FS/GLOBAL ECONOMIC CRISIS AND ASSET VALUE CHANGE Outlooks and Scenarios for Q2-Q4 2008 by Andrew McKillop Director of Research, Vertus Sustineo April 18, 2008
Through 20 or 25 years ending in the 2002-2005 period, the so-called New Economy, or “supply side economics” dictated a strategy for natural resource, food, energy and minerals producers heavily featuring financial operations including M&A activity, and least-cost production strategies ignoring capacity additions or replacement. Linked to this, infrastructures and bulk transport were a near-forgotten, “Stalin era hangover”. Their role in private and public spending stagnated or fell worldwide, most intensely through the 1990s.
For metals and minerals producer corporations and companies the trend was specially clear and somber. These ‘Commodity-linked’ players, today a major focus of investor interest, had little choice but to follow the herd. Keeping their mining operations in service through moving to the highest-grade part of their resource pile, and selling accumulated, low production cost finished metal and minerals stocks at almost any price, their ‘long-term strategy’ was to allow US dollar depreciation and other monetary debasement to catch up with their submarginal ore grades, magically changing them from albatros-grade to eminently bankable ore grade. This process, replicated through the natural resource domain and not only in the depletables subsector, now produces a stark and perhaps surprising result – rising commodity prices, often to all-time inflation-corrected record highs in early 2008, do not produce a “supply side response”. In fact rather often the exact opposite. Net output or supply offer either stagnates or falls, aggravating the now very clear global supply pinch across the natural resource spectrum.
Taking the now acute or critical food grains and other agrocommodities supply garrot, presently the main driver of fast-rising global inflation, the vast bulge in demand side pressure is easy to schematize. We can think about the food (and energy and minerals) demand generated by about 1000 million persons in the Emerging Economies moving up from 1 meal-a-day, to 2 meals-a-day since the mid-1990s. Failure to perceive a demand change as simple and massive as this was not the only, but surely a fatal defect of the New Economy model, ironically called ‘supply side’. The global economic implications of rising incomes and changing food habits, urbanisation, and continuing demographic growth – if declining by annual increment – are now impossible to ignore.
Soaring inflation of world food prices is the clearest impact. Perhaps forgotten by the apprentice sorcerors of the New Economy, the most traditional and basic cause of economic recession is rising food prices. Classic textbook recessions, stretching back even before the Coal Age of European then worldwide industrial revolution and urbanisation, now replicated in China and India, were food-price triggered. In this most-classic possible recession, food supply drops due to bad weather, crop diseases, local or regional wars, food transport shortage and stock losses, or simple population growth. Spending much more on food radically cuts spending power in all other sectors, for non-food goods and services. These, as we know, now include a flood of cheap consumer goods transported across the world from Chinese and Indian sweat shops – and high tech factories with heavy raw materials, infrastructure and energy needs.
Today in 2008 it is legitimate to suggest we may be facing an equally classic recession trigger – but the vast number of other factors in play and their complex interactions make for a hard to model sequence, after this necessarily global economy recession process shifts to higher gear, which it shows many signs of doing this year.
Primal Role of Cheap Energy and Expensive Money
Within the ongoing but threatened process of vintage economic growth driving, and driven by high and rising natural resources prices – that I term Petro Keynesian Growth – this nearly spontaneous process technologically depended, for its start-up, only on ever-cheaper energy, to be sure its relative price, After this pump priming, rising energy and resource prices feed the growth process, notably through rising commodity prices levering up world liquidity. Outside the technology sphere, like any Keynesian ‘tax and spend’ strategy for pushing economic growth to high levels, there is an effective total dependence on continued currency devaluation and inflation in the real world economy, whatever the policy communiqués of OECD governments and Emerging Economy leaders might say. The OECD countries, we can recall and specially during the New Economy heyday of around 1985-2000, made ‘balanced budgets’ and ‘strong money plus low inflation’ their favorite but empty slogans.
In the real world, dependable depreciation of national moneys and real, but officially denied inflation provided essential support, with ever cheaper energy, to an effective debasement or devalorization of real, physical or hard assets, versus financial and derived paper assets. Oil shows this most starkly. Through 1985-86 oil prices crashed, losing about 67%. Prices for oil then stayed low, very low or extreme low, apart from the short ‘Gulf War One’ spike in 1990-91, until 1999.
In the metals and energy sphere this cheap resource party enabled or forced expiring gold, copper, lead or tin mines, and depleting oil or natural gas fields to be ‘rejuvenated’ and given a new lease on life, but only through totally inverting the golden rule of depleting natural resource producers who want to stay in business beyond the next asset crunch, that is worst grade first, best grade last. The only way this circle could be squared for a surprisingly long time in ‘post-modern’ chronology, for a little more than 15 years that is, was a diabolic convergence of cheap energy, currency devaluation and hidden monetary inflation. The most recent and biggest example of this last is the creation and introduction of the Euro, ab initio, at a fantastically over-priced level in the clear majority of Eurozone countries. We can surmise the Euro was, at introduction, around 45% over par with the moneys it replaced. Its impact on world currency values, and on implicit and potential future global economic inflation, was and is at least as pernicious as the Bush Administration’s stolid determination to devalue the dollar, this ‘mission’ being aided by the extreme overvalued Euro.
Probably the inventors of the Euro bet the cheap resources fest was long-term or even permanent, and able to palliate the intrinsic inflation their new baby, or monster could produce after its initial deflationary impacts were revealed as diametrically opposed to reality. If this was part of their strategy the bet was wrong. Firstly cheap oil, then cheap metals and energy, and now cheap food disappeared, forever in the case of oil, at a time and through a process now also making the world money system totally opaque and fragile. Energy-intense depletable natural resources are now brutally revealed for what they are – depleting and precious, radically more expensive as producers are forced back to the lower grade ores and poorer fields, which they ignored in the New Economics heyday. In the case of gold and oil, the legendary days of the yellow metal at 270 USD/ounce are as folklore-style as oil at 20 USD-a-barrel, today.
Today, we are now faced with the same revalorization process in food commodities. Will wheat ever again cost 3 USD-a-bushel, or will it cost 15 USD ? The vegetable oils, now often close to 1000 USD/ton can surely be used to substitute petrodiesel for the thrifty diesel car fleets of the world, or at least Europe, but the simple resource cost of the vegetable oil feedstock is now around 170 USD/barrel. Unsurprisingly, this drives 20-year-record inflation in a global economy still running riot through its growth momentum. Two neglected aspects of the 1929 crash, we can note, were that Commodity prices led by petroleum expanded very fast in the 1920s, and the US dollar, for one reason because of world financial sequels flowing from the 1914-1918 war, was a very strong currency. The currently ‘unthinkable’ sequence of the unrealistically overvalued Euro collapsing against the USD, or simply shrinking back to parity, and Emerging Economy decoupling being revealed as an absolutely unreal myth are two new and frighteningly possible scenarios. These two events would, if they happened and by default temporarily restore the US dollar to strong money status in a context of global economic meltdown. This would inter alia have massive inflation impacts outside the USA, specially in Europe.
The Last Doubling of Oil Prices
The hopscotch doubling process is now well installed in the food commodity price sphere but until late in 2007, through Q3 and Q4, the inflation bomb of unstoppable, pent-up price rises in the food and agrocommodity domain was masked by equally unstoppable oil, energy and metals price inflation. Taking the peak high for the Nymex WTI front month contract in January 2008, and the peak low for the same contract in mid-January 2007, around 49.50 USD/bbl, we achieved more than a full doubling or 100% rise. Projecting the same trend one year forward for Jan 08/Jan 09 generates a theoretical January 2009 price peak above 200 USD/bbl. The related gold price could soar above 2000 USD/ounce.
It is hard, if not impossible to model the economic, social and political impacts of these price levels without also projecting a 1980-style ‘meltdown’ of the US dollar, laminating global economic and trade growth, led and driven by a self-reinforcing and probably global finance and banking sector collapse. World inflation could or should rise well into double-digit precentage rates. Entry to the 1980-1983 recession, we can recall, was the second-strongest, most powerful since the crisis of 1929-1931 and was highly inflationary.
Heroic measures, at least in New Economics mythology, were taken to deal with the 1980-83 recession, notably gouging interest rate hikes lifting base rates near, or beyond 20% pa in many OECD countries including the USA. Inflation, now fed by expensive money hardly reacted. It remained at solid, historic peaks for many months, even years in several countries. It is almost inconceivable, today, to imagine what could happen to the global economy if this horse medecine was applied a second time, but one thing is sure: cheap oil would not return as if by magic. Even more surely, unfortunately, the resilience of the global economy in 1980-83 would not be replicated. This again returns the bottom line of meltdown as the no-alternative result to a simple laisser-aller in the present.
We are therefore forbidden to imagine another oil price doubling and have to be content with about 120 or 130 USD/bbl as an ultimate maximum in 2008, but this modesty does not apply to food commodities. Any index of food-versus-non food commodities tells the same story: agrocommodities have until late 2007 hung well behind the hard commodities in price appreciation, and can or even should appreciate further. Put another way, even the most case-hardened car lover, now paying around 7.50 or 8 dollars/US gallon in several EU countries, has to take time off from the wheel and eat. Eating, in fact, is more basic and harder to substitute than gasoline or petrodiesel burning, albeit a sacred ritual of Consumer Civilization. Ergo, food price prices will tend to produce even less price elastic response, than oil price rises. In the absence of world economic meltdown, we can be rather sure, food prices could rise another 40%-60% in 2008, perhaps more. This will add another direct and possibly lethal inflationary knock-on to the global economy.
Food Price Inflation : Declining Supply and Rising Prices
As already noted, above, we have a somber but totally logical sequel to the 15 or 20-year flirt with the unreal notions of the New Economy, ending with a startling outcome: rather often, rising prices directly reduce forward supply capacity. Gold demonstrates this nexus very well. Oil, natural gas and coal demonstrate this nexus very well. Public, political and media attention is now unable to ignore ever rising prices for basic food commodities even in the high-income ‘postindustrial’ economies of the OECD group. In the Emerging Economies the food price explosion of 2008 has already made any official year-round inflation forecasts unreal by relation to actual and real rates racked up in the first three months of 2008. In the Low Income countries, spiraling food prices already lead to civil riot and increasing ungovernability in 20 or 30 countries.
To be sure, we can more easily and classically explain the process with depletable or ‘one-shot’ resources. Gold is likely the most-classic possible. World deep-mined gold production, today, operates at a clarke or orebody richness near to oblivion – about 4 grams of extractible gold per ton of dirt winched to the surface, from around 3.5 – 5 kilometres depth. Basically, higher gold prices cause the marginal grade of every gold mine to drop. Since the combined milling capacity of the world's gold mines is a given quantity, and can only increase slowly, after big capital expenditure, which management and shareholders are often reluctant to make, the net result is simple to forecast: the gold content of world gold milling output is falling, which is a fact. Upstream, world extraction of fresh-mined gold-bearing ore is at best stagnant, and in fact is tending to fall as the gold price rises and because the gold price rises.
Extending this paradigm to the theoretically renewable resources – food and soft commodities – requires the introduction of many more, sometimes complex, and more subtly interactive pressures, factors and forces. Our concern is to map out future supply capacity, rather than only present and short-term future production. Both in food grains and vegetable oils, the biggest and most important, as well as highest value food commodity subsectors, the ‘gold and oil paradigm’ is now manifest. In other words price rises are not generating rising production and future supply capacity, nor lower prices along the supply chain, at one or more points upstream or downstream. In many cases, probably now including most or all of the most important food commodities, rice, wheat, maize, palm oil, soybean oil, other vegetable oils, dairy products, fish and meat we can legitimately talk about a context where spiraling price rises tend to limit and reduce net supply at some stage in the supply chain – not increase it.
If we extend the analytic framework further in time, and integrate the critical role of ever cheaper energy until the very recent past we find that ever-falling food and agrocommodity prices, in some inflation-corrected cases until 2007, were at least as dependent as the metals and minerals sector on this unrepeatable and unreal free ride for resource destructive, environmentally predatory economic ‘development’ models. Underlying and in fact enabling pesticide-intensive, irrigation-dependent, biodiversity-crunching agribusiness we find the same technology factor: cheap energy. The sequels of this model quite rapidly lead to complex, but rigorous feedbacks from accumulating diseconomies. In turn, we can unfortunately conclude that the whole episode of explosive and constant increases in world food production through the 1980s until about 1998, and lower relative or absolute prices until very recently, was a great historic and economic anomaly. Current data and trends indicate the feat will not and cannot be repeated.
Asset Value Change Will Accelerate
The current and always inflationary escapades of governments, always denied as inflationary, will of course continue but with vastly increasing risk to the world economy. The Old World OECD governments, to be sure, can stay on the warpath but their wars are now downsizing to symbolic, bur expensive publicity operations. These include oppressing Afghan villagers, no doubt to maintain and increase world heroin supply, and ‘overseeing’ a civil war in war-trashed, pillaged and destroyed Iraq. Tibet is moving up the gunsights as a potential proxy war theatre against China, at least in the view of China’s paranoid leadership. Other ways to waste taxpayer funds, weaken the money and stir social conflict include endless reform of employment markets, and endless pet welfare and local or national development projects, now including a swath of Green Energy gimmicks which ensure sustainable moneywasting.
Entry to a harder-than-planned landing of the global economy will not be a neat affair, but it will surely throw up and throw off multiple and recurring asset shifts in the Equities sphere – including the Commodity-linked equities. Some are quite easy to forecast. During any recession in the last 50 years, the energy economy radically responds. Electricity demand always contracts, along with oil. Thus the headlines will trumpet a 30-dollar slump in the barrel price, but tend to ignore the downstream impacts of very sharp falls in electricity demand. In fact, this will be very bad news for a swath of Alternate and Renewable Energy stocks, in companies absolutely dependent on high electricity prices. Conversely, and for all the reasons advanced, above, food price contraction is unlikely to occur as a fast and automatic impact of recession – even hard landing. Stocks values in certain food sector companies will therefore tend to be ‘surprisingly resilient’, even appreciating as other stocks in the Commodity-linked domain start to fall out of bed.
New and innovative entities, we can note, are always favored by sharp recession. This rule will again apply in a very large and increasing domain we can call Sustainable Natural Resources ‘of the second sort’. In other words different from current claimed operations in this domain, many of which are functionally dependent on cheap energy and infrastructure or transport subsidies, usually hidden. Checking, controlling and analysing the full supply chain, upstream-downstream will more than even pay handsome dividends. To be sure, Short Selling opportunities will be legion and remunerative, due to the certainty that over-geared financial conglomerates, pretending to be ‘sustainable and renewables oriented’, will bite the dust with depressing regularity.
The time horizon for this process sorting the wheat from the chaff or low energy cost protein from high, and clear-thinking portfolio managers from the also-rans, is quite short. In some equity sectors the process is already in full flood, notably Financials, where lessons can be learned for possible, or probable lookalike sequences for asset value change in the Alternate Energy and Sustainable Natural Resources domain, already threatened by bubble status.
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