What’s next for Energy and Metals?

This year has been full of surprises. We had hurricanes devastate the U.S. Gulf coast, a U.S. dollar rebound, and still-low long-term bond yields at a time when U.S. headline inflation was reaching the highest levels in over 14 years. But perhaps the biggest surprises were found on the global economic and commodity stage. Not because oil, natural gas, and copper reached new all-time highs or gold and other metals hit cyclical peaks, but because energy and industrial commodity prices surged without significantly hampering economic growth and demand for raw materials. The global economy shrugged off two major hurricanes, rising commodity and consumer price inflation and a steady diet of Federal Reserve tightening.

In previous cycles, the combination of high energy costs and tighter monetary policy had a devastating impact on the economy and, eventually, commodity prices. Not so this time around. Rising incomes in the developing world, where growth has averaged 6.8% over the past two years, and in the United States offset the impact of higher prices —the income effect dominated the price effect. As people get richer, they aren’t overly concerned about paying more for things they want to consume. On the supply side, there was an underinvestment in both the energy and metals mining sector in earlier years, setting the stage for a powerful rally. In the past, most major energy sector swings have been driven by supply shocks (1973, 1979, and 1990). For metals, great turns in market conditions were the result of sudden business cycle conditions changes and were due to major shifts in monetary policy and the dollar (1980 U.S. infl ation, 1985 Plaza Accord, 1997-

98 Asian Crisis, 1995-2002 U.S. dollar bull market).

The key question for commodities is: what happens to energy and metal prices after they peak sometime next year? As prices soar, there is an emerging concern that there will eventually be a sharp commodity price correction. This fear, of course, is based on experience stemming from the fact that commodity markets followed a boom-bust pattern for much of the post- WWII era. In the past, after an average period of about 55 months for energy, 50 months for base metals and 45 months for precious metals of a boom phase, there came the inevitable bust. Prices would plummet by as much as 50% for some commodities soon after demand eased (roughly a 50% correction for energy, and about a 40% correction for base and precious metals). Typically, supply would also overshoot and contribute to the price slump. The current commodity boom for energy started in February 2002 (46 months), for base metals in November 2001 (49 months) and for precious metals in September 1999 (75 months). Using historic benchmarks, all of these commodities are due for a major cyclical correction within a year. However, we believe that commodity prices will not follow the traditional boom-bust cycle this time around. The obvious questions is: why is this cycle different?

The short answer is: demand from China (and increasingly from India) and the fact that the current low level of excess capacity in the commodities sector will take a long time to be rebuilt (largely due to under-investment in the 1990s and long lags), keeping markets tight for at least a year or two. China has emerged as a super consumer of commodities in the last decade and there is no indication this will slow much in the foreseeable future. China will need to go on a still more aggressive building spree to increase its industrial capacity, keeping that nation’s demand for “everything commodity” as a feverish pace. Furthermore, an effort to raise the living standards of the peasants in rural China and to upgrade its strained infrastructure and electrical grid will also keep commodity demand hopping for the next several years. Also, while U.S. industrial activity will moderate next year, Japan’s growth is returning after a decade of slumber and Europe should revive somewhat as well, which are good omens for commodity demand. So, the demand shock which drove global commodity consumption and prices to unprecedented levels in 2005 will carry on into next year and likely into 2007.