development, climate-driven demand shifts) suggest the commodity market’s best days may still be ahead.
The steel example is a useful case study in how government intervention can make oversupply worse. Subsidies and approvals for new facilities in the face of declining demand is the opposite of what the market needs to correct itself.
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