All the tea in China, and then some

Whenever an investment comes to be seen as a “sure thing”, it is, at the very least, important to be wary of it. That is certainly the case today with funds that invest in natural resources companies.

Last year a consensus developed that commodities were likely to benefit as a result of global economic recovery and the rise of China. Fuel and metals were seen as set to gain enormously from the “China effect”. China’s rapid industrialisation and its demand for new infrastructure were assumed to be sources of incredible demand in the future.

It is certainly true that commodity prices have risen rapidly over the past year. The Economist Commodity index has risen by 19.2% in dollar terms. Metals did even better, with a rise of 43.6% over the same period.

Naturally, funds that invest in natural resource companies benefited as a result. Perhaps the most striking example is the Merrill Lynch Gold & General fund, which has long been the best performer over three years in the entire universe of funds sold in Britain.

But before diving into natural resources funds, it is important for fund strategists to take a closer look at the commodities market. For the idea that prices are bound to rise strongly over the medium to longer term is open to question.

Most obviously, it can be argued that rising commodity prices are at least partly a result of the weaker dollar. In euro terms, the Economist Commodity index actually fell by 2.5% in the past year. And in both yen and sterling terms the rise was only about 5%.

However, there are more fundamental reasons to question the assumption that the “China effect” will provide a permanent boost to commodity prices. It is simply a new version of one of the oldest and most pervasive mistakes in economics. Underlying the argument is the false assumption that demand is likely to rise rapidly while supply will be curtailed by natural factors.

Such reasoning was first popularised by Thomas Malthus (1766-1834) in his Essay On The Principle Of Population, which was first published in 1798. Malthus argued that population grows geometrically while food supply grows arithmetically. In other words, population growth was likely to outstrip the supply of food significantly. So if population was allowed to grow unchecked, he saw a future of disease, famine and war.

With the benefit of more than two centuries of hindsight – and despite the remaining problems in the world – it should be clear that Malthus was wrong. The world’s population is much larger than during Malthus’s time and yet on average people are far better fed and healthier than 200 years ago. For instance, during Malthus’s lifetime the average English person lived only to their late 30s.

Malthus grossly underestimated human ingenuity. In particular, he had little faith in the ability of human beings to learn to produce more efficiently. Agricultural yields – the amount of food that can be produced in a given area of land – have risen far faster than population. It has thus proved possible to have a much larger population that is also better fed.

Many of today’s commodity bulls reproduce Malthus’s arguments in a new form. Their focus is on fuel and metals rather than food. But they also argue that natural limits – in this case the amount of resources available – will put a brake on supply, and thus allow them to benefit from rising prices.

But such arguments confuse natural limits (the absolute amount of a commodity that is available on Earth) with social limits (the amount that is profitable to extract at any given time). Although this may seem like a pedantic distinction, it is of enormous importance. Failure to understand it has led to numerous alarmist predictions since Malthus’s time about resources running out.

The point can be understood more clearly by taking a specific example. Back in 1982, world proven crude oil reserves were 696 billion barrels, according Opec. Yet in 2002, after 20 more years of use, reserves had risen to 1,067 billion barrels.

Essentially, oil companies do not go looking for extra reserves until they believe it will be profitable to extract them. As Bjorn Lomborg, a noted critic of environmentalism, has argued, the conventional theory is like someone glancing at their fridge and saying to themselves: “Oh, you’ve only got food for three days. In four days you will die of starvation” (The Skeptical Environmentalist, Cambridge University Press 2001, p125). In reality, when someone gets close to running out of food, they will go to the supermarket to get more.

In relation to oil, there are numerous ways in which the supply could be extended in the future. On top of conventional supplies, the amount of shale oil – extracted from sand and rock – is 1,000 times greater than normal reserves. Although it is expensive to extract at present, it is likely to become cheaper over time. In addition, energy intensity – the amount of energy use per unit of GDP – is improving. America’s Energy Information Administration recently estimated that it is falling at an annual rate of 1.5%. Even if oil does run short, there is always the possibility of switching to new forms of energy, such as fuel cell technology or nuclear fusion. It is impossible to say for sure how the problem will be resolved, but, judging from history, it looks likely that new forms of energy will be found as old ones are used up.

What is true for oil is also true for metals. Vast supplies of most metals remain untapped. For instance, it is estimated that there are eight million tons of gold dissolved in seawater compared with only 100,000 tons quarried so far in human history. There are also substantial amounts of already-processed gold sitting in bank vaults – and the precious metal, unlike fuel, can be recycled.

As a result of human ingenuity, the “China effect” on commodity prices could be short-lived. If it becomes profitable to develop new sources of raw materials, it is likely to happen. Firms will race to supply China’s growing demand for natural resources. As new sources of supply are found, then prices could well fall. Human ingenuity will have won once again, but the victory may be bittersweet for investors in natural resources funds.

Top 10 natural resources funds over one year
Fund Name 1 Year %
JPMF Natural Resources 71.5
Merrill Lynch IIF World Mining 45.5
Merrill Lynch IIF New Energy 35.8
Merrill Lynch Gold & General 31.1
Merrill Lynch IIF World Gold 29.8
Baring Global Resources 28.6
Investec GSF Global Energy 19.8
Investec GSF Global Gold 19.3
Sogelux Fund Eq Gold Mines 17.5
F&C Global Resources 17.0
Category average 24.5%
Top 10 performers in the Natural Resources Equity category, Bid-to-bid, to January 13, 2004 Source: www.morningstar.co.uk