Why commodities will remain strong

The long-term fundamentals driving commodities demand – and by extension oil and gas and mining shares – remain undiminished, despite the many and serious threats to performance over the near term. Volatility will remain a key theme in commodities over the next few months and with robust demand having failed to prevent substantial sell-offs in oil and gas and mining shares, there will be plentiful opportunities to profit for investors who can accept higher levels of risk.

Demand for commodities is primarily driven by developing world urbanisation. While commodity prices will invariably cycle, often violently, urbanisation is a fundamental ‘big picture‘ story that will almost certainly persist for generations.

The current wave of urbanisation is even greater than the industrial revolution of the 19th and 20th centuries, with technological advances accelerating the process for countries developing today. The good news for commodities, and by extension oil and gas and mining companies, is that urbanisation is hugely energy intensive and requires vast amounts of materials.

Urbanisation is expected to spread throughout much of Asia, South America and eventually Africa over the coming decades, but is currently focused heavily on China. Yet, data from the World Bank shows that despite its rapid development over recent decades, China has currently only reached the stage of urbanisation achieved by Japan in the 1950s and western Europe around 1910. With the Chinese culture very aspirational, the clear implication is that urbanisation of China alone could last for several more decades.

However, China’s dominance of current urbanisation creates one of the main short-term dangers to commodities. With India, the next country in the urbanisation queue, still a decade or more behind, China is currently almost single-handedly propping up commodities consumption.

Yet, fears are mounting that the Chinese economy, although still exhibiting enviable growth, might be slowing down. Current estimates are that a ‘soft landing’ would take growth in gross domestic product down to 8 per cent, although current expansion is below that.

As Charles Gibson, head of mining at Edison Investment Research, explains, China is one of the biggest consumers of commodities (along with Japan, the US and Germany). Critically, the more basic the commodity, the more China dominates demand. “If Chinese demand were to go away, it would leave a pretty big hole,” warns Mr Gibson.

Fears have also been growing that China could be facing a property bubble that would slam the economic brakes on even harder. However, it remains to be seen to what extent any problem might spread beyond high-end property in major cities such as Beijing and Shanghai to the social housing developments that underpin the bulk of Chinese construction.

China crisis

Is a collapse of Chinese commodities consumption a significant risk? Mr Gibson believes not, although he doesn’t discount the possibility altogether. He argues that as a major exporter, China has greater scope, if necessary, to stimulate higher economic activity provided nothing happens that would trigger a major flow of money out of the country. Indeed, China’s recent cut in its banks’ reserve requirement ratio (which makes it easier for them to lend) demonstrates that the government is taking positive steps to stimulate the economy as it did in 2009.

Assuming, therefore, no collapse of Chinese demand before other countries join it in major urbanisation, or there is a recovery in demand from developed economies, most importantly the US, the price pressure on commodities is more likely to be upward than downward.

At the same time, however, the ability of miners and oil companies to meet this demand is far from certain. Mines and oilfields are depleting and diminishing in grade. Explorers increasingly have to turn to more remote, politically riskier locations where resources are often harder and more expensive to extract. As the oil industry mantra states: “The easy oil has been found.” And this extends way beyond just oil to most commodities, which bodes well for oil and gas and mining companies around the globe.

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