If you are a true long-term investor, the time has come to change your entire frame of reference – to recognize that we now live in a different, more-constrained world in which the prices of our finite resources will rise and shortages will be common.
Accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of raw materials and finite resources: After 100 years or more of price declines, resource prices are now rising, and in the last eight years have undone, remarkably, the effects of the last 100-year decline!
The world is facing an unsustainable surge in demand. In fact, it's no longer just a question of "peak oil" – we're now facing a future of "peak everything." How we deal with this unsustainable surge is going to be the greatest challenge facing our species.
If I am right in this assumption, then when our finite resources are on their downward slope, the hydrocarbon-fed population will be left far above its sustainable level; that is, far beyond the Earth's carrying capacity.
But whether we rise to the occasion or not, some great fortunes will be made along the way in finite resources and resource efficiency, and it makes sense to participate.
Take a minute to reflect on how remarkable these finite resources are! In a sense, hydrocarbons did not have to exist. On a trivially different planet, this incredible, dense store of the sun's energy and millions of years' worth of compressed, decayed vegetable and animal matter would not exist.
And as for metals, many are scarce throughout the universe and became our inheritance only through the death throes of other large stars.
These are truly rare elements, ultimately precious, which – with a few exceptions, such as gold – are used up by us and their remnants scattered more or less uselessly around. After millions of years of trial and error, it had found a stable and admirable balance, which we are dramatically disturbing.
Given our current inability to show discipline in the use of scarce resources, I would not have held my breath waiting for a good outcome in that alternative universe. But in the real world, we do have hydrocarbons and other finite resources, and most of our current welfare, technology, and population size depends on that fact. Slowly running out of these resources will be painful enough. Running out abruptly and being ill-prepared would be disastrous.
The Great Paradigm Shift: Prices That Were Declining…
The history of pricing for commodities has been an incredibly helpful one for the economic progress of our species: In general, prices have declined steadily for all of the last century. In fact, in apparent defiance of the ultimately limited nature of these resources, a study that we conducted of the 33 most important commodities found that the average price falls by 1.2% a year after inflation adjustment, finally reaching its low point in 2002.
Just imagine what this 102-year decline of 1.2% compounded has done to our increased wealth and well-being. Despite digging deeper holes to mine lower-grade ores, and despite using the best land first, and the best of everything else for that matter, the prices fell by an average of over 70% in real terms. The undeniable law of diminishing returns was overcome by technological progress – a real testimonial to human inventiveness and ingenuity.
But the decline in price was not a natural law. It simply reflected that in this particular period, with our particular balance of supply and demand, the increasing marginal cost of, say, 2.0% a year was overcome by even larger increases in annual productivity of 3.2%.
But this was just a historical accident. Marginal rates could have risen faster; productivity could have risen more slowly. In those relationships we have been lucky. Above all, demand could have risen faster, and it is here, recently, that our luck has begun to run out.
… Now Are Rising
Just as we began to see at least the potential for peak oil and a rapid decline in the quality of some of our resources, we had the explosion of demand from China and India and the rest of the developing world. Here, the key differences from the past were the sheer scale of China and India and the unprecedented growth rates of developing countries in total.
This acceleration of growth affected global demand quite suddenly. Prior to 1995, there was (remarkably, seen through today's eyes) no difference in aggregate growth between the developing world and the developed world. But for the last several years now, growth has been 3-to-1 in their favor!
The 102 years prior to 2002 saw almost each individual commodity – both metals and agricultural – hit all-time lows. Only oil had clearly peeled off in 1974, a precursor of things to come. But since 2002, we have the most remarkable price rise, in real terms, ever recorded, and this, I believe, will go down in the history books.
The primary cause of this change is not just the accelerated size and growth of China, but also its astonishingly high percentage of capital spending, which is over 50% of gross domestic product (GDP), a level never before reached (or even closely rivaled) by any economy in history. Yes, it was aided and abetted by India and most other emerging countries, but still it is remarkable how large a percentage of some commodities China was taking by 2009.
Among important non-agricultural commodities, China takes a relatively small fraction of the world's oil, using a little over 10%, which is about in line with its share of GDP (adjusted for purchasing parity). The next lowest is nickel at 36%.
The other eight – including cement, coal, and iron ore – rise to around an astonishing 50%. In agricultural commodities, the numbers are more varied and generally lower: 17% of the world's wheat, 25% of the soybeans, 28% of the rice, and 46% of the pigs.
The "Creative Tension" in Resource Investing Today
As resource prices rise, the entire system loses in overall well-being, but the world is not without winners. Good land, in short supply, will rise in price, to the benefit of landowners.
Technological progress in agriculture will add to the value of land holdings. Fertilizer resources – potash and potassium – will become particularly precious. Hydrocarbon reserves will, of course, also increase in value.
In general, owners or controllers of all limited resources, certainly including water, will benefit. But everyone else will be worse off, and a constrained-resource world will increase in affluence per capita more slowly than it would have otherwise, and more slowly than in the past.
Remember, this is not simply a recycling of income and wealth as it was when Saudi Arabia stopped some of its pumping for political reasons. Then, we paid a few extra billion and they put money in the bank for recycling. There was no net loss.
But now when they pump the last of the cheapest $5 per barrel of oil and we replace it with $120-a-barrel oil from the tortured Canadian tar sands, the cost differential is a deadweight loss. GDP accounting can make it look fine, and it certainly creates more jobs but, like a few thousand men digging a hole with teaspoons, it adds jobs but no incremental value compared to the original cheap oil.
How does an investor today handle the creative tension between brilliant long-term prospects and very high short-term risks?
The frustrating – but very accurate – answer is: with great difficulty. For me, personally, it will be a great time to practice my new specialty of regret minimization. My foundation, for example, is taking a small position (say, one-quarter of my eventual target) in "stuff in the ground" and resource efficiency.
Given my growing confidence in the idea of resource limitation over the last four years, if commodities were to keep going up, never to fall back, and I owned none of them, then I would have to throw myself under a bus. If prices continue to run away, then my small position will be a solace and I would then try to focus on the more-reasonably priced – "left behind" – commodities. If, on the other hand, and much more likely, they come down a lot – perhaps a whole lot – then I will grit my teeth and triple or quadruple my stake and look to own them forever. So, that's the story.
The U.S. Outlook
The United States is, of course, very well-positioned to deal with the constraints.
First, it starts rich, both in wealth and income per capita, and also in resources, particularly the two that in the long run will turn out to be the most precious: great agricultural land and a pretty good water supply.
The United States is also well-endowed with hydrocarbons. Its substantial oil-and-gas reserves look likely to prove unexpectedly resilient, buoyed by improving skills at fracking and lateral drilling. And, by any standard, U.S. coal reserves are very large. All other countries should be so lucky.
Second, we are the most profligate or wasteful developed country and this fact, paradoxically, becomes a great advantage. We in the U.S. market can save resources by the billions of dollars and actually end up feeling better for it in the end, like someone suffering from obesity who succeeds with a new diet.
The slowing growth in working age population has reduced the GDP growth for all developed countries. Adding resource limitations is further reducing it. If U.S. GDP grew 2% for the next 20 years, I think we would be doing very well. Dropping to 1.5% would not surprise me, nor would it be a disaster. In the past 28 years, we have increased our GDP by 3.0% per year, with only a 0.9% increase in energy required.
In other words, we increased our energy efficiency by 2.1% without a decent energy policy and despite some very inefficient pockets like autos and residential housing. This would suggest that at a reduced 2% GDP growth rate, we might expect little or no incremental demand for energy, even without an improved effort. If, in addition, we halved our deficit in energy efficiency compared with Europe and Japan over the next 20 years, then our energy requirements might drop at 1.5% a year. Given the plentiful availability of low-hanging fruit in the U.S. economy, this is achievable.
Other Key Markets
Other countries will not be so lucky.
Almost all will suffer lower growth, but resource-rich countries will have a relative benefit as the terms of trade continue to move in their favor. Less obviously, those countries that are particularly energy efficient will also benefit. If Japan, for example, can produce more than twice the GDP per unit of energy than China, then, other things being equal, the terms of trade will move in Japan's favor as oil prices rise.
At the bottom of the list, poor countries with few resources and little efficiency, which already use up to 50% of their income on the commodity "necessities," will suffer. The irony that they suffered the most having used up the least will probably not make their misery less. Limited resources create a win-lose proposition, quite unlike the win-win we are accustomed to in global trade.
The bottom line is both simple and clear: In the face of "peak everything," the United States and every other country need a longer-term resource plan – especially for energy.
And we need it now.
In its May 2009 issue – in an article titled "Why Jeremy Grantham Changed his Mind" – SmartMoney magazine recounted how the veteran investment strategist had "called" the 2007 market top. In the face of a roaring bull market that sent U.S. stocks to record highs, Grantham sounded the alarm and warned of the dangers of the global-investing bubble – well ahead of the global financial crisis that led to a near-collapse of the world's securities markets.
Grantham's warning had proved to be correct: After achieving record highs, U.S. stocks careened into a bloody bear market.
But Grantham, having predicted the market top, turned his attention to the bear-market bottom. In March 2009 – the month that turned out to be the precise market nadir – Grantham exhorted investors to buy back in – meaning that he also "called" one of the strongest market rebounds in market history.
Grantham co-founded GMO in 1977. Prior to that, Grantham was co-founder of Batterymarch Financial Management, where he recommended commercial indexing in 1971, one of several claims to being first. He began his investment career as an economist with Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B). Grantham is GMO's chief investment strategist and is an active member of GMO's asset allocation division. He is a member of the GMO board of directors and has also served on investment boards of several non-profit organizations.
Grantham has been featured in Forbes, Barron's and BusinessWeek and is routinely quoted by the financial press. He earned his undergraduate degree from the University of Sheffield and an MBA from Harvard Business School. To learn more about GMO, please visit the company's Website by clicking here.]
News and Related Story Links:
- GMO LLC:
- GMO Quarterly Letter (April 2011):
Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever.
- Money Morning:
Jeremy Grantham: With Great Depression II Nowhere in Sight, Look to the "Emerging Markets Bubble" for Maximum Profits.
Why Jeremy Grantham Changed his Mind.