The Malthusian bull market carries on

IN 1980, two academics, Julian Simon and Paul Ehrlich, agreed a now famous wager. Ehrlich chose five commodity metals and bet that over the next 10 years, they would get more expensive. Ultimately, Simon won, and all five metals – copper, chromium, nickel, tin and tungsten – got progressively less expensive all the way up to 2002.

For much of the last nine years however, that trend has gone in reverse, in a pattern known as the commodity super-cycle. A barrel of oil, which went for $20 in 2002, now costs $100. Copper recently passed through the $10,000 a tonne level. Even food prices are rocketing, creating uncomfortable conditions for third world dictatorships.

What has hurt dictators (and their subjects) has, however, benefitted some canny speculators. Over recent years, exchange traded commodities (ETC) have offered an easy way to place a long-run bet on rising commodity prices. But should investors want to? Commodity prices may seem to be going up relentlessly, pushed up by unquenchable Chinese and Indian demand, but as Simon’s and Ehrlich’s bet showed, they are not guaranteed to climb – the price of stuff quite often falls.

As analysts from Barclays Capital observe, the question is essentially a Malthusian one. Thomas Malthus, writing at the end of the 18th century, argued that the demands of humanity’s endlessly growing population would eventually outstrip the available natural resources. The population would then inevitably be checked by “Malthusian crises”, where the natural resources available run out.

Quite clearly, based on history, Malthus was wrong. Despite growing from less than 1bn in 1800 to nearly 7bn now, the human population is better fed, housed and clothed than ever.

But according to the Barclays analysts, he was not completely wrong. Instead, they argue, we are currently entering a tightening period for commodities. While there is still supply growth, the sheer pace of demand growth in China and India is likely to outpace it, pushing up prices for much of the foreseeable future. As they put it, “The very fast rate of growth in some large emerging markets would then support the Malthusian prediction across a broad spectrum of commodities.” Investors would seem wise then to buy up commodities.

But nothing is assured. As Dylan Grice of Societe Generale points out, the expected long run real return of commodities is nothing – and all commodity bull runs eventually come to an end. As Grice puts it: “When you buy commodities, you’re selling human ingenuity.” He says that while informed speculators might be able to make money from fluctuations, even over several years, over a long enough period, even the most conservative investments will still outperform commodities – as the chart below demonstrates.

According to Grice: “Prior commodity bull markets have been much like England football managers: they promised much, burned brightly for a while, but ultimately crashed, breaking the hearts of those who believed in them most.” He recommends that commodity bulls buy shares in the companies that produce them, rather than the products themselves, since then they will also benefit from improvements in technology and labour productivity, as well as from rising demand.

Because what long-run ETC investors are ultimately betting on is the long trend of history reversing now. That is not an uncommon view these days, but as Ehrlich discovered in the 1980s, it can be a dangerous bet to make.