Understanding commodity super-cycles – by Van’t Veld (Troy Media – May 15, 2012)

http://www.troymedia.com/

Will Van’t Veld is an economist with ATB Financial.

Why they start and why they end

EDMONTON, AB, May. 15, 2012/ Troy Media/ – Canada’s political and business leaders obviously think we’re at the front-end of a commodity super-cycle and they’re trying to put in place policies and infrastructure so that Canada can take full advantage. But what exactly is a commodity super-cycle?

Capitalism is incredibly efficient at producing wealth, but unfortunately society hasn’t figured out how to keep every expansion phase from ending in an unpleasant contraction phase. This is the business cycle and there may be multiple business cycles that occur within each commodity super-cycle.

How does a super-cycle begin . . . and end? A commodity super-cycle occurs over multiple decades during which the rise in commodity prices is observed across the board, before declining for a long period. This is the definition given by economists Bilge Erten and Jose Ocampo, who wrote an interesting working paper on the topic for the United Nations Department of Economic and Social Affairs entitled, Super-cycles of commodity prices since the mid-19th century.

Of interest here is what gets the commodity super-cycle going and why it ends. According to Erten and Ocampo, it’s a rapid shock to demand that starts the cycle. This shock is often associated with a major technological innovation, such as the industrial revolution, or the rapid industrialization and urbanization of a major nation (or nations).

What causes the eventual demise of the commodity prices? A plausible rationale, formulated by Joseph Schumpeter back in 1939, is that eventually the induced demand for raw materials will decline as eventually any ascending industry will attract competition, decrease profits and reduce derived demand for commodities. New efficiencies and technology then tends to dominate, depressing commodity prices.

Another, more recent, interpretation as to why commodities hit an inflection point and begin declining comes from Alan Heap, former head of commodity research at Citibank. Back in 2005, Heap presented a now famous paper to the Mineral Economics and Management Society in which he succinctly made his case as to why he believed China’s rise had induced such a significant change to commodity markets.

The commodity price driver is the shock in demand for commodities – and the reason the price is expected to remain elevated for decade long periods is because production can only be increased at higher costs (even with improving technology). Heap doesn’t see the cycle coming to an end until the developing economies driving the demand growth become more service sector oriented – reducing the commodity intensity of their economies.

Using statistical techniques, Erten and Ocampo attempted to measure and analyze the commodity super-cycles that have occurred since the end of the 1800s. The authors split their analysis up by commodity type and found there were roughly four super-cycles over the period, with the length and timing of each cycle depending on the commodity analyzed.

The first cycle corresponding with the rapid industrialization of the United States, the second with the rebuilding Europe, the third with Japan’s rapid expansion and the current super-cycle that began with the emergence of China.

Usually last 30 to 40 years

The typical length of each cycle has been about 30 to 40 years, split between a couple decades of rising commodity prices followed by a couple decades of falling prices. For non-energy commodities, each cycle has resulted in a peak real-commodity price that is below the previous cycle’s peak. Energy commodities, and to a lesser extent metals, are different in that the cycle peaks tend to climb higher after each cycle.

It’s certainly possible the current super-cycle will last longer than historical cycles, meaning that prices may have another couple decades of growth – making it the longest expansionary period in recent memory. What shouldn’t be forgotten is that these cycles will eventually end. Canada will benefit immensely from the cycle, but it needs to prepare for life afterward.
For the original version of this column, please go to the Troy Media website: http://www.troymedia.com/2012/05/15/understanding-commodity-super-cycles/

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