As we all know, commodity prices have been in a secular bull market for the better part of a decade – subject only to temporary, albeit violent, corrections. Three main explanations have been offered for the trend. The first is that rapacious demand from emerging markets is fueling price increases, as the developing countries consume tremendous amounts of raw materials in pursuit of growth. The second is that the dollar is being debased, which in turn is stoking inflation in hard assets, especially gold. The third argument (most recently advanced by Jeremy Grantham at GMO LLC) is that the world is facing a crisis of limits: commodity prices are surging as the world struggles with the depletion of its finite resources.

I think all three arguments hold a degree of truth. Curiously though, I have seen little written on a fourth rationale, one that might shed additional light on the steep gains in commodities. The argument goes like this: companies around the world face tremendous uncertainty over the future price and availability of raw materials. In emerging markets, that uncertainty is compounded by sporadic and uneven access to commercial credit. Banking systems, either under direct government ownership, or at government behest, are rationing credit. This means that a credit crunch looms for the least well-connected entities (i.e., those without government ownership or patronage – in other words, the private sector). How can management tackle dual problems (inflation on inputs and looming credit shortages), killing two birds with one stone?

In my experience, I have seen some companies in developing countries solve such problems by stockpiling inventories.¹ Companies take advantage of credit when it is abundant (as it was in most emerging markets between early 2009 and mid-2010), anticipating that it will soon become relatively scarce again (as it has become in China, India and elsewhere). Management uses the new credit to finance the accumulation of inventory, stocking up for a rainy day. By doing so, they expand the size of their balance sheet; as such, they have greater resources under their direct control, and are less dependent on banks. Meanwhile, they simultaneously fix their material costs at present spot prices, and consequently they deem themselves “hedged” against inflationary pressures and shortages in supply. While the transaction is effectively a leveraged bet on commodities, management perceives it as a low-risk way to solve two problems at once. If anything goes wrong – if, for example, material prices decline – the commodity markets are presumed to be liquid enough to allow an exit before any major damage occurs. However, if most companies follow the same line of reasoning, and dump their materials at the same time, the price action is obviously destructive.

Several weeks ago, I wrote a piece on how companies hedge their input costs; in it I mentioned that excess stockpiling is one technique used (badly) to manage cost pressures. While the commentary was abstract, it may have practical application at present: new data from China makes me wonder whether stockpiling has exacerbated the recent trend in commodities. The chart below, courtesy of Thomas Kwan, Asia ex-Japan strategist at UBS, shows the annual percentage growth of inventories in China over the past few years.

What stands out is the astonishing growth that occurred in 2010: inventories at public companies in China rose 180% during the year. This rapid accumulation (stockpiling?) follows on the heels of a tremendous burst in credit growth, one that is now decelerating. Between 2008 and 2010, bank loans in China expanded by nearly $3 trillion, equivalent to 59% cumulative growth over the two-year period.² Now the government is reining in the credit cycle – but perhaps not before stockpiling has occurred to a substantial (maybe massive) extent.

To be fair, the chart is derived from a database that aggregates financial statements of individual public companies – and thus it should not be taken at face value, as such databases are often rife with errors, omissions and incompatible data. Perhaps the magnitude of the trend is exaggerated; and at best it constitutes only one anecdotal piece of evidence. Even so, the swings it suggests are pronounced. Given China’s newfound status as the world’s second largest economy, such shifts are presumably large enough to sway commodity markets in a manner not seen before in modern history.

In conclusion, it makes sense to me that commodities have gained ground over the last decade, and in principle I do not dispute the three major arguments that have been offered to explain their rise. However, I am concerned that the magnitude of recent gains has been exaggerated by excessive stockpiling. Further, I wonder whether China’s policy-driven credit cycle has distorted the situation in a new and profound manner. Consequently, my reading of commodity markets is not quite as dire as some others, who see every upward tick in prices as positive affirmation of chronic shortages and depletion. I think the commodity markets are rife with complexity – and reading too much into them, with great precision, may be overreaching.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

1. I am by no means the first to comment on correlations between the credit and commodity cycles. Numerous “wave” and “cycle” theories purport to identify such linkages; however, I know none of them well enough to offer an argument on their behalf. My aim is not to introduce a comprehensive model of cyclical behaviors, but rather to make the very basic point that current evidence from China suggests that stockpiling may be influencing global commodity markets at the margin.
2. Peoples’ Bank of China, “Summary of Sources & Uses of Funds of Financial Institutions,” 2008-2010, http://www.pbc.gov.cn/publish/english/958/index.html.