By WallStreetDaily.com

By Shelley Goldberg, Senior Correspondent

The recent decline in commodity prices resembles a downhill mountain biking expedition.

The price drop has been so severe that we’ve seen a nearly one-sided market, with buyers largely absent in futures, commodity indices, and exchange-traded funds (ETFs). As a result, many commodity hedge funds have closed and are returning capital, despite their ability to trade short.

Indeed, we knew it was getting serious when the phrase “market correction” was slowly replaced by the word “carnage.”

Yet, if you believe in the commodity super cycle – defined as the decades-long price movements in a wide range of commodities – then this shouldn’t have been entirely surprising.

In fact, you likely expected it, albeit not so soon.

Commodity super cycles have been building and unwinding since the late 1800s, according to the collected data on commodity prices. But why do these cycles occur? Are they some sort of trading pattern embedded in the human psyche, or is it purely coincidence?

It’s neither, actually. You see, they’re supported by structural reasoning and economic logic.

The commodities cycle exists because it takes time – roughly 15 to 20 years – to construct, say, an aluminum smelter, and get it up and running. Or to dig and develop a copper or gold mine and extract, refine, and market the ore.

And for their part, offshore rigs require years of exploration before any drilling actually occurs. Even then, drilling typically takes place once prices have begun to rally, which incentivizes producers to increase output.

The latest super cycle was interrupted during the financial crisis but continued its upward trajectory soon afterward. In fact, the Commodity Price Index of the International Monetary Fund rose 400% from 2000 to 2008 until the crisis.

And when the crisis came to an end, it was the commodity sector that was the first to recover from its depressed state, long before the equity and fixed income markets took off.

Back to Basics: Supply and Demand

On the demand side, the voracious appetite of the Chinese fueled this most recent commodity super cycle.

The country’s growing economy placed it at the head of the international economic powers, and China quickly became the No. 1 global commodity consumer. It purchased about 40% of all natural resources, and its imports of fuel, minerals, and grains multiplied 16 times over since 2000.

Furthermore, the growing middle class in emerging markets drove increased demand for homes, food, and cars – all in a market with insufficient supply.

At the same time, U.S. economic stimulus packages weakened the U.S. dollar relative to other global currencies, which was an added bonus that made commodity imports affordable for other nations.

On the supply side, constraints throughout the commodity complex pressured prices upwards.

The global supply of natural resources was hamstrung by a variety of factors, including drought in the major grain-growing regions, turmoil in the oil-producing regions, and rising labor and operational costs at mining facilities.

Meanwhile, low interest rates, particularly in the United States, created a search for yield outside of traditional markets. Investor demand for hard assets and alternative investments increased substantially.

Finally, high commodity prices exacerbated the fear of even greater price increases down the road. This caused both the industry and governments to hoard their inventories.

China, for example, filled its warehouses with copper and iron ore. Crude oil tankers populated the seas with no immediate destination or port to go to, and Middle Eastern governments hoarded grains to placate the uprisings that resulted from higher wheat prices.

Finally, international banks were buying and storing aluminum, as their transactions were nearly risk-free while the metal’s yield curve was in contango.

This Too Shall End

But today, the cycle has reached its end.

China is attempting to transition from an export-and-investment-led economy to a consumption-led growth economy – which isn’t necessarily a bad thing, as this is what drove the U.S. economy during the baby boomer to yuppie days.

However, the transition may have painful repercussions.

Furthermore, OPEC has shot itself in the foot by maintaining output levels and putting the onus on U.S. producers. The move forced prices lower as inventory numbers climbed like a Mount Everest hiker with a relentless goal. On top of that, demand growth has slowed as the world has become more efficient in its use of oil.

Lastly, the move lower has been exacerbated by fears of a U.S. interest rate hike, the strengthening U.S. dollar, and the drawing down of developed market stimulus packages.

Low Commodity Prices Can Be a Good Thing

Over the last few weeks, traders and investors alike have been crying in their beers as doomsday headlines have dominated the media.

Equities across all sectors are falling dramatically while volatility rises, as evidenced by the Dow Jones Industrial Average’s 1000-point trading range last Monday.

Meanwhile, the contagion effect has led to the belief that China – along with other emerging markets, such as Kazakhstan, Greece, and Turkey – will bring down the sector, which has already seen yield spreads widen dramatically.

Then there’s the renewable energy industry, which can only shrug its shoulders when crude is at $40, and greener pastures – windmills, electric cars, and recycling – are no longer a priority.

Still, low commodity prices can be a good thing for the world’s economies, particularly those that are dependent on commodity imports.  Low prices spur growth, reduce inflation, and increase investment in and spending toward other goods and services.

But the question remains: What does it all mean for commodity markets going forward?

Once it becomes evident that producers have been forced out and inventory levels show signs of declines, we’ll likely see markets find stability a bit north of current prices.

You see, even though the world has become more efficient in both its production and consumption of global resources, the population continues to grow. And there’s no sign of it slowing down, either.

Thus, while the opportunities for employment in the commodity space are falling, they’ll likely become the hottest jobs from Houston to Wall Street to Geneva again further down the road.

Good investing,

Shelley Goldberg

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