Tuesday, March 01, 2005
Coffee Trees Take Time to Grow – an Essay on Commodities, China, and Jim Rogers
Most people are skeptical of efforts to predict the future, and understandably so: fortune-telling has a long and for the most part disreputable history. It is a curious paradox, then, that the same rational individuals who would cavil at paying a psychic five dollars to shuffle a pack of tarot cards are more than happy to trust their life savings to various questionable investment schemes – simply because their financial analyst tells them to. And there’s never a shortage of questionable investment schemes on offer, promoted by a variety of hucksters and conmen (aka ‘Wall Street’) who range from the merely incompetent to the actively unethical. Buyer beware!
Typically, Wall Street predictions involve the extrapolation of recent events to ludicrous extremes; more than most people, the financial industry drives while looking into the rear-view mirror. Equities outperformed bonds in the last 20 years, ergo, they will always outperform bonds. Inflation has been low of late, hence it will always remain low. The Dow goes from 5,000 to 10,000, and pundits rush to predict 36,000 or even 100,000. When it is pointed out to these pundits that economics tends to follow cycles, and that equally strong previous trends have always eventually come to an end, they say "this time it will be different".
Alas, it never is. Human psychology remains the same, in every era and every market. When prices are high, producers rush to increase their production. Meanwhile, consumers strive to reduce their consumption. As supply rises and demand drops, prices invariably head lower, and the savants who predicted a never-ending bull market are left looking silly.
Unfortunately, this does not prevent a new crop of crystal-ball gazers from grabbing the headlines with their next set of zany predictions. Moreover, the mass media ensure that it is always the most outrageous predictions that hog the spotlight; nobody wants to hear that the future will by and large resemble the past.
In all this charlatanry, it’s refreshing to hear the voice of calm reason and common sense. For me, that voice belongs to a poor kid from Alabama who became one of the greatest investors of all time – Jim Rogers.
Who is Jim Rogers? George Soros once called him "the greatest analyst ever", and he should know: in 1973, Soros and Rogers formed an investment partnership that would be the 20th century’s most successful. The Quantum Fund, as their partnership was labelled, would average a return of over 30% a year for nearly 30 years, a remarkable record by any standards. Soros would continue trading into the 90s, but Rogers, having amassed a small fortune, retired in 1980, after less than 10 years at the top table. Since then, he’s been travelling the world, teaching finance at Columbia, and writing the occasional book on investing.
I state the above, not to buttress my argument with an appeal to authority, but merely to point out that – unlike the vast majority of writers on investing – Rogers has actually put his money where his mouth is; furthermore, he’s been more successful at it than almost anybody else in the world. No armchair academic or CNBC quotesmith he.
So what, precisely, is Jim Rogers’ latest thesis? In a nutshell, it is this: we are in the early stages of a multi-year bull market in commodities.
The word ‘commodity’ is a short-hand for a variety of goods, all of which share one important property – they are physical and real. Iron ore is a commodity. Gold is a commodity. Coffee and orange juice are commodities. Oil is a commodity – the most important one of all. The raw materials that go into every industry in the world are all commodities of various kinds.
By way of contrast, stocks and bonds are not commodities – they’re financial assets. Stocks represent a share of the future income of a company; bonds represent a stream of future interest rate payments. By themselves, stock and bond certificates have no intrinsic value; their value is implicit in the future obligations they represent. Commodities, however, represent real present value in themselves.
Real estate is also not considered a commodity, because it’s not fungible; an acre of land in Wyoming is very different from an acre of land in California. Iron ore, however, is pretty much the same no matter where it comes from.
How unglamorous, I hear you say. Iron and steel, nickel and aluminium, coffee and cotton – where’s the excitement in these markets? They’re old news: the inputs into a moribund manufacturing sector that will at best be a bit player in our digital future.
Ah, but it was not always thus. Twenty-five years ago, commodities were the darling of Wall Street. A combination of double-digit inflation and persistent shortages in supply (hint: ‘OPEC embargo’) fuelled a huge speculative boom in the market for real assets. Where today’s analysts wait with bated breath for the non-farm payrolls report, for company earnings numbers, and for the wisdom of Alan Greenspan, their predecessors in the 70s used to wait with equally bated breath for OPEC production quotas, for Florida crop growers’ reports, and for the utterances of Saudi oil ministers. Commodity traders became celebrities. Egged on by the media, teachers and truckdrivers alike quit their day jobs to punt on pork belly futures. In short, it was a mania.
So what happened? How and why did commodities lose their exalted position? What happened was what always happens. The investment boom turned into an investment bust. Tempted by higher prices, producers invested heavily in production infrastructure: the first oil rigs in the North Sea and in Alaska date to this period, as do the first modern ‘industrial’ farms. Meanwhile, consumers adjusted their preferences away from their old habits: gas-guzzling monstrosities from Detroit were outflanked by smaller, cheaper and above all more efficient compacts from Japan. The resultant glut in everthing from oil to orange juice caused commodity prices to fall precipitously. Speculators who had bought at the peak of the market (and there was no shortage of them) were ruined; many vowed never to buy commodities again. Meanwhile, helped by a triple delight of falling input prices, falling inflation and falling interest rates, the financial markets (ie, stocks and bonds) embarked on a spectacular 20-year bull run. The commodity markets languished in obscurity, commodity news was banished to the inside pages of the financial press, and the pork belly traders returned to teaching and driving trucks.
But the tide may be turning. Just like high prices in the 70s caused overinvestment and a glut in production, low prices in the 80s and 90s have resulted in a tremendous shortfall in supply relative to demand. The Commodity Research Bureau’s handbook for 2004 paints a sobering picture. Worldwide production of lead, for instance, has fallen every year since 2000. Global oil production (from existing fields) is forecast to hit Hubbert’s Peak before the decade is out, and no major new oil field has been discovered anywhere in the world for more than 35 years; the US has not built a new oil refinery since 1976. Hurt by low prices for agricultural products, farmers worldwide are leaving the countryside and migrating to cities in greater numbers than at any time in human history, leaving their farms fallow and unproductive. And so on.
A legitimate question at this point is, won’t market forces change the supply dynamic just like they did in the last commodities boom? Won’t high prices stimulate additional production, thus planting the seeds of their own collapse? The answer is yes, they will – but not for some time yet. The crucial point to understand here is that commodities, to a far greater extent than other asset classes, take time to bring to market. Oil fields take years if not decades to develop; OPEC cannot simply wave a magic wand and double global petroleum production instantly, no matter how high crude prices go. Similarly, a newly-planted coffee seedling has to grow for several years before it can yield the beans for your morning latté. Aluminium smelters and steel plants cannot be fabricated ovenight. So while it is true that in the long run rising commodities prices will create their own supply, in the short run there is still tremendous potential for growth in this market. In any case, commodity prices are still well below their previous bull market peak in real terms (ie, after adjusting for inflation); there’s plenty of room to grow.
Another reason to be bullish on commodities, at least for US-based investors, is the issue of valuation. Most international trade in commodities is denominated in dollars, and the greenback is a fundamentally unsound currency. The US government is running a large deficit which appears poised to grow even larger thanks to costly entitlement programs such as Medicare and Social Security, thanks to tax cuts and fiscal indiscipline, and thanks to the ongoing ‘war on terror’. The private savings picture is not much better; America’s savings rate is close to zero. The country also runs the largest trade deficit in history.
At the moment, these multiple deficits are financed by overseas money. Asian central banks buy dollars to keep their own currencies from appreciating (in classic mercantilist practice). They then invest the proceeds in US Treasury bonds, thus plugging the US fiscal deficit and keeping long-term interest rates artificially low. Low long rates help finance private debt via the channel of home equity withdrawal, thus fuelling further American consumption. Alan Greenspan, meanwhile, supports the domestic economy by flooding the system with liquidity: despite the rapid GDP growth of the last couple of years, the real Fed Funds rate remains negative.
This equilibrium will not last. Sooner or later, overseas investors will refuse to finance America’s twin deficits. Interest rates will soar, as no one will want to buy US debt. And the dollar will plummet. Needless to say, both of these developments will be very positive for commodities: real assets tend to do very well in inflationary environments.
You’ve heard about supply, and you’ve heard about valuation. Now it’s time to turn to the 800-lb gorilla in the room: China. In recent years, the Chinese economy has grown at an astonishing clip, and much of this growth has been in the manufacturing and industrial sectors. But China is a relatively resource-poor country; it needs to import most of the raw materials that feed its relentless expansion in every sector from kitchen appliances to plastic toys to cars. It’s no surprise that, with fresh supply still to come on line, much of the recent increase in global commodity prices can be correlated almost perfectly with the growth in Chinese imports. China accounted for 37% of the increase in world oil consumption between 2000 and 2004, putting it second only to the US in total consumption of energy products. And China is already the world’s number one consumer of copper, steel, iron ore and soybeans.
Would a global economic slowdown cramp China’s demand for raw materials? Not likely. China’s domestic growth will prove a sufficiently powerful engine to drive commodities prices higher on its own. The pace of urban migration in China is such that the equivalent of a Houston or a Philadelphia has to be built every month. Can you imagine the demand for coal, steel, cement, glass and asphalt that such fantastic growth would engender? And having moved into these new supercities, the Chinese middle class (estimated to be comfortably twice the size of the entire American population) will soon demand the same creature comforts that their compatriots in Hong Kong and Taiwan already enjoy. China’s per capita consumption of coffee is estimated to be less than 20 cups annually, while the Taiwanese consume close to 100 cups a year. If the Chinese middle class were to increase their coffee-drinking to comparable levels, that alone would necessitate a 10% rise in global coffee production. And as I’ve already mentioned, coffee trees take time to grow.
Postscript: Regular readers of the financial press will know that none of this is particularly ‘new’. Popular measures such as the DowJones-AIG Commodity Index have nearly doubled since the start of 2002, and the supply squeeze – China – inflation story has been receiving a fair bit of coverage of late. I make no assertions of either originality or timeliness in this essay. Jim Rogers, however, can lay claim to both: he launched a raw materials index fund in August 1998, just a few months before the DJAIG hit a multi-year low. Since inception, his has been the best performing index (fund) in the world, bar none. Likewise, he has been writing about supply shortages, incipient dollar inflation and the rising influence of China for several years, both on his website and in his books (which, if you haven’t guessed by now, I strongly recommend).
Typically, Wall Street predictions involve the extrapolation of recent events to ludicrous extremes; more than most people, the financial industry drives while looking into the rear-view mirror. Equities outperformed bonds in the last 20 years, ergo, they will always outperform bonds. Inflation has been low of late, hence it will always remain low. The Dow goes from 5,000 to 10,000, and pundits rush to predict 36,000 or even 100,000. When it is pointed out to these pundits that economics tends to follow cycles, and that equally strong previous trends have always eventually come to an end, they say "this time it will be different".
Alas, it never is. Human psychology remains the same, in every era and every market. When prices are high, producers rush to increase their production. Meanwhile, consumers strive to reduce their consumption. As supply rises and demand drops, prices invariably head lower, and the savants who predicted a never-ending bull market are left looking silly.
Unfortunately, this does not prevent a new crop of crystal-ball gazers from grabbing the headlines with their next set of zany predictions. Moreover, the mass media ensure that it is always the most outrageous predictions that hog the spotlight; nobody wants to hear that the future will by and large resemble the past.
In all this charlatanry, it’s refreshing to hear the voice of calm reason and common sense. For me, that voice belongs to a poor kid from Alabama who became one of the greatest investors of all time – Jim Rogers.
Who is Jim Rogers? George Soros once called him "the greatest analyst ever", and he should know: in 1973, Soros and Rogers formed an investment partnership that would be the 20th century’s most successful. The Quantum Fund, as their partnership was labelled, would average a return of over 30% a year for nearly 30 years, a remarkable record by any standards. Soros would continue trading into the 90s, but Rogers, having amassed a small fortune, retired in 1980, after less than 10 years at the top table. Since then, he’s been travelling the world, teaching finance at Columbia, and writing the occasional book on investing.
I state the above, not to buttress my argument with an appeal to authority, but merely to point out that – unlike the vast majority of writers on investing – Rogers has actually put his money where his mouth is; furthermore, he’s been more successful at it than almost anybody else in the world. No armchair academic or CNBC quotesmith he.
So what, precisely, is Jim Rogers’ latest thesis? In a nutshell, it is this: we are in the early stages of a multi-year bull market in commodities.
The word ‘commodity’ is a short-hand for a variety of goods, all of which share one important property – they are physical and real. Iron ore is a commodity. Gold is a commodity. Coffee and orange juice are commodities. Oil is a commodity – the most important one of all. The raw materials that go into every industry in the world are all commodities of various kinds.
By way of contrast, stocks and bonds are not commodities – they’re financial assets. Stocks represent a share of the future income of a company; bonds represent a stream of future interest rate payments. By themselves, stock and bond certificates have no intrinsic value; their value is implicit in the future obligations they represent. Commodities, however, represent real present value in themselves.
Real estate is also not considered a commodity, because it’s not fungible; an acre of land in Wyoming is very different from an acre of land in California. Iron ore, however, is pretty much the same no matter where it comes from.
How unglamorous, I hear you say. Iron and steel, nickel and aluminium, coffee and cotton – where’s the excitement in these markets? They’re old news: the inputs into a moribund manufacturing sector that will at best be a bit player in our digital future.
Ah, but it was not always thus. Twenty-five years ago, commodities were the darling of Wall Street. A combination of double-digit inflation and persistent shortages in supply (hint: ‘OPEC embargo’) fuelled a huge speculative boom in the market for real assets. Where today’s analysts wait with bated breath for the non-farm payrolls report, for company earnings numbers, and for the wisdom of Alan Greenspan, their predecessors in the 70s used to wait with equally bated breath for OPEC production quotas, for Florida crop growers’ reports, and for the utterances of Saudi oil ministers. Commodity traders became celebrities. Egged on by the media, teachers and truckdrivers alike quit their day jobs to punt on pork belly futures. In short, it was a mania.
So what happened? How and why did commodities lose their exalted position? What happened was what always happens. The investment boom turned into an investment bust. Tempted by higher prices, producers invested heavily in production infrastructure: the first oil rigs in the North Sea and in Alaska date to this period, as do the first modern ‘industrial’ farms. Meanwhile, consumers adjusted their preferences away from their old habits: gas-guzzling monstrosities from Detroit were outflanked by smaller, cheaper and above all more efficient compacts from Japan. The resultant glut in everthing from oil to orange juice caused commodity prices to fall precipitously. Speculators who had bought at the peak of the market (and there was no shortage of them) were ruined; many vowed never to buy commodities again. Meanwhile, helped by a triple delight of falling input prices, falling inflation and falling interest rates, the financial markets (ie, stocks and bonds) embarked on a spectacular 20-year bull run. The commodity markets languished in obscurity, commodity news was banished to the inside pages of the financial press, and the pork belly traders returned to teaching and driving trucks.
But the tide may be turning. Just like high prices in the 70s caused overinvestment and a glut in production, low prices in the 80s and 90s have resulted in a tremendous shortfall in supply relative to demand. The Commodity Research Bureau’s handbook for 2004 paints a sobering picture. Worldwide production of lead, for instance, has fallen every year since 2000. Global oil production (from existing fields) is forecast to hit Hubbert’s Peak before the decade is out, and no major new oil field has been discovered anywhere in the world for more than 35 years; the US has not built a new oil refinery since 1976. Hurt by low prices for agricultural products, farmers worldwide are leaving the countryside and migrating to cities in greater numbers than at any time in human history, leaving their farms fallow and unproductive. And so on.
A legitimate question at this point is, won’t market forces change the supply dynamic just like they did in the last commodities boom? Won’t high prices stimulate additional production, thus planting the seeds of their own collapse? The answer is yes, they will – but not for some time yet. The crucial point to understand here is that commodities, to a far greater extent than other asset classes, take time to bring to market. Oil fields take years if not decades to develop; OPEC cannot simply wave a magic wand and double global petroleum production instantly, no matter how high crude prices go. Similarly, a newly-planted coffee seedling has to grow for several years before it can yield the beans for your morning latté. Aluminium smelters and steel plants cannot be fabricated ovenight. So while it is true that in the long run rising commodities prices will create their own supply, in the short run there is still tremendous potential for growth in this market. In any case, commodity prices are still well below their previous bull market peak in real terms (ie, after adjusting for inflation); there’s plenty of room to grow.
Another reason to be bullish on commodities, at least for US-based investors, is the issue of valuation. Most international trade in commodities is denominated in dollars, and the greenback is a fundamentally unsound currency. The US government is running a large deficit which appears poised to grow even larger thanks to costly entitlement programs such as Medicare and Social Security, thanks to tax cuts and fiscal indiscipline, and thanks to the ongoing ‘war on terror’. The private savings picture is not much better; America’s savings rate is close to zero. The country also runs the largest trade deficit in history.
At the moment, these multiple deficits are financed by overseas money. Asian central banks buy dollars to keep their own currencies from appreciating (in classic mercantilist practice). They then invest the proceeds in US Treasury bonds, thus plugging the US fiscal deficit and keeping long-term interest rates artificially low. Low long rates help finance private debt via the channel of home equity withdrawal, thus fuelling further American consumption. Alan Greenspan, meanwhile, supports the domestic economy by flooding the system with liquidity: despite the rapid GDP growth of the last couple of years, the real Fed Funds rate remains negative.
This equilibrium will not last. Sooner or later, overseas investors will refuse to finance America’s twin deficits. Interest rates will soar, as no one will want to buy US debt. And the dollar will plummet. Needless to say, both of these developments will be very positive for commodities: real assets tend to do very well in inflationary environments.
You’ve heard about supply, and you’ve heard about valuation. Now it’s time to turn to the 800-lb gorilla in the room: China. In recent years, the Chinese economy has grown at an astonishing clip, and much of this growth has been in the manufacturing and industrial sectors. But China is a relatively resource-poor country; it needs to import most of the raw materials that feed its relentless expansion in every sector from kitchen appliances to plastic toys to cars. It’s no surprise that, with fresh supply still to come on line, much of the recent increase in global commodity prices can be correlated almost perfectly with the growth in Chinese imports. China accounted for 37% of the increase in world oil consumption between 2000 and 2004, putting it second only to the US in total consumption of energy products. And China is already the world’s number one consumer of copper, steel, iron ore and soybeans.
Would a global economic slowdown cramp China’s demand for raw materials? Not likely. China’s domestic growth will prove a sufficiently powerful engine to drive commodities prices higher on its own. The pace of urban migration in China is such that the equivalent of a Houston or a Philadelphia has to be built every month. Can you imagine the demand for coal, steel, cement, glass and asphalt that such fantastic growth would engender? And having moved into these new supercities, the Chinese middle class (estimated to be comfortably twice the size of the entire American population) will soon demand the same creature comforts that their compatriots in Hong Kong and Taiwan already enjoy. China’s per capita consumption of coffee is estimated to be less than 20 cups annually, while the Taiwanese consume close to 100 cups a year. If the Chinese middle class were to increase their coffee-drinking to comparable levels, that alone would necessitate a 10% rise in global coffee production. And as I’ve already mentioned, coffee trees take time to grow.
Postscript: Regular readers of the financial press will know that none of this is particularly ‘new’. Popular measures such as the DowJones-AIG Commodity Index have nearly doubled since the start of 2002, and the supply squeeze – China – inflation story has been receiving a fair bit of coverage of late. I make no assertions of either originality or timeliness in this essay. Jim Rogers, however, can lay claim to both: he launched a raw materials index fund in August 1998, just a few months before the DJAIG hit a multi-year low. Since inception, his has been the best performing index (fund) in the world, bar none. Likewise, he has been writing about supply shortages, incipient dollar inflation and the rising influence of China for several years, both on his website and in his books (which, if you haven’t guessed by now, I strongly recommend).
