The run-up in commodity prices that began more than a decade ago as a result of rapid economic growth in developing countries like China, India, Brazil and Russia appears to have ended. This has significant implications for the Canadian economy, dependent as it is on energy and other commodity prices.
“We believe that this is going to continue to work its way through the economy at least through until the end of next year,” said Chhad Aul, assistant vice-president, portfolio management at Sun Life Global Investments, in an interview with me on Friday. “It’s not something we expect to reverse in the short term. It’s going to take several quarters because we’re dealing with an unwinding of a buildup that was 15 years in the making.”
While a sharp drop in oil prices has dominated the business press since last year, that is only one part of a larger, surprisingly complex story. Both soft commodities (agricultural products such as lumber and produce) and hard commodities (oil and metals, for example) are falling as a perfect storm of softening economic demand and political decision-making wreaks havoc.
“We’ve seen price drops across the commodity complex,” said Aul.
First, a reminder of how we got here. Efforts in China and India to grow their domestic economies resulted in the emergence of a rapidly expanding middle class in both countries. We saw similar growth in Brazil and Russia (hence the excitement about the so-called BRIC countries), and later in South Africa. This rapid economic development triggered a boom in the demand for commodities. China in particular spent billions building infrastructure and housing, all of which required iron ore for steel, copper for wiring and more.
In time, millions of Chinese, Indian and other citizens found themselves part of a burgeoning class of upwardly mobile consumers. Just about everything they wanted — homes, cars, iPhones, better food — placed tremendous demand on commodity markets around the world.
This super cycle powered the Canadian economy, even as the world struggled through the financial crisis.
The high price of oil and other commodities reflected more than just this upswing in demand. Traders assumed that unprecedented economic growth rates in China and other developing countries would continue in the long term, and priced all of that in.
“These growth rates were extrapolated out into the future,” said Aul. “So of course many of the prices of the underlying commodities overshot on the upside. And now they need to normalize... The market will need to reflect these lower growth and demand rates.”
What went wrong?
Two unrelated sets of political decisions spelled the beginning of the super cycle’s end. The first impacted demand.
“The growth model in China has been to support exporters and large-scale capital investment,” explained Aul. That’s no longer the focus. “The authorities are trying to reengineer the economy to shift away from that unsustainable level of capital investment into a more consumer- and services-oriented economy.”
Given the size of the Chinese economy, this has had a tremendous effect on the market for key commodities. The softening industrial demand for metals is a prime example. (Food products are expected to remain relatively strong, as consumers continue to demand high-quality nutrition. But that will be tempered by weakening economic growth.)
The second set of decisions affected the supply side.
After an extended period in which Canadian oil sands and U.S. shale oil production boomed, leaders in the Organization of the Petroleum Exporting Countries (OPEC) implemented a monumental change. “They decided that they were going to produce essentially as much oil as they could, and take back market share from those higher-cost producers,” said Aul.
Historically, OPEC nations have cut the supply of oil when prices fell too low. “They decided they’re no longer going to do that,” said Aul. Saudi Arabia and other Gulf region suppliers can produce a barrel of oil for about US$32. A shale producer needs to make twice that, and an oil sands producer needs to see oil at least in the low-$70 range.
“We have to watch the market now and see how quickly those U.S. shale producers and Canadian oil sands producers respond to lower oil prices and begin to take supply off the market place,” said Aul. It’s not clear how low oil prices will go.
Effect on the Canadian economy
This helps explain the sorry state of things in Canada. We learned last week that the domestic economy contracted in May. That’s the fifth straight month of negative gross domestic product (GDP) growth and the sixth month in the last seven. There is good reason to believe we entered a technical recession in the first half of the year (defined as two consecutive quarters of negative GDP growth), and the short- to medium-term outlook remains soft.
The optimistic view is that this painful period will trigger a rebalancing of the economy, away from such a heavy reliance on energy markets.
“We could see improvements — because the Canadian dollar is lower – in manufacturing,” said Aul. “We could be exporting goods on a more competitive basis. The problem is that so much of that manufacturing capacity was essentially shuttered over the last 15 years. These plants were shut down as the rising Canadian dollar made them less competitive. So it’s not like those plants can come back online in the very short term. We’re going to need a low Canadian dollar for a longer period of time for the market to really believe and for companies to increase our manufacturing capacity.”
Commodity prices will come back eventually. It’s not clear when, but declines of this magnitude don’t go on forever. What appears clear, though, is that the boom triggered by policy making in developing countries like China and India is over. The super cycle has run its course.