Going by the charts alone, you might think the “commodity supercycle” is as dead as Monty Python’s famed parrot. But there is more here than meets the eye...

Hear ye, hear ye, one and all: The supercycle is dead. Long live the supercycle!

Commodities on the whole have declined nearly 50% from their peak as a result of the credit crisis. This has led some to declare that the “commodity supercycle” – the idea that we are merely in mid-innings of a massive, multi-decade commodity bull market – is defunct too.

I’ll admit it... the weekly chart is hard to ignore. If one had to assess the health of the supercycle by way of the Reuters CRB Index alone (as shown above), Monty Python’s Dead Parrot sketch would spring to mind.

Really though – in spite of deeply dire appearances, it’s a fair question to ask: Has the commodity supercycle shuffled off its mortal coil? Are we now dealing with an “ex-supercycle?”

Believe it or not, there’s a case to be made that the commodity supercycle is not dead – that it really is just resting – despite the speed and ferocity with which commodity prices have been chain-sawed in half.

Let me explain...

Cures What Ails Ya

There is a hoary old saying in the commodities biz: “The best cure for high prices is high prices.”

What this means is that, when a commodity gets pricey enough, production naturally expands. Expensive oil & gas leads to more drilling in hard-to-get-at places... expensive hogs lead to more hog farming... expensive corn to more corn acreage being planted, and so on. High prices, in other words, act as a “cure” for high prices by drawing new supply into the market.

The same idea works in reverse: “The best cure for low prices is low prices.”

As you can probably guess, the “low price” cure means that when a commodity gets cheap enough, producers start throwing in the towel. New projects are canceled... existing production is cut back... and marginal production is shut down entirely. As profit margins fall, more and more producers rein it in... or simply throw up their hands and quit. Over time, this winnowing process shrinks supply until it matches up with newly reduced demand. Then things stabilize, demand shifts, and the cycle begins anew.

So here’s the ironic thing: Those who declared commodities to be in a “bubble” feel vindicated because commodity prices have been smashed. And yet, today’s ultra-low commodity prices are merely reestablishing the same conditions that fed the supercycle thesis in the first place!

From High to Low (in Record Time)

When the commodity bull really hit stride, it was largely based on a strong outlook for global growth. With so many emerging market countries coming of age, resource after resource was projected to be in short supply as far as the eye could see. Investors of all stripes and sizes, from institutional on down, wanted a piece of the action.

Then the mortgage bubble popped, trust and liquidity evaporated, and credit and commerce fell off a cliff.

Not wanting to be left out, commodity prices jumped off a cliff too... and now things have come full circle. Commodities fell so violently and so quickly, we’ve been rudely transported backwards (or perhaps forwards) to the “low prices cure low prices” part of the cycle again!

For many commodity producers – and metal miners in particular – these new low prices (no pun intended) aren’t high enough to justify keeping the doors open. (That hushed sound you hear? It’s an idle haulpak with an empty gas tank; keys left dangling in the ignition.)

Pity the Miners

Pity the poor miners. Well before the panic and ensuing collapse, profits in the mining business were being squeezed by rising costs. The cost of essentials like fuel, skilled labor, equipment, and even oversized truck tires threatened to spiral out of control.

Due to this relentless “cost creep,” many of the miners – precious metals in particular – struggled to maintain healthy margins even when metals prices were riding high.

And thus when the credit bubble burst, the fall in prices was so vicious that many miners’ profits were simply wiped out. All those sky-high operational costs came down too, it’s true – but that was cold comfort in light of bank credit, investor capital, and pricing power all disappearing into thin air at once.

So now we have a situation where marginal miners all over the globe are shutting down. Operations that were profitable three to four months ago are now bleeding red ink... and screeching to an utter halt.

“Virtually all [mining] projects except those of the biggest companies need financing,” the Wall Street Journal observes, “and even some of the largest still need to borrow after starting out with equity capital.” The debt window is closed, and raising new equity in these conditions would take a miracle.

As a result of all this, production levels are being scaled back rapidly. New production is no longer in the pipeline. And post-panic prices suggest the world has given up on growth.

The Global Growth Question

Say, what about global growth? Is the uptrend in long-term demand dead too?

We know that a large element of this “fire sale” was forced asset selling... a vicious little quirk of the credit crisis that has nothing to do with fundamental outlook. But investors also seem to be arguing for a world of much diminished demand for a long time to come. That could be a mistake.

Rick Rule, a legendary natural resource investor with 35 years experience, points out that emerging market demand going forward could be “steadier... than many people think... simply because the developing countries' balance sheets are better than we are accustomed to.”

I agree with Mr. Rule. This is the first crisis we have seen where the balance sheets of many emerging countries actually look better than those in the Western World. Not all, but many, of the upcoming emerging market players stuffed the proverbial mattress with cash during the run-up.

China alone, for example, has nearly two trillion dollars in reserves... Russia more than half a trillion at last count... India nearly a quarter trillion. Having that kind of cash on hand can smooth over a lot of bumps on the road to middle-classdom. Their stock markets may be punk, but emerging market consumers could be back in action sooner than we think.

Lags and Gaps

There is another thing to remember about commodity price swings: Normally the shift from high to low prices (or vice versa) takes quite a while. This is because of time lag. Simply put, it physically takes a long time for production to adjust to an upward shift in demand. It’s not as if you can throw a switch and suddenly have a new mine or refinery or power plant in operation just like that. The preparation process – assessing, planning, funding, building – takes years.

Much of the supercycle thesis was predicated on the idea that it will take a very long time – perhaps a decade or two – for the world’s lagging commodity infrastructure to catch up with soaring global demand. As far as I’m concerned, that thesis is still in play.

Right now, commodity production trends and global demand trends have both flat lined (or even flat out declined). But when commodity demand trends start ticking up again – something that is bound to occur – it will happen at a faster rate than production can match. In the long term, this velocity discrepancy is what truly matters.

Think of two upward sloping lines that intersect in the lower left corner a graph. The X axis equals time, the lower sloping line equals commodity production, and the higher sloping line equals global demand trends. Though both lines move higher with time, the distance between the upper and lower line only gets wider as you move to the right.

That’s why I think the supercycle still lives, be it lying at the bottom of the stairs in a heap at moment. Global demand will be back... and when demand trends get back on form, they will again outpace our ability to keep up. And with so many commodity operations scaled back or mothballed thanks to the credit crunch, the starting gap will be even wider when things get rolling again.

And Don’t Forget Gold

And by the way, don’t forget gold in all this. With fiat currencies headed for a predestined tragedy of Shakespearian proportions, it doesn’t take a genius to see how physical gold demand could rise. Gold bars and coins are already flying from the vaults. Faith in the yellow metal will only wax further as faith in paper wanes.

And as for the miners’ role? John Embry, Chief Investment Strategist for Sprott Asset Management, states things flatly: “When the gold’s all gone, the market will go nuts.”

“If gold hasn’t moved up by the end of this year, I would be very surprised,” Embry says. “People don't realize how distressed the gold mining industry is. Even at $1,000, miners weren’t doing very well. At $800, the entire industry is in crisis. Costs have risen so much, nobody’s making any real money. In fact, some mines are starting to close.”

Embry thinks gold would have to hit at least $1,200 an ounce before the shuttered mines reopen... a 50% rise from gold’s price as of this writing. And if, or should I say when, gold reaches that new high, it will likely be on the way to even higher climes.

And now if you’ll excuse me, I’ve got to go research some very attractive junior mining candidates. Long live the supercycle!

Warm Regards,

JL

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