Herbert Stein, who was President Richard Nixon’s chairman of the Counsel of Economic Advisors, is often quoted as saying, “If something cannot go on forever, it will stop.” This statement, known as “Stein’s Law,” has the right ring of profundity about it, a mixture of tautology and empirically verifiable generalization.
It’s a bit like the Objectivist profundity, “existence exists.” One wants to rub one’s chin and say, “Indeed.”
A new paper, from CoreCommodity Management LLC, explores the implications of Stein’s law in the field of commodities, where in recent years production cost has steadily increased, but price has not kept pace. That is a situation that cannot be sustained forever, because in the words of the authors of the paper, Bob Hyman and Bob Greer, put the point: “commodity producers will not continue to produce if prices are below their costs of production.”
Prices, Profits, Equilibria
The paper is a reminder of truths familiar to those who have made their way through, for example, Paul Samuelson’s classic economics textbook in an undergraduate course. On the one hand the cure for high prices is … high prices (because their height draws in new competitors, which creates competitive pressure bringing the prices down.) On the other hand the cure for low prices is … low prices (because their basement-dwelling quality drives out business that cannot or do not chose to sustain the red ink, and that allows the smaller number of remaining producers to raise prices).
The CoreCommodity paper, then, has the straightforward title “Rising Production Costs Lead to Higher Commodity Prices.”
Investments in the capital necessary to extract oil and natural gas from the ground make for a stark example of this equilibrium-seeking dynamic. Since 1950 the level of capex has risen as oil and natgas prices have rises, fallen when prices have fallen, almost in lockstep, though with somewhat more volatility on the capex side of the equation.
Commodity Investment Returns
Bob Hyman is portfolio manager at CoreCommodity. Bob Greer is senior advisor there. Greer is also scholar in residence at the JPMorgan Center for Commodities at the Denver School of Business, University of Colorado.
Hyman and Greer concede that commodities investing has had an impressive performance over the last two years. But that is a brief window. Measured since 2002, returns from passive long-only futures have been anemic, just 1.2% per year.
This point leads the authors into a broader discussion of the difference between commodity prices and commodity investment returns. Taking a long position on a commodity price and holding it for an extended period of time has costs that doing the same with shares of, for example, a company’s equity does not entail. Given contango there is a negative roll yield associated with the roll-over of futures contracts.
Costs Will Continue to Press
The cost increases pressing upon many commodities producing industries are likely to continue. The authors provide several reasons to believe this:
- Energy is a significant production element for other commodities (for example, fuels drive the machinery used in mining metals, industrial or precious), and the price of energy is likely to increase over time;
- The boom in oil production from North American shale is slowing, which will alleviate the downward pressure that new shale oil and gas production has had on energy prices;
- Extractive industries generally develop the easiest reserves first, so costs naturally rise as the industries have to work harder to get to deeper or more remote or more technologically challenging reserves;
- The human population is growing, underdeveloped nations are developing industrial bases, and in general the demand for commodities of all types can be expected to increase near and medium term;
- World oil demand in particular is about to surpass 100 million barrels per day;
- Central bankers have to pull back on the easy money they created post-GFC. This means higher interest rates, and greater difficulty attracting or borrowing money except with the promise of returns that only increasing prices can render plausible.
Nonetheless, the authors observe, there remains a popular conception that improvements in technology have driven costs in these industries down. That is a myth.
The authors include a footnote cautioning that “all expressions of opinion are subject to change without notice in reaction to shifting market conditions.”