As many commodity prices – being economically sensitive resources – have dropped massively over the last months (and even more so over the last weeks) as well as a recession being expected by the consensus, the question is whether equities of commodity producers in general are about to crash. At least this was the procedure during the last Great Recession of 2008–2009. However, this is too simplified, completely ignoring history.
Summary and key takeaways from today’s Weekly
– You should be aware that there is an overall business cycle and a (in most cases opposing) commodity spending cycle.
– Commodities usually go into the opposite direction, because commodities are costs for the general economy.
– During boom phases, commodities get neglected and supply becomes scare. This is the foundation for rising commodity prices – especially during economically bad times! Currently, commodities are valued at a 100-year low compared to general financial assets.
Oil – both WTI and Brent – have fallen by around 40% since their multi-year highs around 120 USD in early June 2022. The price drops even accelerated over the last several weeks, as both decreased by another 15% each during the banking panic.
The price developments of gas have even been more extreme. US Nat Gas fell from ca. 10 USD by nearly 75%, while the European counterpart TFF Gas crashed by nearly 90% from 350 EUR to around 40 EUR and is now lower than during all of 2022!
The mood shifted seemingly from “next stop 200 USD for oil” to “uninvestable” due to recession fears.
Likewise, since their highs, steel prices dropped by around a third, lithium crashed by 50% since November and aluminum lost nearly 40% over the last twelve months.
Will the lights go out for commodities and the stocks of their producers due to a recessionary-driven falling demand? While I myself also believe that a recession in some form or another will either come or is even already occurrent, I take the contrarian position that equities of commodity producers should be considered even as long-term investments.
History shows that the odds are clearly in favor of higher – much higher – not lower, prices of commodities and their stocks. And the best is yet to come, as recessions have historically been periods of massive outperformance – for commodities!
I will surprise many readers with a historic review which shows that commodities have – with the exception of 2008–2009 – always been a beneficiary and a hedge during recessions, not a loser! It all depends on the capital spending cycle, supply and demand as well as valuations.
In this regard, the Great Recession was rather an uncommon accident, not the norm.
By saying “long-term investments”, I don’t mean it ironically in the sense of buying the high, making the way down and hoping for a break-even to sell at zero, again.
But in the context of what is happening in the background.
In today’s Weekly, I am going to explain what you should know.
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Commodity prices and stocks fall in recessions, right?
I’m using as a source a treasure-trove with a precious historical look back, I wanted to share with you. Credit, where credit is due: Goehring & Rozencwajg, Natural Resource Market Commentary Q2 2022 (see here).
The whole report – it takes some time to read – is a true eye-opener and goes way deeper than I do today. I highly recommend it to those interested in history. You need to sign up for their free newsletter (I did) and then you can access the full PDF.
As they analyzed and evaluated lots of historical data, here are the key insights I gathered from this report.
The first thing is cleaning up with a common misconception.
It is rather set in stone to think that resource and especially energy companies rise during good times of economic expansion and fall during crises or recessions where economies can run sideways or even contract for a brief period of time.
Sure, when times are good, demand is high. When an economy turns sour, demand slows down, too. Logical, isn’t it?
Nothing could be further from the truth!
But how come this misconception? The problem is that this academic mainstream view is based on the demand side, totally leaving aside the supply side. Unfortunately, you will often hear about
manipulating steering and influencing demand, being it increasing or lowering demand to achieve a certain goal.
This has never worked.
As you know, I prefer to look at the supply side to anticipate future developments. Supply is slow-moving and more reliable to forecast than demand.
I already wrote about the topics of sector rotation, capital expenditures and oil supply and demand in two other articles – please read and view this new article as an add-on to those older, but still valid, ones:
- “How to beat the bear market – inflation, stagflation, recession” (see here)
- “Are evil energy (oil) stocks already priced too ambitiously for a recession?” (see here)
I firmly believe that humans either aren’t aware of history or tend to neglect it anyway.
Think of “this time it’s different” – one of the most costly sentences, if you invest according to it. Mistakes others already have done are repeated again and again.
Add to this that often only the most recent events are remembered.
Such a “recent event” is the Global Financial Crisis of 2008–2009 – though not for everyone. There, indeed, nearly everything fell in price – yes, initially also gold, although gold bugs don’t like to admit that – because for them, gold only rises or it is mysteriously manipulated!
History shows that this period was an uncommon outlier and not the norm.
However, it is the last big economic downturn most of us remember. There aren’t many who actively and consciously – knowing what was going on and why – experienced the 1970s inflationary period or even invested during this decade.
Most investing memories reach only back into the 1980s or 1990s, at best.
Resource companies – energy and materials – collapsed back then in 2008–2009 as the housing, banking and liquidity crisis led to a fierce recession. Together with – obviously – real estate and financials, commodities were among the worst performing sectors. This is why many connect a recession to falling prices of resources.
However, not the recession was the cause.
Here is the thing.
To call the buying and selling points for commodities, not the broader economic cycle is the determining factor. It is the capital spending cycle of the resource companies.
Please read these two sentences so many times until you know ’em by heart.
Isn’t this a stupid assumption that defies any logic?
And what is a capital spending cycle?
It is not an assumption, to begin with.
Let me show you two charts from the mentioned report. First, the relationship between a commodity index and the Dow Jones Index, everyone knows, as it hosts many of the Blue Chip companies of the USA (though not the 30 biggest by market cap!).
It is easy to read.
If the graph is too high, commodities (and their respective stocks) have historically been overvalued and vice-versa.
Currently, we are at a stage where commodities are undervalued as they seldomly have been since 1900 compared to the Dow Jones Index! What has followed have always been massive upswings – although it could take some time, until they started.
Sure, a rising graph does not only include rising commodity (and their equity) prices, but also falling equity prices (of non-resource sectors) in general.
Those who are familiar with stock market history, know the most important points from the chart:
- 1920s–1929: rising stocks into a bubble – the “dotcom”-bubble of that era with automobiles and radios – but it is seldomly mentioned, that commodities declined during this time! They had a brutal bear market!
- 1929–1933: crashing equities – likewise not mentioned often: commodities rallied! At best, you hear that gold rallied, however, it was (tied to) money back then and money always “rallies” in a stock market crash, hence nothing to freak out about
- 1950s–mid-1960s: stocks rose into richly valued territories, many say the 1950s have been the greatest bull market of the last century – commodities weren’t strong
- mid-1960s–1973: stocks moved sideways in general, the “Nifty 50” stocks – the 50 biggest and most respected companies then, like Polaroid – rose to absurdly high levels and then crashed in the pretty severe recession of 1973/1974 – commodities rallied!
- in the years after, stocks recovered, but fell victim again to high inflation and commodity prices
- 1980s: with the record-interest rates and the subsequent recession, the picture turned; stocks after a bottom started their 40-year bull market, while commodities during most the 1980s fell
- 1999/2000: cheap commodities, over-valued stocks that ended in the dotcom crash
- then the only outlier happened: as emerging markets have played a greater role and resource companies invested like crazy, it is the only period where stocks and commodities rallied in parallel – with the exaggeration of 2006–2009 (depending on which commodities); however, stocks in general weren’t overvalued like at the turn of the century – with the exception of housing, financials and commodities – those that crashed the most
- the 2010s were again a “normal” period: stocks rose while most commodities had brutal bear markets!
I think you see the pattern that usually (in most cases) non-commodity stocks and those linked to resources don’t run in the same direction, but each have their own cycles. It can happen like from around 2000 until 2008 that both go in one direction – but this is a rare occurrence – not the norm!
And with this in mind, you should be able to see that we are currently having the exact opposite situation compared to 2008/2009.
Richly valued general-economy stocks (due to prior too low interest rates) that are plagued by high inflation which puts pressure on margins on one side and absurdly cheaply priced commodity stocks on the other (often with strong cash flows!).
We are in this regard more in a 1999/2000 or even in a ca. 1970s situation – or any other extreme in history, but definitely not like prior to the Great Recession!
Please, make sure you understand this difference!
There is a second chart, this time showing the sector weighting of commodities (energy & mining) compared to the broad S&P 500 index – the graphic is from last summer, but is hasn’t changed much since then.
You see from both charts that commodities have their own cycles which most of the time tend to be the exact opposite of what the general non-commodities market does. Otherwise, these graphs were flat lines and not swinging back and forth.
The extreme points are those that are the interesting ones.
And currently, we are again in such a situation where the common belief is “everything will crash” – but history has shown us there is a different pattern. Thus, commodities are comparatively undervalued and extremely cheap! If so, they should present excellent investment opportunities and attractive entry points, until they become overvalued themselves, again. But are they?
Well, it depends on the capital cycle – capital spending cycle, in full – which has created throughout history imbalances in supply and demand.
These imbalances have led to huge outperformances – or huge underperformances, depending on when one invested.
The typical pattern of a commodity capital spending cycle is:
- high commodity prices lead to disproportionately high earnings due to a relatively fixed cost base of the companies; margins rise to extremes
- these abnormal profits have two consequences: more competition with otherwise unprofitable projects enters the game and overall capital spending increases to fund new exploration and production to increase volumes
- higher spending increases supply to such a point where it overtakes demand and then prices start to fall
- with oversupply and falling prices, the high-cost projects begin to hurt – companies start to become unprofitable and finally have to write expensive projects off – some even end up in complete bankrupcy
- hot money loses its patience and nerves, realizes losses and starts to leave the commodities sector in favor of more promising sectors
- the commodities space becomes underfunded and undercapitalized which leads to starvation, extreme reduction in capital spending and thus a lot less output
- With falling inventories and roaring economies due to now cheap resources (which are costs for other companies), the situation for resource companies gets extreme – it is about survival, not maximizing volumes
- but this point of maximum pessimism, too little capital and spending, is the known tightened spring that is about to explode due to high pressure
- the next bull market starts
This is what is meant with the capital spending cycle above.
It can correlate with the broader economy and markets, but this is usually not the case.
Although many investors know this commodity spending cycle when you ask them, there are still people surprised why during a recession commodities should tend to do well.
The interaction is as follows (important!):
- high commodity prices depress the economy, because they are costs for the other companies (inflation, anyone?)
- falling commodity prices lead to lower costs and thus higher earnings for other general-economy sectors
- depressed commodities are the point where supply starts to get scarce – only the low-cost suppliers survive
- prices start to rise and hurt other sectors again due to undersupply – this takes years of capital spending to catch up with demand, not days or weeks!
- finally, oversupply and the next turning
If you understand this relationship described above between commodities and the general economy, you should know why commodities are cheap and about to go higher rather than lower and that it is unlikely we will see a 2008/2009 scenario.
If you’re still not convinced, have this one!
Even during the 1930s – the Great Depression – commodities rallied!
THE Great Depression that caused stocks to fall by more than 80%. It took them until 1954 – long 25 years (buy and hold?) on a nominal basis to reach the former high again! The same Great Depression where industrial production crashed by 50% and where over 7,000 (!) banks failed.
Does it sound frighteningly familiar somehow?
Here is passage, quoted from the G&R report (bold is highlighted by me):
Given their economic sensitivity, it is reasonable to think that commodities and natural resource equities must have fared terribly during the Great Depression. Surprisingly, natural resource investments did not collapse during the Great Depression; they turned out to one of the best performing asset classes.
How could a portfolio of economically sensitive stocks lead the market during the worst economic collapse in history? The answer is the natural resource capital cycle. Commodity prices fell throughout the 1920s and by 1929, had become radically undervalued relative to financial assets. Just as important, low commodity prices starved the industry of capital throughout the decade.source: Goehring & Rozencwajg, Natural Resource Market Commentary Q2 2022 (see here)
From 1999 until 2006–2009 both, the overall business cycle and the commodities capital spending cycle, were in harmony going in the same direction. In 2008, commodities had a share of 20% of the S&P 500 which was a 30-year high back then!
Currently, we are at a 100-year low!
Thus: Look at the capital spending cycle, because it tells you something about the supply and likely coming scarcity.
Nonetheless, skepticism overweighs optimism as to resources.
Another quote to stress the point (bold is highlighted by me):
For those fearing a recession, what happened to commodity related equities in the Great Depression is a great example of what might happen today if a severe recession gripped the global economy. The radical undervaluation of commodities and commodity related equities is greater now than it was back in 1929, and the level of capital starvation is just as great. History tells us that commodities could again be an excellent place to seek high returns, even if the 2020s experience a period of economic turmoil as severe as the Great Depression — a scenario we consider unlikely.source: Goehring & Rozencwajg, Natural Resource Market Commentary Q2 2022 (see here)
Many are talking about a recession, but not another Great Depression. And even then, commodities didn’t crash!
Today, commodities are hated and pretty much out of favor – the exact mirror image compared to 2006–2008. Keep this in mind when someone tells you everything’s going to crash. History is on the side of those who have studied it, not on those who just claim to think something could happen.
In the chart below, you see in the bottom right corner that resources – energy and materials – are still only a small fraction of the entire S&P 500. This is certainly not an overvaluation.
During the 2010s decade, commodity companies were busy with:
- closing and writing down unprofitable projects
- cleaning up their balance sheets, also raising equity
- lowering costs, focusing on the most profitable projects
- preserving cash
It should be no surprise that in this context capital spending (or capital expenditure) declines massively. The authors write in their report that capital spending in the energy sector of the S&P 500 has fallen from over 320 bn. USD p.a. to less than 100 bn. USD p.a. – a shocking drop of ca. 70%!
Here are some impressions from other sources.
First, from Reuters, an overview of mining exploration expenditures that led to the great boom and subsequent bust, due to over-supply:
You see clearly that capital spending cycle aligned with the overall business cycle.
But after that, the general economy continued to grow, while commodities entered a fierce bear market.
The next chart shows a large time frame, including the above, but going until 2021:
The major high – from a ca. 40-year perspective, by far still is not reached.
Add to this the massive uptick in inflation starting from 2020–2021 – these were decade-high numbers, i.e. the inflation-adjusted all-time high for CAPEX would be even higher. With a broad-brush, we can say, that capital spending is – at best – half of the highs ten years ago.
The next two charts are bringing some more clarity.
The first is more or less the same as above if you don’t close closely:
But the second chart is really interesting:
You see that overall CAPEX is rising slightly, but by far not enough to reach its former high. Even more interesting is the relative share between sustaining and expanding / developing CAPEX. Most CAPEX is spent just on sustaining operations as they are, while new projects are scarce!
Where shall the commodity supply come from in the future?
Add to this the insane ESG plans and mandates that put even more pressure on the resources companies. Activist investors, governments but also financial institutions make it even harder for those companies to do their businesses.
However, to fulfill their unrealistic and unreliable plans, even MORE commodities are necessary. To extract minerals from the ground, you obviously need energy. Both somehow shall be dialed down.
In other words, supply is even more disrupted than has historically been the case.
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You should be aware that there is an overall business cycle and a (in most cases opposing) commodity spending cycle.
Commodities usually go into the opposite direction, because commodities are costs for the general economy.
During boom phases, commodities get neglected and supply becomes scare. This is the foundation for rising commodity prices – especially during economically bad times! Currently, commodities are valued at a 100-year low compared to general financial assets.
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