After the Commodity Boom

John Hancock speculates on the fate of the Canadian economy if commodity prices fall.
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March 26, 2012
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The government’s dream of turning Canada into a resource superpower is predicated on one crucial assumption: that global commodity prices will continue their inexorable rise. 

That assumption is – at best – optimistic. Hard as it is to believe with gasoline prices surging passed $1.30 per litre, the current decade-long commodity boom is a temporary aberration in the otherwise relentless decline in raw-material prices over the past 200 years. This is not the first time in history that commodity markets have soared: Prices rose before the First World War, after the Second, and again in the 1970s. But each great boom was invariably followed by a great bust. And over the long run, the real price of almost every raw material – from oil to iron to copper to corn – has slid steadily downwards.

The explanation lies with the power of technology to outrace scarcity. Economic expansion drives up commodity prices as markets swallow limited resources and demand outstrips supply. But rising prices also increase incentives to invest in new exploration, new extraction methods, new infrastructure, and new, more efficient, ways to use existing (or substitute) resources. Sooner or later, supply outstrips demand and prices tumble again, weakening incentives to explore, invest, and innovate, thus laying the groundwork for the next big resource “crisis.”

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The perception that mining, forestry, or farming are low-tech industries – mere “hewers of wood and drawers of water” – couldn’t be further from the truth. (Think vast prairie agribusinesses or the Hibernia oil platform.) But massive productivity and efficiency gains also translate into falling resource prices and declining shares of global output – allowing us to spend more and more of our incomes on cars, gadgets, and holidays abroad. Less than five per cent of North Americans are farmers or miners today, compared to almost 50 per cent a century ago. Our great-grandparents saved for coal, we save for iPads. All signs point to a world economy moving inexorably away from the raw-material age, through the machine age, to the information age.

It’s possible that the current commodity boom is different – that population growth, declining reserves, and the mass industrialization of China and other emerging giants has opened up a yawning gap between rising global demand and finite global supplies that technology can’t bridge, creating a permanent shift in the price structure of resources. Thomas Robert Malthus wasn’t wrong, just premature.

But things have been “different” before. In 1972, at the height of the energy crisis, the Club of Rome gloomily predicted that exponential rates of growth and resource depletion would result in the world running out of gold by 1981, mercury by 1985, tin by 1987, zinc by 1990, oil by 1992, and natural gas by 1993 – less than a decade before the onset of a 20-year commodity glut. Two centuries before that, Malthus warned that population increases would overwhelm finite food supplies and plunge humanity into starvation. Since then, the world’s population has grown seven-fold and the economy 16-fold.

Already, today’s sky-high commodity prices are spurring a wave of new investment and innovation in the resource sector. Hydraulic fracking technology is an obvious example, responsible for turning the U.S. from a major natural-gas importer to an emerging gas exporter – and slashing prices by two-thirds – in less than a decade. Advances in technology and infrastructure are transforming the U.S. into the world’s fastest-growing oil producer, as well. Just last week, Citigroup analysts offered the startling prediction that the U.S. could eclipse Russian and Saudi Arabian oil production by 2020, and that oil prices would fall. China, too, is responding to its dependence on scarce raw materials by dramatically ramping up its domestic output of coal, nickel, and other raw materials, and by investing massively in oversees oilfields, mines, and farmland. Meanwhile, global output of iron ore, copper, and other raw materials is rising exponentially, giant new oil fields have been discovered off the coasts of Africa and Latin America, and science is coming up with substitute materials, alternative energy sources, and more efficient ways to use them.

Add to this the fact that the tidal wave of speculative capital pouring into commodity markets – the result of huge money supply growth and investors’ search for hard assets – could flow out again just as quickly when supply outpaces demand and prices fall, and some analysts now predict not an endlessly rising commodity market, but the inevitable bursting of a global commodity bubble.

This is not an argument for Canada turning its back on industries where it has a comparative advantage. But it is an argument for saving a greater share of Canada’s resource bonanza while the good times last. Where’s the Canadian equivalent of Norway’s $570-billion Oil Fund, for example, after decades of energy-industry profits? It’s also an argument for focusing more on the supplier, services, and R&D sides of the industry, which is where the main value is added. Why are Chicago and New York, and not Toronto, the main commodity-market hubs? And why are so few of the world’s top mining and energy companies headquartered in Canada?

Above all, it’s an argument for recognizing that – if history’s any guide – this long commodity boom will eventually be followed by a long bust. Canada’s economic future hinges on more than tar sands or pipelines.

Photo courtesy of Reuters