Back on May 13, 2006 I wrote a letter titled “A more defensive stance” in which I stated that I thought metal prices had risen too high, too fast and that I had essentially sold half of my portfolio and moved 50% of the capital into cash. The following week I wrote a letter called “Gold will go up while commodities will go down” in which I said that I thought the bull market in commodities was now over, and that the gold price would decouple from base metal prices. I have essentially been saying the same ever since.

I recently got the following email: “I remember a few years ago when you declared that the commodities bull run WAS OVER. I wonder what your thoughts are on that TOTALLY wrong call?”

When I talk about commodities I try and make it clear that I am referring primarily to base metals, as opposed to gold, which I view as money. I do not recall ever making a call, one way or another, regarding soft commodity prices and I have stayed away from commenting on oil until just very recently. So my assertion that the bull market in commodities was over referred to the bull market in base metals. If my loose use of “commodities” instead of “base metals” has caused confusion, I apologize; however, anyone who has read my work or listened to my talks should have been able to recognize that I was referring principally to base metals.

Now, let’s see how wrong I have really been.

As I mentioned, I sold 50% of my stocks in early May 2006 after a tremendous increase in metals prices, and suggested the bull market in base metals had expired. In May 2006 the LMEX stood at 3,732 and last month it was 3,775 for a 1.2% nominal gain over two years. One could be excused for thinking the bull market in commodities is therefore still alive, albeit on life support; however, we cannot let the discussion stop there.

Merely looking at the nominal price change of the LMEX tells us very little about the real prices of base metals. Since I find it hard to understand how hedonic adjustments that are used to calculate the official CPI apply to base metal prices -- there has been no improvement in the quality of copper since 2006 – I used John Williams’ SGS-CPI (link) as a measure of price inflation. For the sake of brevity I will not use money supply since it would take more time to work through the inflation-adjustments and would not result in a materially different answer.

Adjusted for inflation we see that the real prices of base metals have in fact declined since May 2006. In May 2006 the LMEX stood at 3,732 and in May 2008 it was 18% lower at 3,061. An 18% decline in base metal prices over the past two years does not qualify as a bull market in my books and so I’ll stick to my assertion that the bull market in base metals is over, and that it ended in May 2006.

It is not hard to understand why base metal prices are falling in real terms. The largest economy in the world, by a wide margin, is the US and it is currently in recession; therefore the demand for base metals is falling. In addition, the UK economy is also in dire straights and so is the European economy. These economies also happen to be the largest consumers of Asian manufactured goods so I don’t see how Asian, and in particular Chinese, economic growth is going to be sufficient to keep the “bull” alive.

There are a lot of people who believe China’s internal economic growth is going to offset any decline in base metal demand from Europe and the United States. Below are two tables with data obtained from the World Bank. The first table shows China’s GDP in relation to Europe (specifically, the Euro area), the UK and the USA. As you can see, China’s total GDP is a mere fraction of the economies that are going through tough times.

Table 1: GDP in trillions of US dollars

	Euro Area	UK	US	China
GDP (2006)	$10.6	$2.3	$13.2	$2.6

China’s GDP is a mere 10% of that of Europe, the UK and the US combined. The latter are in recession or on their way to recession -- how is an economy only 10% the size of those with slowing growth to make up for lost base metal demand?
Perhaps more important, in the next table we look at China’s exports in relation to its GDP. Here we can see that China’s exports of goods and services represented 40% of its GDP in 2006 (2007 data has not yet been released). If 40% of China’s GDP is exports of goods and services, the majority of which is goods, and most of which is exported to the US, Europe and the UK, then I don’t see how China’s economy is going to sustain its current rate of growth during a recession in the West, never mind make up for lost base metal demand.

Table 2: China’s exports in relation to GDP

	Exports % GDP	Exports growth	Exports growth contribution to GDP growth	Annual GDP growth
2002	25.13%	29.42%	7.4%	9.1%
2003	29.56%	26.78%	7.9%	10.0%
2004	33.95%	28.42%	9.6%	10.1%
2005	37.30%	24.25%	9.0%	10.4%
2006	40.14%	23.29%	9.3%	10.7%
Average	33.20%	26.60%	9.0%	10.0%

Exports as a percentage of China’s GDP have steadily increased over the past five years. Now those export markets are no longer growing, and could in fact start contracting, so where is China’s growth going to come from? Just from simple arithmetic we can see that export growth alone has increased China’s GDP by an average of 9% per year over the past five years while total GDP growth over the same time period was only 10%. That means 90% of China’s GDP growth over the past five years was solely due to growth in exports.

China’s perceived insatiable demand for base metals is offset by a decline in demand from North America, Europe and Japan, as goods previously manufactured in those jurisdictions are now being manufactured in China. Metals imported by China are not being used to satisfy internal demand; they are being used to produce manufactured goods that are then exported. If export demand falters, China’s economy will falter, and its demand for base metals will falter as well. This is only now beginning to filter through to the metals markets and we have already seen that base metals prices are down 18% in real terms over the past two years.

Fundamentally I cannot see any good reason to believe that a bull market in base metals can sustain itself in real terms (inflation adjusted) while the US, the UK and Europe are going through a recession, and the LMEX price index we looked at earlier confirms this.

The week after I wrote that I thought the bull market in commodities (base metals) was over, I wrote that the gold price would decouple from base metal prices. This call was based on the fact that economic activity has a direct impact on base metal demand, and hence base metal prices, whereas the gold price is impervious to economic activity over the long run. The price of gold is merely a function of inflation and exchange rates.