Commodities are cyclical. The prices of oil, wheat, aluminium and a range of raw materials move up and down hand in hand with the global economy. Cycles tend to be short and sprinkled with occasional anomalies. While the price of one particular commodity - say coffee - could spike at any given moment, the cost of another - say iron ore - could fall at exactly the same time.
Every few decades, however, the commodities industry experiences something completely different from the normal boom and bust sequence: a 'super-cycle', which abruptly lifts the price of almost every raw material to a much higher level.
The global economy is weathering one of these super-cycles right now, thanks principally to emerging market urbanisation and industrialisation. The financial crisis tested the resilience of this particular super-cycle. But soaring prices last year have proved that the experience of late 2008 and early 2009 was just a temporary blip within an upward trend, rather than the conclusion of another round of boom and bust in commodities markets.
While strong demand in nations such as China, India and Brazil is the main factor propelling commodities prices ever higher, other factors also play a part. Between 1985 and 2000, depressed commodities prices moved capital away from the natural resources industry and years of underinvestment ensued. As investment dwindled, so did supply growth.
Higher prices are pushing capital back into the natural resources industry, but it can take many years - in some cases as much as two decades - for exploration to turn into commercial production.
Discovering copper ore in a remote corner of Congo is one thing. Mining it, refining it and selling it is something else entirely. The road from one to the other can be long, arduous and riddled with pitfalls.
An increase in resource nationalism has imposed further pressure, as countries from Russia to Venezuela have demanded higher taxes for their vast natural resources, raising wholesale prices on a worldwide basis.
"Raw materials shortages, infrastructure constraints and resource nationalism continue to hamper production growth for many commodities, while emerging market demand is already soaring," says Roger Jones, co-head of global commodities at Barclays Capital. His views are shared by many other bankers and industry executives.
Super-cycles are relatively rare and only three took place during the whole of the 20th century. The first occurred during the First World War; the second, between 1950 and 1957, was fuelled by the reconstruction of Europe and Japan after the Second World War; and the third arose between 1972 and 1975, during the oil and food crisis.
The current super-cycle, which started around 2003, is somewhat different from these previous spells, dwarfing its predecessors in terms of magnitude, duration and breadth.
Raw materials cover energy, metals and food, and previous booms included one or two of those segments but never all three. The reconstruction effort that followed the Second World War lifted metal prices, and bad harvests pushed up the cost of agricultural products. Oil was unaffected.
In the 1970s, oil prices spiked and agriculture followed. But metals, after a brief jump, collapsed amid lower economic growth. The 1915-17 boom saw metals and agriculture rising, but oil prices remained stable. This time, all three sectors have been swept upwards.
The sheer scale of the price rises also stands out. "The magnitude of commodities price increases during the current boom is without precedent," says the World Bank. In real terms, commodities prices have more than doubled since 1999. By contrast, increases in earlier booms never exceeded 60 per cent, according to the World Bank's estimates.
Although speculators have been widely blamed for soaring prices, a closer look at the market shows that the fundamentals of supply, demand and inventories are at play. True, speculative activity has added a bit of froth, on both the upside and downside. But some raw materials are not even traded on financial markets and have still seen prices move sharply higher.
The cost of the CRB RIND index, which tracks the cost of non-exchange commodities, including raw materials such as metal scrap, tallow and burlap, has risen to an all-time high, above the peak of 2008.
"We are still ruled by Malthus: natural resources are scarce," says Carlos Murilo Barros de Mello, a commodities banker at Macquarie in Sao Paulo.
The strength, breadth and length of the current super-cycle pose multiple challenges for companies, particularly in Europe and the US, where economic growth is still weak. A few businesses are benefiting: oil and gas producers such as ExxonMobil, BP and Royal Dutch Shell; miners including BHP Billiton, Vale of Brazil and Rio Tinto; and commodities traders such as Glencore, Cargill and Vitol. But for most companies, the super-cycle is a problem. Commodities procurement costs are rising, volatility is unprecedented and, in some cases, critical raw materials are in desperately short supply.
Commodities consumers can respond on two fronts: price insurance, or hedging, should keep costs under reasonable control, and strengthening supply chains may avoid running short of critical raw materials.
Many companies already buy insurance to mitigate the impact of volatile foreign exchange or interest rates so they are not new to the concept of hedging. But apart from sectors such as airlines and power plants, few industries have tried to hedge against commodity risk.
This may seem strange but, until recently, chief executives dealt with rising commodities prices by simply passing increased costs to consumers. As raw materials prices rise more and more, however, passing the costs to consumers is proving increasingly difficult, particularly in fragile European economies.
Now companies are learning from airlines, which have systematically hedged against energy costs since the spike in oil prices during the Gulf War brought some of them to the brink of bankruptcy. Companies are moving slowly up the learning curve, but more commodities are being hedged and hedging periods are becoming longer.
In the past, hedging was palmed off on the treasury division. Now the most sophisticated companies have put chief executives and board members at the centre of their hedging policies. Hedging is also becoming more developed, as companies gain experience: from physical forward buying and the use of primitive financial contracts, some companies have moved to more complex policies, including the use of two- and three-way options.
The food industry is a good example of this trend. Large companies have launched systematic commodities hedging programmes, following the price shocks of 2007 and 2008, which left many of them reeling. Chief executives are also seeking to lock in prices for much longer than in the past. Will Shropshire, head of agriculture business at JPMorgan in London, says some companies are hedging sugar consumption until as far as 2015 to mitigate volatile prices.
Other companies are investing in production, reversing recent trends to sell upstream assets. Steelmakers, for example, are investing in iron ore and coking coal mines to cushion against rising prices. Food producers have yet to start investing in farming but they are moving closer to their suppliers, in some cases providing credit to farmers to secure output.
The other area of action is the supply chain. Not only has the price of commodities increased, but some companies are also facing localised shortages. The run on sugar in Portugal, which left supermarkets empty, is a classic example. And there is a global shortfall in coking, or metallurgical, coal after the recent severe flooding in Australia.
The issue of shortages has increased sharply over the past two decades as production has become concentrated on a few countries, with some exporters accounting for 30 to 40 per cent of global shipments. Ivory Coast and cocoa; Brazil and sugar; the US and corn; Chile and copper are some of the more extreme pairings. Chief executives have discovered, in panic, that they are not only exposed to price increases, but also that political, weather or operational problems could leave their business without supplies.
The surge in commodities prices is not an abstract - they have an actual impact on consumers and companies' margins. Take wheat: the cost of bread has surged more than 10 per cent over the last year and some companies, such as UK-based Hovis, have to fight with supermarkets such as Tesco to increase prices. The cost of Arabica coffee in the wholesale market has surged to a 34-year high. The result? Roasters have increased prices. For example, J.M. Smucker, which is behind the popular Folgers coffee brand and is seen as a price trendsetter, has hiked retail prices three times over the past 12 months and has warned a fourth increase could be coming soon.
But the impact goes beyond food. The surge in iron ore - more than double over the past year - has filtered into higher steel costs and is putting huge pressure on everyday goods, from cars to washing machines. Electrolux, the world's second-largest home appliances maker, announced in early February retail price increases of up to 10 per cent to cope with higher steel prices. Other companies are following suit.
Fortunately, even in the midst of this prolonged commodities super-cycle, it is worth remembering that in the world of raw materials, as in all other markets, cycles do turn. At some point in the future, prices will stop moving higher. Experts disagree on how long it will take, and most believe the upward trend will last at least another five years. Ultimately though, the pattern will change: but by that time, the plateau will almost certainly be considerably higher than it was before the current cycle began.
"In real terms, commodities prices have more than doubled since 1999. Increases in earlier booms never exceeded 60 per cent"
"The cost of Arabica coffee in the wholesale market has surged to a 34-year high so roasters have hiked retail prices three times over the last 12 months"
"Production has become concentrated on a few single countries, with some exporters accounting for 30 to 40 per cent of global shipments. Ivory Coast and cocoa; Brazil and sugar; the US and corn; Chile and copper are some of the more extreme pairings"
