In what may be a surprise to many, quantitative easing appears to be helping to engender an atmosphere of commodity deflation.
Can printing money cause prices to drop?
The creation of trillions of dollars of liquidity has created an interesting paradoxical effect on commodities. If a business is able to finance a resource extraction project which is sustaining a loss, and that funding becomes cheaper than shutting it down entirely, then operating at a loss may become the ‘new normal.’
As a result, those very same companies are selling their product for less than it costs them to extract it. Additionally, and perhaps equally importantly, this adds to supply at artificially low prices creating a distortion in prices downward.
Meanwhile, demand dries up because the same monetary policy transfers wealth (and purchasing power) from consumers to what the financial media calls the investing class.
Beyond a mere thought experiment…
This increase in supply and drop in demand appears to be evident across many elements of the commodity spectrum right now, including perhaps most visibly energy and metals.
Extraction of resources continues, perhaps at a slightly slower pace, but at much higher levels than if financing were more expensive (or the cost of idling operations was lower). This is especially evident in the North American shale gas industry and in many oil suppliers inside and outside of OPEC.
Additionally, many gold miners continue to operate at a loss rather than throttling production or shuttering mines.
Such a paradox has two major problems:
1: Should such activities of pulling future demand in to today’s artificially low prices continue it will cause significantly higher resource utilization, leading to more pollution, misallocation of resources and poor planning.
2: A lack of future resource availability sets the stage for significant structural economic problems. The misallocation of resources and resulting poor planning would lead to less demand for renewable energy sources and their development, as an example. In effect the first problem makes the second worse.
Bears set the stage for bulls
When such a fantastic crash in commodities happens, it cannot be ignored. We’ve seen commodity index prices across many measures crash to levels not seen since the late 1990s. Part of this has to do with an ailing China, but the other component, the lack of supply destruction, has to do with the aforementioned financing making continued operations more sensible on paper than throttling or shutting down extraction projects.
As a result, it would appear as though we are in the midst of a vicious commodity bear market that could be setting the stage for an incredible bull market in commodity prices.
As misallocation of resources leads to a lack of availability when demand does return, this will in turn cause a significant price shift higher as prices must destroy demand that cannot be met by supply.
Shifting sentiment can take years
The lead time for companies to re-expand their operations and engage in additional exploration generally takes years. That is to say, the shifting mindset from one of conservation of capital to one of speculation and euphoria will not happen overnight.
When it does, however, this bear market may be seen as a generational opportunity to have invested in commodities and the companies that produce them at a fraction of their fair market value.