Uptick, downturn, or a plateau?
We may not yet have hit the bottom, but investors and companies seem to believe the worst of the cycle has largely passed
Where are we exactly in the current commodity cycle? At the bottom, as some think? Or will a whole lot more value be lost in the next few months?
Major commodity cycles tend to happen every 25 years or so. The patterns are the same: commodity prices move up strongly, driven by a structural shift in the demand curve and a protracted lag in the supply response. They can be a long time coming and a long time going, especially within the context of institutional memory among investors.
The problem for investors is that the signals of these peaks and troughs are not immediately obvious. So patience is a virtue.
While the market tends to focus on supply and demand, and the resulting surplus or deficit, it is invariably the slowing rate of demand growth and rising rate of supply growth that accompanies the peak in a cycle. And that can be difficult to anticipate.
Of course, supply signals can point to the bottom of the cycle, but you won’t find a genuine commodity cycle unless you have an improving demand trend.
It’s tricky, of course, to identify the peak of the cycle.
Ironically, however, this challenge enhances the magnitude of the cycle: after all, if the signs were clear to all, the market would be able to pre-empt the turns and dampen the cycle’s size.
Changes in inventories are also often the key to amplifying the cycle, as panicked buyers (and momentum investors) build up stock when the supply is weak, which amplifies the rising price. Conversely, in the downturn, just-in-time buyers sell their stock during periods when there’s a surplus at the same time as investors liquidate their positions (because of an expected drop in returns). So where are we now in this cycle?
To some extent, the 2008 financial crisis blurred the playing out of the current cycle, but speaking simplistically, many commodity prices peaked in US dollar terms in 2011 (copper, gold, coal, iron ore). Using another measure, companies’ capital expenditure peaked in 2012 and 2013, as committed projects continued to be completed beyond the top of the price cycle.
Even today, supplies for some commodities continue to rise, as those companies focus on maximising supply and cutting costs to optimise economies of scale. The result is a flattening off, or even a drop, in these companies’ cost curves — which only adds to the price weakness.
But any way you look at it, we are less than five years away from the previous peak — so calling the bottom of the cycle now feels premature. This is especially so given the heights commodity prices reached, as well as the extent of new capital spending in the sector. However, even though we may not yet have hit the bottom, investors and companies seem to believe that the worst of the cycle has largely passed.
There’s certainly more than a fair share of denial around. Some executives, for example, believe the price downturn will be short lived. Others are keeping their dividend distributions relatively high, and still seem tied to a progressive dividend policy. So, too, when it comes to debt: while debt levels are high, the cash flow to pay down the debt is falling.
We believe that more signs are needed before we call the bottom of the cycle — including, simply, more time.
At my company, Prudential, we’re continuing to build our resource exposure around the defensive, low operating-cost companies with relatively low levels of gearing. At the same time, tactically, we’re looking to take advantage of lower-quality laggards, based on their attractive valuation and the potential that share price movements can actually pre-empt visible signs of a turn in the cycle.
Since we do not know whether we’ve hit the bottom already, it’s the most pragmatic, conservative approach to a sector that has been rocked by a plethora of bad news in recent months.
Any way you look at it, we are less than five years away from the previous peak — so calling the bottom of the cycle now feels premature