The supercycle: Sprott weighs in

Last week, proponents of the commoditysupercycle shared their views. This week, we’ll hear from a supercycle believer, Eric Sprott, and a skeptic, Jeffrey Christian.

Eric Sprott, CEO of Sprott Inc. (SII-T), and chairman of Sprott Resource Corp. (SCP-T, SCPZF-O) and Sprott Molybdenum Participation Corp. (MLY-T, SMPCF-O), is firmlyon the bullish side of the commodity market. While he is upbeat on the entire commodity spectrum, he says that different factors are at work for different commodities. Sprott divides the commodity universe into three groups: precious metals, energy, and base metals/agricultural commodities.

For precious metals, the driving force is the money-printing that governments engage in. This erodes the purchasing power of paper money, so investors flock to hard assets, particularly precious metals, in order to protect themselves. Sprott believes that the erosion in the value of paper money will persist, so precious metals will continue to appreciate.

Turning to the second group of commodities, energy, Sprott says that the factor at work here is the peak oil theory, which states that the world is, or will soon be at, the point of maximum oil production.

“We ascribe the whole energy complex going up to our belief in the peak oil thesis — that, for sure in conventional production, we probably peaked in 2005,” Sprott says. “And peak oil says that once we’ve peaked, oil production goes down forever. And if it goes down forever, then anything connected to energy will do better, whether it’s coal, uranium, natural gas or alternative energy.”

Furthermore, Sprott believes that precious metals and energy may perform well even in a serious economic slump.

As for the third group of commodities, which includes base metals and agricultural commodities such as grains, Sprott says that there is just not enough supply to satisfy the demand from a large and growing world population. The supply of many of these basic commodities is tight, and even though demand growth in the developed G-7 countries is sluggish or stagnant, commodity demand in the developing world continues to grow. Sprott says that demand may already exceed supply for a number of basic commodities, and the shortfall is made up from a drawdown of inventories. Once inventories are exhausted, shortages will develop. (Backing up this view, a recent issue of Mining Engineering magazine quotes UBS Securities as projecting deficits in the copper market this year of 100,000 tonnes and a similar amount in 2009.)

Even if the developed economies were to experience a recession and an economic contraction, Sprott believes that these countries are now mostly decoupled from developing economies, so a recession should not spill over into the developing world. Therefore, commodity demand should not be affected significantly by a possible economic contraction.

A further problem causing tight supply, and therefore high commodity prices, is what Sprott calls “logistics.” Here, he refers to the various problems occurring in mining or agricultural districts all over the world that interfere with steady production: floods in one country, for example, insufficient rain in another, restrictions on availability of electricity elsewhere, and a host of other similar problems.

“Little logistical issues can cause the price to spike, because supply and demand are in such a fine balance,” Sprott says.

Another constraint on supply is the difficulty in bringing new mines into production. Sprott says that manyprojects experiencedelays be- cause of rapidly escalating costs, which make the projects difficult to finance.

Not all market commentators share Sprott’s upbeat stance on the supercycle — including Jeffrey Christian, managing director of the CPM Group in New York City and author of the book Commodities Rising: the reality behind the hype and how to really profit in the commodities market. One chapter in Christian’s book, “The myths of the commodity supercycle and the Chinese consumer giant,” says it all: Christian does not buy into the supercycle theory.

Christian, who uses classical economics to explain what is happening in commodity markets, is firmly opposed to the view that commodities are about to enter a supercycle that will last for many years. He adds that the history books are devoid of any references to long-lasting upward moves in commodities.

In an interview, Christian acknowledges that China and other Asian countries will consume all kinds of commodities as their populations move toward a Western middle-class standard of living. He maintains that classical economics explains the present behaviour of commodity markets as a result of an upward shift in fabrication demand, an upward shift in investment demand, and a lagged response on the supply side. He points out that while fabrication demand decreases when price goes up, investment demand responds inversely, so it increases when price goes up. Although investment demand increases volatility, Christian acknowledges that it also leads to sustained price rises.

Christian identifies a number of secular factors that have led to commodity markets behaving the way they do. He agrees that the upward shift in fabrication demand is a secular factor. He also says that business cycles seem to have become longer, with fewer recessions, and these recessions are shorter and shallower that those experienced in the past.

There are a number of trends that may have contributed to these changes, for example globalization, deregulation, automation and com- puterization. These are all secular trends, so their influence on markets is secular as well.

Christian says that the commodity bear market lasted for 20 years, from 1981 to 2001, during which time exploration activity dwindled, and few new mines were brought into production.

This helps explain the slow pace of supply side response to commoditydemand during the bull market, which has lasted seven years so far. He maintains that as production from new mines is brought on-line, prices will come down, although not to the levels that were in force before the bull move.

As an example of supply side response, Christian puts forward the situation in China. The country has increased gold production, and it is now the world’s largest producer of the yellow metal. Similarly, it is moving to increase silver, copper and aluminum production. China will continue to increase production of raw materials and intensify exploration activity and discover more mineral deposits. Christian believes that there are substantial opportunities to explore and discover mineral deposits in other parts of the world as well.

Christian does acknowledge that there are some constraints on supply, but he firmly believes that these are not geological, and stem mostly from politics, time lags and prices.

Part 1 of the Commodity Supercycle was published last week. Next week, we hear from more supercycle skeptics in Part 3.