Canada’s Precarious Dependence on the Commodity Price Super-Cycle

04/22/2013 by Alex Carrick

Mid-April was not a good time for Canada’s raw materials sector. In the course of just a couple of days, an already weakening price of gold surrendered all restraint and plunged the most in three decades.

Falling from its most recent high of $1,900 per ounce to a low of $1,350 per ounce, gold has exhibited a “bear” market. The usual definitions of “bull” and “bear” markets are asset value swings of at least +20% and -20% respectively.

From previous peak to most current trough, the price of gold fell by nearly 30%. It has since recovered slightly.

Three primary reasons are cited for the floor-dropping air pocket.   

First, inflation is still nowhere to be found. Canada’s latest year-over-year increase in the Consumer Price Index (CPI) was only +1.0%. In the U.S., April’s inflation rate was a slow +1.5%.

Gold is usually seen as a hedge against rapid price run-ups. Central banks around the world have been keeping interest rates low while rapidly expanding the money supply. The Federal Reserve in the U.S. has been buying $85 billion per month in bonds and the Bank of Japan is about to embark on a similar 7.5 trillion-yen per month ($75 billion U.S.) bond-purchase spree.

Such loose monetary practices are supposed to cause an inflationary flare-up. So far, the impact has been negligible. Cries of alarm about imminent inflation are wearing thin. Doomsayers are growing fatigued.

Second, there is increasing speculation that the quantitative easing program in the U.S. will be terminated at the end of this year. This will remove another prop to worries about inflation.

Third, as part of its deficit and debt busting efforts, the central bank in Cyprus plans to sell off much of its (relatively small) gold reserves. This has led to concern that other central banks, particularly in the financially distressed Euro zone, will follow suit.  

Some of the price drop is in anticipation that there will be more gold for sale.

Naysayers like to point out that gold has little “intrinsic” value. That it has few industrial uses. That it derives its supposed worth from historical precedent.

Nevertheless, there’s something about its visual and tactile nature that has always made it appealing – from ancient times in Babylon and Egypt, through Aztec and Inca treasure troves, right up to the present. Even for modern couples, weddings aren’t “official” without a gold band.

Some analysts believe the price will drop to as low as $1,000 per ounce, bringing gold closer in line with its historical relationship to other commodities. But there’s also the alternative view that it will return to its previous high, probably not right away – since too many people have been badly burned in the latest collapse – but not so far in the future as one might suppose.

The largest portion of gold purchases globally is in the form of jewelry and coins. Rapid additions to the middle class in emerging nations will fuel further demand. Customers in China and India already account for about half the world’s sales. For many consumers in those two countries, as well as elsewhere, the drop in price is seen as a buying opportunity.

While the central bank in Cyprus may be about to sell gold, thereby applying a downward bias to the price, the bailout of the nation’s banks actually provides a reason for “gold bugs” to cling more firmly to their belief system. A dangerous precedent has been set.

As in most countries, there is insurance to cover deposits in Cypriot banks up to a certain cut-off point, 100,000 Euros. As part of the bailout process, however, depositors with accounts above that level will be required to forfeit nearly 40% of their holdings. They’ll receive shares in return, but no guarantee that they’ll ever be able to redeem them.

As an aside, many of the largest savings accounts at the two biggest banks in Cyprus belong to Russian oligarchs. This explains why the government in Nicosia, in its darkest days, approached Moscow for help with its financial troubles, all to no avail.

Gold is the antidote to anxiety. Its allure shines brighter in times of financial market uncertainty. The possibility that bank deposits may be less secure in any future European banking crisis will make gold more of a “safe haven” draw.  

But that’s longer-term. In the present, gold has had its moment in the sun and will spend a while relegated to the shade.

Another metal, copper – which does have important industrial uses (e.g., in pipes and wiring) – has also moved into bear territory.

The price drop for copper is a combination of an inventory build-up and lower-than-expected output growth in China. Chinese gross domestic product (GDP) expanded 7.7% in the first quarter of this year, which was a further slide from +7.9% in the fourth quarter of last year.

Two to three years out, copper prices will be supported by the shortage of new facilities coming on stream. Cost overruns and environmental issues are slowing natural resource development around the world. For example, Barrick Resources has just paused work at its giant Pascua-Lama gold and silver mining site on the Andes border between Chile and Argentina.

The days of annualized double-digit percentage gain in China’s GDP may be over. The figure is trending towards +6.0%, which will still be high but nothing like its former glory (+10.0% and more).

The nation’s own success story has set in motion a script re-write. The cost of labor is shifting higher, driving up the overall cost of production. Beijing is striving to move towards a more consumer-oriented economy, one with less reliance on export sales.

This may bring an end to the decade-long “super cycle” for commodity prices. The price of silver has fallen by an even greater percentage than gold. Nickel and aluminum prices are slipping.

None of this is good news for Canada, which relies heavily on raw material exports.

Even the price of oil – our nation’s major export – has retreated to only $88 U.S. per barrel for benchmark West Texas Intermediate (WTI). Natural gas “futures” sit well below $5.00 U.S. per million cubic feet.

Nor do we have the means (pipelines, etc.) to ship bitumen and liquefied natural gas (LNG) to markets in the Far East where the selling price is much higher.

This gloomy narrative may be overblown. China’s growth rate has moderated largely because its number one customer, Europe, is still in borderline recession. Once Europe is back on a healthy recovery path, China’s growth pace will improve.

And the plans for the Chinese economy may not be as disruptive as they first seem. Beijing is attempting to move the nation towards a stronger consumer-spending orientation. As part of this process, the value of the nation’s currency will be allowed to trade in a wider band.

An appreciation in the value of the yuan, versus the U.S. greenback, will raise the price of China’s export goods, but it will also lower the cost of its imports. Almost all commodities are priced in U.S. dollars.

Therefore, a higher-valued yuan will make all the basic materials used in Chinese manufacturing somewhat cheaper, thereby continuing to support a massive supply chain that draws on raw materials from around the world, including Canada.