The commodity supercycle: myth or reality? Part 9

Eric Sprott is firmly in the bullish camp. Sprott is CEO of Sprott Inc. (SII-T), chairman of Sprott Resource Corp. (SCP-T), and chairman of Sprott Molybdenum Participation Corp. (MLY-T). Although he is bullish on the entire commodity spectrum, he says that different factors are at work for different commodities. Sprott divides the commodity universe to three groups: precious metals; energy; base metals / agriculturals.

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. Once the peak is reached, oil production will be on a steady decline. This implies that energy will appreciate, which is bullish for most energy commodities: oil, natural gas, coal, uranium and some forms of 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 of these commodities available to satisfy all 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 G7 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.

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 very much 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, which interfere with steady production. For example, floods in one country, insufficient rain in another country, and a host of other similar problems. The resulting disruptions keep supply of many commodities tight.

One last constraint on supply is the difficulty in bringing on production from new projects. Most projects experience delays because of rapidly escalating costs, which make the projects difficult to finance.

Opinions on the commodity supercycle range across the entire spectrum, from the bullish to the cautious. The bullish camp believes that “this time it’s really different”. The cautious camp is not quite as enthusiastic. Both sides raise valid points. It also helps to remember that in previous bull markets, investors who piled into commodities or commodity-related stocks during the latter part of a cyclical bull usually ended up in tears.

Last part in the series.