Commodity Cycle

A Commodity Cycle is the recurring, often long-term pattern of price fluctuations in raw materials, such as oil, copper, iron ore, and agricultural products. Think of it as the natural “breathing” of the raw materials market. These cycles are primarily driven by the fundamental economic principles of Supply and Demand. The key feature that makes these cycles so pronounced is the significant time lag between price signals and the actual supply response. When demand for a commodity like copper surges, it can take years to find a new deposit, secure permits, and build a mine. This delay means supply can't keep up, causing prices to soar. Eventually, new production comes online—often all at once—and can flood the market just as demand might be cooling, leading to a price crash. This inherent, slow-moving imbalance between supply and demand creates a powerful boom-and-bust rhythm that astute investors can learn to anticipate.

Like the changing of the seasons, a commodity cycle typically moves through four distinct phases. Understanding where we are in the “year” is crucial for an investor.

This is the bottom of the cycle. Prices are low, often below the cost of production for many suppliers. The market is plagued by oversupply, and headlines are filled with doom and gloom about bankruptcies and project cancellations. Demand is weak but may be showing the first faint signs of recovery. For a value investor, this is the point of maximum opportunity—a time to be “greedy when others are fearful,” as Warren Buffett advises.

As the global economy recovers, demand starts to outgrow the now-reduced supply. Prices begin a steady climb. Producers, still healing from the downturn, are hesitant to invest in new projects. As prices continue to rise, confidence returns, and companies cautiously start increasing Capital Expenditure (CapEx). The mood shifts from pessimism to cautious optimism. This is the “boom” phase, where fortunes begin to be made.

The party is in full swing. Demand is red-hot, and prices may go parabolic as shortages dominate the news. Producers are now spending aggressively on new capacity, fueled by easy credit and investor enthusiasm. This is often the point of maximum risk. The market is euphoric, and novice investors, driven by fear of missing out, pile in at the top. Meanwhile, the “smart money” may be quietly selling their positions as they see the massive new supply on the horizon.

The new supply that was commissioned during the peak finally starts hitting the market. Unfortunately, this often coincides with a slowing Economic Cycle, which dampens demand. The market tips from a deficit into a surplus. Prices plateau and then begin to fall, gathering downward momentum as producers scramble to sell their inventory. This is the “bust” phase, which sets the stage for the next winter.

Several powerful forces work together to create these dramatic swings.

This is the single most important factor. Think of the global supply of a commodity like an enormous oil tanker; you can't turn it on a dime. It takes years and billions of dollars to bring a new mine or oil field online. Because supply is so inelastic in the short term, even a small shift in demand can cause a dramatic price swing.

Demand for industrial commodities is tightly linked to global economic activity. Rapid industrialization in a large economy like China can create a “super-cycle” that pulls prices up for a decade or more. Conversely, a global recession, like the one seen in 2008, can crush demand and send prices plummeting. Watching the economic health of major players like the United States is key.

Investors using financial instruments like futures contracts can amplify the cycle's moves. In an uptrend, speculative buying can push prices far above what fundamentals might justify. In a downtrend, speculative selling can accelerate the crash. Speculation adds fuel to the fire, making the peaks higher and the troughs deeper.

For a value investor, the commodity cycle isn't something to fear; it's a field of opportunity. The key is to act counter-cyclically.

The strategy, as articulated by cycle-investing guru Howard Marks, is to be a contrarian. You should be buying shares in high-quality, low-cost commodity producers during the Winter, when their stock prices are battered and the market has written them off. The goal is to purchase these productive assets for far less than their long-term Intrinsic Value. When the Summer eventually arrives, you can sell them to the euphoric crowd at a handsome profit.

Spotting the bottom of a cycle is more art than science, but there are clues:

• Widespread industry pessimism and negative media coverage.
• Producers drastically cutting CapEx and shelving new projects.
• Industry consolidation and bankruptcies of high-cost producers.
• Prices falling below the marginal cost of production.

Commodity cycles are long-term affairs, often lasting 7-10 years from peak to peak. They don't adhere to a neat calendar. Investing in them requires immense patience and the fortitude to hold on—and even buy more—when it feels like the downturn will never end. As with all value investing, the focus is on the long game, not on trying to time the market perfectly.