Long Live the Commodity Super Cycle - Daniels Trading

Long Live the Commodity Super Cycle

INDEPENDENT. OBJECTIVE. RELIABLE.



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It is our view that demand for commodities will continue

to be very strong and that the prices of most commod-

ities have a very long way to go before they can insure

adequate supply and some semblance of demand con-

servation. While many commodities have already risen

to historic price levels, an interesting phenomenon has

surfaced that suggests that prices have not reached high

enough levels to achieve consistent supply. For exam-

ple, crude oil prices have settled in at roughly four or

five times the levels seen from 1992 through 2000, yet

alternative energy sources, such as natural gas, solar and

wind power, are still underutilized. In the food protein

area, nearly historic high beef prices have failed to provide

beef producers with a consistently profitable environ-

ment due to surging feed costs, spiraling regulation and

other increases in production costs. Similarly, the U.S.

dairy industry remains in the midst of a decade-long

collapse because retail prices for milk, butter and cheese

are rarely offering producers an acceptable profit in the

face of rising. While we aren’t suggesting that all com-

modities will take on the status of rare earth metals, key

commodities like grains, metals, energies and livestock

are destined to become “rarer” in the future, and the cost

to produce these commodities is sure to escalate. This in

turn should ensure these commodities will continue to of-

fer investment opportunities for at least another decade.

The case for commodities continues to burn brightly, as

evidenced by the growing volume of trade since the sub-

prime crisis despite disappointing recoveries in mature

economies. The total volume of commodities traded

bottomed out quickly in 2009, the depths of the financial

crisis, and then posted impressive gains in 2010 and 2011.

In contrast, the total volume of stocks traded on the NYSE

continued to fall in 2010 and 2011. Total money under

management in commodities saw only a minor decline

in 2008 (the first time since 2000), and from 2008 to

September 2012, it posted a very impressive 63% gain!

Energy – A Leading Indicator of Commodity DemandIn the wake of the sub-prime crisis and then again in 2011,

the commodity markets were besieged with predictions

that the Commodity Super-Cycle was coming to an end.

Some analysts even predicted that many commodities

were poised for a multi-decade decline, as the damage

to the world economy in 2008-2009 had brought forth

a peak in demand. The commodity bears were further

emboldened in 2011 when four additional, epic-type

disasters, the Fukushima earthquake and tsunami, the

threat of Greece defaulting, the U.S. debt debacle and

talk of a Euro zone failure, weighed on the world econo-

my. However, global energy demand, which we view as a

leading indicator for overall world commodity demand,

Money Under Management In Managed Futures

337.

133

4.7

328.

331

4.3

0255075

100125150175200225250275300325350375

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 0910

Q411

Q111

Q211

Q311

Q412

Q112

Q212

Q3

Bill

ion

USD

Source: barclayhedge.com


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continued to grow year on year through the sub-prime

crisis and has moved beyond several previous “peak”

demand plateaus. Instead of looking for energy demand to

top out, the U.S. Energy Information Agency is forecast-

ing it to grow an average of 1.6% per year out to 2035.

The Importance of Price Discovery It takes a long time to shift entrenched commodity

production practices. Those who stand against specula-

tion in commodities think that long-term shortages can

be recognized without signals from the marketplace,

but what really boosts production or curtails demand

better than higher prices? The notion that the world

would eventually have to diversify away from petro-

leum-based energy would have gotten nowhere without

the periodic energy flare ups in energy prices over the

past 40 years. And while speculation can accentuate

price movements, global oil production wouldn’t have

responded as quickly and as convincingly without the

market providing an incentive. Without lofty oil prices

there would have been no incentive to develop Ca-

nadian tar sands, and the U.S. wouldn’t be seeing its

domestic oil production expand rapidly as it has from

the Bakken formation in North Dakota and Montana.

In the grain markets, the speculative reaction to

the 2012 drought may have accentuated the rise in

grain prices, but without that early warning signal

from the futures markets, the ethanol and livestock

sectors might have burned through enough corn to

result in a multi-year supply shortage. The sharp es-

calation of grain prices prompted an expansion of

global grain planting area that was absolutely neces-

sary to make up for the lost production in the U.S.

Another example is the natural gas market. Stubbornly

high natural gas prices during in the late 1990s ushered

in an expansion in production. This eventually resulted

in an excess supply. Subsequent speculation has driven

natural gas prices down sharply, especially compared

World Total Primary Energy Consumption (Quadrillion Btu)

300

350

400

450

500

550

600

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15Sources: EIA Internation Energy Statistics and International Energy Outlook 2011 (2012-2015 are Forecasts)

Quarterly US Crude Oil Production vs. WTI Crude Price

4.5

4.8

5.1

5.4

5.7

6.0

6.3

6.6

6.9

7.2

7.5

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Prod

uctio

n - M

illio

n B

arre

ls /

Day

0

14

28

42

56

70

84

98

112

126

140

USD

/ Barrel

US Production WTI PriceSource: EIA Short-Term Energy Outlook 2012Q3 -2013Q4 are Forecasts


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to other energy sources, and that in turn has hastened

a the switch away from petroleum-based feed stocks

to natural gas. Without the distinct price advantage, it

would probably have taken decades for natural gas to

become as important as it has for electricity generation.

Given the size of the investment required to shift glob-

al energy sources, it would be folly to assume that

some other mechanism, such as one supported by

taxpayer money, could have achieved that transition.

The U.S. government has already wasted billions in

its attempt to speed up the transition to solar energy

with little to show for it. Full-scale implementation of

solar and other alternatives will probably only come

from higher energy prices and the potential for signif-

icant profits for those developing the technology.

Government Involvement in Commodity SupplyAnother artifact of the sharp escalation in commodity

prices between 2005 and 2008 was that many countries

began to build or expand strategic reserves. Initially,

strategic reserves were limited to petroleum and gold, but

countries like China, India and Russia have long main-

tained grain reserves as well. With its breakneck growth,

China seems to have taken domestic stock-building to

new heights. While individual governments (the U.S.

included) see strategic reserves as a way to blunt short-

ages and avert rapid increased in prices, a global push to

stockpile could lead to the need for even larger global

production as more output is set aside for future use.

In reality, historically high commodity prices and the

2012 drought have prompted many nations to move

beyond mere stockpiling and search for even more cre-

ative ways to commandeer foreign commodity supply:

• Saudi Arabia, Egypt, Kuwait and South

Korea have leased lands in sub-Saharan

Africa for growing crops. Russia has leased

land in Ukraine for the same purposes.

• For some time China has been looking to Africa

for mineral resources, but more recently it

has been making significant investments in

agricultural production there and elsewhere.

• Australia approved a Chinese company’s bid

for a giant cotton farm this past August.

• Ukraine agreed to a 3 billion dollar credit loan

from China in order to purchase inputs to boost

production to supply China with corn.

• Chinese investors are making headway on a 1,215

mile railroad investment for moving soybeans

grown in Mato Grosso, Brazil to port. This is the first

proposed project for that area in the last 100 years.

Government involvement in commodities has at times cre-

ated a wave of buying that has easily dwarfed the activi-

ties of largest funds and commercial traders. Speculator

buying and selling can accentuate volatility and move the

market, but without open and actively traded futures mar-

kets, there would be nothing to countervail the govern-

ment buying. As they currently stand, active, deep and liq-

uid futures markets are a formidable countervailing force

to large governments, large funds and large producers.

As with most situations in a capitalist market structure,


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multiple buyers and multiple sellers are always preferred

over backroom deals and under the table transactions.

IV. Ever-Increasing Relevance of Commodity Futures to Global Trade

Commodity futures have become increasingly important

to the global economy as their role in helping companies

reduce their risk from price volatility has grown. Futures

and options are used by corporations to offset price risk

for commodities. This leaves them in a better position to

concentrate on their core businesses and is much more ef-

fective than relying upon luck to manage their input costs.

Producers and end users of commodities are more in-

volved than ever transferring risk to those who want to

accept it. Open interest in options has expanded dramat-

ically in the last decade. The use of these instruments as

price insurance has been widely accepted as an essential

for doing business for both producers and end users.

New Exchanges Mean More OpportunityExchanges have been popping up around the world as fu-

tures and options have grown more popular and produc-

ers and end users have become more sophisticated. Black

Sea Wheat, Malaysia Palm Oil and Australia Wool are all

examples of local markets that have benefited from the

availability of futures trading. Local producers and global

consumers can use these markets to hedge their price risk.

Exchange Volume TrendWhile total futures and option global volume may be

down for 2012, the trend over the past five years has

been very strong. The exchanges with some of the stron-

gest growth include the Multi Commodity Exchange of

India, Dalian Commodity exchange in China, the Shanghai

Commodity Exchange and the Singapore Exchange. In

the first half of 2012 the CME Group was still the vol-

ume leader with 1.55 trillion contracts traded, but there

were four other exchanges with volume greater an 1

trillion contracts during that time frame and 17 exchang-

es around the globe with volume over 100 million.

RegulationsThe events of the last several years have clearly put the

futures industry on a fast track toward even more intense

regulation, but the most significant development is the

push toward insuring customer segmented funds. The

China Soybean - Net Imports / Exports

-10-505

10152025303540455055606570

86 88 90 92 94 96 98 00 02 04 06 08 10 12Crop Year Beginning

Mill

ion

Met

ric T

onne

s (M

MT)

Most Recent: 62.75 As Of 12/11/2012 Source: USDA

Net Imports

Net Exports


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industry is considering the implementation of something

similar to SIPC, the Securities Investors Protection Cor-

poration. While fraud issues are tough to detect, removing

the “customer funds” financial risk through the use of

insurance would go a long way towards restoring confi-

dence in the futures industry. Indeed, the combination

of intense regulatory scrutiny and this type of financial

backstop should finally bring commodities to an invest-

ment class standing. Tighter regulations should benefit

the industry in the long run, especially since swap activity

will now be monitored more effectively in the wake of

swap trades becoming part of organized exchanges. This

in turn means that those instruments will be regulated

to the same extent as futures and options. With recent

news that the Intercontinental Commodity Exchange

was poised to purchase NYSE/EuroNext, it would appear

that commodity markets are poised to take on a more

dominant role than equities in the years ahead. Some

economists think that the net result of the sub-prime

crisis is an ongoing rotation from financial assets into

physical assets, especially when one considers the linger-

ing negative influence from record global debt levels.

ConclusionCommodities have only just begun to receive the respect

they have been denied over the last 50 years. In the past

some parties have suggested that commodities shouldn’t

be an asset class because they were too critical to the

global economy and they thought allowing investment

and trade in commodities would result in inflated prices.

In reality, commodity prices need to be free adjust rapidly

in order to register concern about upcoming supply, to

foster expanded production capacity through technology,

and perhaps most importantly, to increase the world’s

conservation of its somewhat dear natural resources.

With rapid rise in the standards of living in China, South-

east Asia, India, the Middle East and Africa all a long

way from running their ultimate course, interest and

trade in commodities looks to be an entrenched trend.

Surging interest in commodities by investors and gov-

ernments, increased volatility from weather issues and

the ongoing expansion of global commodity production

areas (beyond ideal production zones) probably means

that the battle between supply and demand will at times

burn white hot with severe shortages, ultimately giving

way to temporary overabundance. In the end, one of the

most positive results of the sub-prime crisis might be that

the pause in global growth allowed for a minor catch up in

supply for some commodities and that in turn could delay

what we think will be an inevitable inflationary end game.

Change is positive and necessary, especially when one

considers that commodities are a critical component

of the global economy. A recent Bloomberg survey

Vegetable Oil - Major Consumers

30.584

17.994

13.067

0

3

6

9

12

15

18

21

24

27

30

33

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12Crop Year Beginning

Mill

ion

Met

ric T

onne

s (M

MT)

China India United StatesMost Recent: As Of 12/11/2012Source: USDA


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put global investor sentiment at its highest level in 18

months. That combined with the slow but sure progress

in handling the travails in the Euro zone suggests that

smoother economic waters lie ahead. In addition, Chi-

na’s economic outlook is beginning to improve having

successfully navigated a transfer of national power, but

more importantly having halted a tight monetary stance

that had been place for almost 15 months. Therefore the

world’s biggest physical commodity consumer should

be expected to see a recovery in commodity demand.

In the end, improving economic confidence, historically

high global money supplies and no way out but forward

from global debt loads could mean most central bankers

will be forced to keep their foot on the gas in 2013. If

so, commodity consumption trends, especially with the

growth in China, India and Southeast Asia, should mean

a continuation of the longer-term uptrend in commodity

trading volumes and even higher commodity prices.

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Long Live the Commodity Super Cycle - Daniels Trading

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