Jeremy Grantham, "Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever" - Jeremy Grantham - Does anybody want to read a horribly formatted copy-paste of an Acrobat PDF?

Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever - Jeremy Grantham

I'm using a Windows 98 computer at home, and I can't install any newer versions of Acrobat, so I couldn't read this pdf. I went to the library, read it there, and then copied and pasted it, and emailed it to myself. It has ABSOLUTELY HORRIBLE formatting because of being copied and pasted - the original, obviously, didn't look anything like this, and it had graphs and images. Still, someone can glance through this. I decided to paste it here because somebody found my blog while looking for Jeremy Grantham, and I also saw that other people on the net were having the same problem I was having, of not being able to read the pdf file.

Here it is. I warned you: very long, and horrible formatting.

GMO
QUARTERLY LETTER
April 2011
Time to Wake Up: Days of Abundant Resources and
Falling Prices Are Over Forever
Jeremy Grantham
Summary of the Summary
The world is using up its natural resources at an alarming rate, and
this has caused a permanent shift in their value.
We all need to adjust our behavior to this new environment. It would
help if we did it quickly.
Summary
 Until about 1800, our species had no safety margin and lived, like
other animals, up to the limit of the food supply,
ebbing and fl owing in population.
 From about 1800 on the use of hydrocarbons allowed for an explosion
in energy use, in food supply, and, through
the creation of surpluses, a dramatic increase in wealth and scientifi
c progress.
 Since 1800, the population has surged from 800 million to 7 billion,
on its way to an estimated 8 billion, at
minimum.
 The rise in population, the ten-fold increase in wealth in developed
countries, and the current explosive growth in
developing countries have eaten rapidly into our fi nite resources of
hydrocarbons and metals, fertilizer, available
land, and water.
 Now, despite a massive increase in fertilizer use, the growth in
crop yields per acre has declined from 3.5% in
the 1960s to 1.2% today. There is little productive new land to bring
on and, as people get richer, they eat more
grain-intensive meat. Because the population continues to grow at over
1%, there is little safety margin.
 The problems of compounding growth in the face of fi nite resources
are not easily understood by optimistic,
short-term-oriented, and relatively innumerate humans (especially the
political variety).
 The fact is that no compound growth is sustainable. If we maintain
our desperate focus on growth, we will run
out of everything and crash. We must substitute qualitative growth for
quantitative growth.
 But Mrs. Market is helping, and right now she is sending us the
Mother of all price signals. The prices of all
important commodities except oil declined for 100 years until 2002, by
an average of 70%. From 2002 until now,
this entire decline was erased by a bigger price surge than occurred
during World War II.
 Statistically, most commodities are now so far away from their
former downward trend that it makes it very
probable that the old trend has changed – that there is in fact a
Paradigm Shift – perhaps the most important
economic event since the Industrial Revolution.
 Climate change is associated with weather instability, but the last
year was exceptionally bad. Near term it will
surely get less bad.
 Excellent long-term investment opportunities in resources and
resource effi ciency are compromised by the high
chance of an improvement in weather next year and by the possibility
that China may stumble.
 From now on, price pressure and shortages of resources will be a
permanent feature of our lives. This will
increasingly slow down the growth rate of the developed and developing
world and put a severe burden on poor
countries.
 We all need to develop serious resource plans, particularly energy
policies. There is little time to waste.
GMO
QUARTERLY LETTER
April 2011
Time to Wake Up: Days of Abundant Resources and
Falling Prices Are Over Forever
Jeremy Grantham
Introduction
The purpose of this, my second (and much longer) piece on resource
limitations, is to persuade investors with an
interest in the long term to change their whole frame of reference: to
recognize that we now live in a different, more
constrained, world in which prices of raw materials will rise and
shortages will be common. (Previously, I had
promised to update you when we had new data. Well, after a lot of
grinding, this is our fi rst comprehensive look at
some of this data.)
Accelerated demand from developing countries, especially China, has
caused an unprecedented shift in the price
structure of resources: after 100 hundred years or more of price
declines, they are now rising, and in the last 8 years
have undone, remarkably, the effects of the last 100-year decline!
Statistically, also, the level of price rises makes it
extremely unlikely that the old trend is still in place. If I am
right, we are now entering a period in which, like it or
not, we must fi nally follow President Carter’s advice to develop a
thoughtful energy policy and give up our carefree
and careless ways with resources. The quicker we do this, the lower
the cost will be. Any improvement at all in
lifestyle for our grandchildren will take much more thoughtful
behavior from political leaders and more restraint from
everyone. Rapid growth is not ours by divine right; it is not even
mathematically possible over a sustained period.
Our goal should be to get everyone out of abject poverty, even if it
necessitates some income redistribution. Because
we have way overstepped sustainable levels, the greatest challenge
will be in redesigning lifestyles to emphasize
quality of life while quantitatively reducing our demand levels. A
lower population would help. Just to start you off,
I offer Exhibit 1: the world’s population growth. X marks the spot
where Malthus wrote his defi ning work. Y marks
my entry into the world. What a surge in population has occurred since
then! Such compound growth cannot continue
with fi nite resources. Along the way, you are certain to have a
paradigm shift. And, increasingly, it looks like this is it!
Malthus and Hydrocarbons
Malthus’ writing in 1798 was accurate in describing the past – the
whole multi-million year development of our
species. For the past 150,000 years or so, our species has lived,
pushed up to the very limits of the available food
supply. A good rainy season, and food is plentiful and births are
plentiful. A few tough years, and the population
shrinks way back. It seems likely, in fact, that our species came
close to extinction at least once and perhaps several
times. This complete link between population and food supply was noted
by Malthus, who also noticed that we have
been blessed, or cursed, like most other mammals, with a hugely
redundant ability to breed. When bamboo blooms in
parts of India every 30 years or so, it produces a huge increase in
protein, and the rat population – even more blessed
than we in this respect – apparently explodes to many times its normal
population; then as the bamboo’s protein
bounty is exhausted, the rat population implodes again, but not before
exhibiting a great determination to stay alive,
refl ected in the pillaging of the neighboring villages of everything
edible. What hydrocarbons are doing to us is very
similar. For a small window of time, about 250 years (starting,
ironically, just in time to make Malthus’ predictions
based on the past look ridiculously pessimistic), from 1800 to, say,
2050, hydrocarbons partially removed the barriers
to rapid population growth, wealth, and scientifi c progress. World
population will have shot up from 1 to at least
8, and possibly 11, billion in this window, and the average per capita
income in developed countries has already
increased perhaps a hundred-fold (from $400 a year to $40,000). Give or take.
GMO 2 Quarterly Letter – Time to Wake Up – April 2011
As I wrote three years ago, this growth process accelerated as time
passed. Britain, leading the charge, doubled her
wealth in a then unheard of 100 years. Germany, starting later, did it
in 80 years, and so on until Japan in the 20th
century doubled in 20 years, followed by South Korea in 15. But Japan
had only 80 million people and South Korea
20 million back then. Starting quite recently, say, as the Japanese
surge ended 21 years ago, China, with nearly
1.3 billion people today, started to double every 10 years, or even
less. India was soon to join the charge and now,
offi cially, 2.5 billion people in just these two countries – 2.5
times the planet’s entire population in Malthus’ time
– have been growing their GDP at a level last year of over 8%. This,
together with a broad-based acceleration of
growth in smaller, developing countries has changed the world. In no
way is this effect more profound than on the
demand for resources. If I am right in this assumption, then when our
fi nite resources are on their downward slope,
the hydrocarbon-fed population will be left far above its sustainable
level; that is, far beyond the Earth’s carrying
capacity. How we deal with this unsustainable surge in demand and not
just “peak oil,” but “peak everything,” is
going to be the greatest challenge facing our species. But whether we
rise to the occasion or not, there will be some
great fortunes made along the way in fi nite resources and resource
effi ciency, and it would be sensible to participate.
Finite Resources
Take a minute to refl ect on how remarkable these fi nite resources
are! In a sense, hydrocarbons did not have to
exist. On a trivially different planet, this incredible, dense store
of the sun’s energy and millions of years’ worth of
compressed, decayed vegetable and animal matter would not exist. And
as for metals, many are scarce throughout the
universe and became our inheritance only through the death throes of
other large stars. Intergalactic mining does not
appear in so many science fi ction novels for nothing. These are truly
rare elements, ultimately precious, which, with
a few exceptions like gold, are used up by us and their remnants
scattered more or less uselessly around. Scavenging
refuse pits will no doubt be a feature of the next century if we are
lucky enough to still be in one piece. And what an
irony if we turned this inheritance into a curse by having our use of
it alter the way the environment fi ts together. After
millions of years of trial and error, it had found a stable and
admirable balance, which we are dramatically disturbing.
Exhibit 1
World Population: 1500-2050
Source: U.S. Census Bureau, United Nations Actual data as of 12/31/10
0
2,000,000,000
4,000,000,000
6,000,000,000
8,000,000,000
10,000,000,000
12,000,000,000
1500 1600 1700 1800 1900 2000
Actual Low Projection Mid Projection High Projection
1798: Malthus publishes
Essay on the Principle of Population
1938: I was born
X
Y
Quarterly Letter – Time to Wake Up – April 2011 3 GMO
Setting the Scene: A World Without Hydrocarbons
To realize how threatening it would be to start to run out of cheap
hydrocarbons before we have a renewable
replacement technology, we have only to imagine a world without them.
In 17th and 18th century Holland and Britain,
there were small pockets of considerable wealth, commercial success,
and technological progress. Western Europe
was just beginning to build canals, a huge step forward in
transportation productivity that would last 200 years and
leave some canals that are still in use today. With Newton, Leibniz,
and many others, science, by past standards, was
leaping forward. Before the world came to owe much to hydrocarbons,
Florence Nightingale – a great statistician,
by the way – convinced the establishment that cleanliness would save
lives. Clipper ships were soon models of presteam
technology. A great power like Britain could muster the amazing
resources to engage in multiple foreign wars
around the globe (not quite winning all of them!), and all without
hydrocarbons or even steam power. Population
worldwide, though, was one-seventh of today’s population, and life
expectancy was in the thirties.
But there was a near fatal fl aw in that world: a looming lack of
wood. It was necessary for producing the charcoal
used in making steel, which in turn was critical to improving
machinery – a key to progress. (It is now estimated that
all of China’s wood production could not even produce 5% of its
current steel output!) The wealth of Holland and
Britain in particular depended on wooden sailing ships with tall,
straight masts to the extent that access to suitable
wood was a major item in foreign policy and foreign wars. Even more
important, wood was also pretty much the sole
producer of energy in Western Europe. Not surprisingly, a growing
population and growing wealth put intolerable
strains on the natural forests, which were quickly disappearing in
Western Europe, especially in England, and had
already been decimated in North Africa and the Near East. Wood
availability was probably the most limiting factor
on economic growth in the world and, in a hydrocarbonless world, the
planet would have hurtled to a nearly treeless
state. Science, which depended on the wealth and the surpluses that
hydrocarbons permitted, would have proceeded
at a much slower speed, perhaps as little as a third of its actual
progress. Thus, from 1800 until today science might
have advanced to only 1870 levels, and, even then, advances in
medicine might have exceeded our ability to feed the
growing population. And one thing is nearly certain: in such a world,
we would either have developed the discipline
to stay within our ability to grow and protect our tree supply, or we
would eventually have pulled an Easter Island,
cutting down the last trees and then watching, fi rst, our quality of
life decline and then, eventually, our population
implode. Given our current inability to show discipline in the use of
scarce resources, I would not have held my
breath waiting for a good outcome in that alternative universe.
But in the real world, we do have hydrocarbons and other fi nite
resources, and most of our current welfare, technology,
and population size depends on that fact. Slowly running out of these
resources will be painful enough. Running out
abruptly and being ill-prepared would be disastrous.
The Great Paradigm Shift: from Declining Prices…
The history of pricing for commodities has been an incredibly helpful
one for the economic progress of our species: in
general, prices have declined steadily for all of the last century. We
have created an equal-weighted index of the most
important 33 commodities. This is not designed to show their
importance to the economy, but simply to show the
average price trend of important commodities as a class. The index
shown in Exhibit 2 starts 110 years ago and trends
steadily downward, in apparent defi ance of the ultimately limited
nature of these resources. The average price falls
by 1.2% a year after infl ation adjustment to its low point in 2002.
Just imagine what this 102-year decline of 1.2%
compounded has done to our increased wealth and well-being. Despite
digging deeper holes to mine lower grade
ores, and despite using the best land fi rst, and the best of
everything else for that matter, the prices fell by an average
of over 70% in real terms. The undeniable law of diminishing returns
was overcome by technological progress – a
real testimonial to human inventiveness and ingenuity.
But the decline in price was not a natural law. It simply refl ected
that in this particular period, with our particular
balance of supply and demand, the increasing marginal cost of, say,
2.0% a year was overcome by even larger
increases in annual productivity of 3.2%. But this was just a
historical accident. Marginal rates could have risen
GMO 4 Quarterly Letter – Time to Wake Up – April 2011
faster; productivity could have risen more slowly. In those
relationships we have been lucky. Above all, demand
could have risen faster, and it is here, recently, that our luck has
begun to run out.
… to Rising Prices
Just as we began to see at least the potential for peak oil and a
rapid decline in the quality of some of our resources,
we had the explosion of demand from China and India and the rest of
the developing world. Here, the key differences
from the past were, as mentioned, the sheer scale of China and India
and the unprecedented growth rates of developing
countries in total. This acceleration of growth affected global demand
quite suddenly. Prior to 1995, there was
(remarkably, seen through today’s eyes) no difference in aggregate
growth between the developing world and the
developed world. And, for the last several years now, growth has been
3 to 1 in their favor!
The 102 years to 2002 saw almost each individual commodity – both
metals and agricultural – hit all-time lows.
Only oil had clearly peeled off in 1974, a precursor of things to
come. But since 2002, we have the most remarkable
price rise, in real terms, ever recorded, and this, I believe, will go
down in the history books. Exhibit 2 shows this
watershed event. Until 20 years ago, there were no surprises at all in
the sense that great unexpected events like World
War I, World War II, and the double infl ationary oil crises of 1974
and 1979 would cause prices to generally surge;
and setbacks like the post-World War I depression and the Great
Depression would cause prices to generally collapse.
Much as you might expect, except that it all took place around a
downward trend. But in the 1990s, things started to
act oddly. First, there was a remarkable decline for the 15 or so
years to 2002. What description should be added to
our exhibit? “The 1990’s Surge in Resource Productivity” might be one.
Perhaps it was encouraged by the fall of
the Soviet bloc. It was a very important but rather stealthy move, and
certainly not one that was much remarked on
in investment circles. It was as if lower prices were our divine
right. And more to the point, what description do we
Exhibit 2
GMO Commodity Index: The Great Paradigm Shift
Source: GMO As of 2/28/11
World War I
Effect
Inflationary
Oil Shock
Post-war
Depression
Great
Depression
Great
Depression
Part 2
33 Commodity Index
10
100
Jan-1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
???
World War II
Effect
􀍲1.2%􀀃
Annual􀀃Decline
“The
Great
Paradigm
Shift”
Note: The GMO commodity index is an index comprised of the following
33 commodities, equally weighted at
initiation: aluminum, coal, coconut oil, coffee, copper, corn, cotton,
diammonium phosphate, flaxseed, gold, iron
ore, jute, lard, lead, natural gas, nickel, oil, palladium, palm oil,
pepper, platinum, plywood, rubber, silver, sorghum,
soybeans, sugar, tin, tobacco, uranium, wheat, wool, zinc.
Quarterly Letter – Time to Wake Up – April 2011 5 GMO
put on the surge from 2002 until now? It is far bigger than the one
caused by World War II, happily without World
War III. My own suggestion would be “The Great Paradigm Shift.”
The primary cause of this change is not just the accelerated size and
growth of China, but also its astonishingly
high percentage of capital spending, which is over 50% of GDP, a level
never before reached by any economy in
history, and by a wide margin. Yes, it was aided and abetted by India
and most other emerging countries, but still it
is remarkable how large a percentage of some commodities China was
taking by 2009. Exhibit 3 shows that among
important non-agricultural commodities, China takes a relatively small
fraction of the world’s oil, using a little over
10%, which is about in line with its share of GDP (adjusted for
purchasing parity). The next lowest is nickel at 36%.
The other eight, including cement, coal, and iron ore, rise to around
an astonishing 50%! In agricultural commodities,
the numbers are more varied and generally lower: 17% of the world’s
wheat, 25% of the soybeans (thank Heaven for
Brazil!) 28% of the rice, and 46% of the pigs. That’s a lot of pigs!
Optimists will answer that the situation that Exhibit 3 describes is
at worst temporary, perhaps caused by too
many institutions moving into commodities. The Monetary Maniacs may
ascribe the entire move to low interest
rates. Now, even I know that low rates can have a large effect, at
least when combined with moral hazard, on the
movement of stocks, but in the short term, there is no real world
check on stock prices and they can be, and often are,
psychologically fl akey. But commodities are made and bought by
serious professionals for whom today’s price is life
and death. Realistic supply and demand really is the main infl uence.
Exhibit 4 shows how out of line with their previous declining trends
most commodities are. We have stated this in
terms of standard deviations, but for most of us, certainly including
me, a probabilistic – 1-in-44-year event, etc. – is
more comprehensible. GMO’s extended work on asset bubbles now covers
330 completed bubbles, including even
quite minor ones. These bubbles have occurred only 30% or so more than
would be expected in a perfectly random
world. In a world where black swans are becoming very popular, this is
quite a surprise.
Exhibit 3
China’s Share of World Commodity Consumption
Source: Barclays Capital (2010), Credit Suisse (2010), Goldman Sachs,
United States Geological Survey (2009), BP Statistical
Review of World Energy (2009), Food and Agriculture Organization of
the United Nations (2008), International Monetary Fund (2010)
Commodity China % of World
Cement 53.2%
Iron Ore 47.7%
Coal 46.9%
Pigs 46.4%
Steel 45.4%
Lead 44.6%
Zinc 41.3%
Aluminum 40.6%
Copper 38.9%
Eggs 37.2%
Nickel 36.3%
Rice 28.1%
Soybeans 24.6%
Wheat 16.6%
Chickens 15.6%
PPP GDP 13.6%
Oil 10.3%
Cattle 9.5%
GDP 9.4%
GMO 6 Quarterly Letter – Time to Wake Up – April 2011
Exhibit 4 is headed by iron ore. It has a 1 in 2.2 million chance that
it is still on its original declining price trend.
Now, with odds of over a million to one, I don’t believe the data.
Except if it’s our own triple-checked data. Then I
don’t believe the trend! The list continues: coal, copper, corn, and
silver … a real cross section and all in hyper bubble
territory if the old trends were still in force. And look at the whole
list: twelve over 3-sigma, eleven others in 2-sigma
territory (which we have always used as the defi nition of a bubble),
four more on the cusp at 1.9, two more over 1.0,
and three more up. Only four are down, three of which are insignifi
cantly below long-term trend, and the single
outlier is not even an economic good – it’s what could be called an
economic “bad” – tobacco. This is an amazing
picture and it is absolutely not a refl ection of general investment
euphoria. Global stocks are pricey but well within
normal ranges, and housing is mixed. But commodities are collectively
worse than equities (S&P 500) were in the
U.S. in the tech bubble of 2000! If you believe that commodities are
indeed on their old 100-year downward trend,
then their current pricing is collectively vastly improbable. It is
far more likely that for most commodities the trend
has changed, just as it did for oil back in 1974, as we’ll see later.
Exhibit 4
The Mother of All Paradigm Shifts
Source: GMO As of 2/28/11
z􀍲score* Probability**
Iron􀀃Ore 4.9 1􀀃in􀀃2,200,000
Coal 4.1 1􀀃in􀀃48,000
Copper 3.9 1􀀃in􀀃17,000
Corn 3.8 1􀀃in􀀃14,000
Silver 3.7 1􀀃in􀀃9,300
Sorghum 3.5 1􀀃in􀀃4,300
Palladium 3.4 1􀀃in􀀃3,000
Rubber 3.3 1􀀃in􀀃2,100
Flaxseed 3.3 1􀀃in􀀃2,100
Palm􀀃Oil 3.2 1􀀃in􀀃1,500
Soybeans 3.1 1􀀃in􀀃1,000
Coconut􀀃Oil 3.0 1􀀃in􀀃740
Nickel 2.7 1􀀃in􀀃290
Gold 2.6 1􀀃in􀀃210
Oil 2.5 1􀀃in􀀃160
Sugar 2.5 1􀀃in􀀃160
Platinum 2.4 1􀀃in􀀃120
Lead 2.4 1􀀃in􀀃120
Wheat 2.4 1􀀃in􀀃120
Coffee 2.3 1􀀃in􀀃85
Diammonium􀀃Phosphate 2.1 1􀀃in􀀃56
Jute 2.1 1􀀃in􀀃56
Cotton 2.0 1􀀃in􀀃44
Uranium 1.9 1􀀃in􀀃35
Tin 1.9 1􀀃in􀀃35
Zinc 1.9 1􀀃in􀀃35
Potash 1.9 1􀀃in􀀃35
Wool 1.7 1􀀃in􀀃22
Aluminum 1.4 1􀀃in􀀃12
Lard 0.9 1􀀃in􀀃5
Pepper 0.5 1􀀃in􀀃3
Natural􀀃Gas 0.2 1􀀃in􀀃2
Plywood 􀍲0.1 1􀀃in􀀃2
Beef 􀍲0.1 1􀀃in􀀃2
Cocoa 􀍲0.1 1􀀃in􀀃2
Tobacco 􀍲3.3 1􀀃in􀀃2000
* z-score: difference between current price and long-term trend,
expressed in standard deviations
** Probability: implied probability under assumption of normal
distribution of valuations
Quarterly Letter – Time to Wake Up – April 2011 7 GMO
Aware of the fi nite nature of our resources, a handful of economists
had propounded several times in the past (but
back in the 1970s in particular) the theory that our resources would
soon run out and prices would rise steadily. Their
work, however, was never supported by any early warning indicators
(read: steadily rising prices) that, in fact, this
running out was imminent. Quite the reverse. Prices continued to fall.
The bears’ estimates of supply and demand
were also quite wrong in that they continuously underestimated cheap
supplies. But now, after more than another
doubling in annual demand for the average commodity and with a 50%
increase in population, it is the price signals
that are noisy and the economists who are strangely quiet. Perhaps
they have, like premature bears in a major bull
market, lost their nerve.
Why So Little Fuss?
I believe that we are in the midst of one of the giant infl ection
points in economic history. This is likely the beginning
of the end for the heroic growth spurt in population and wealth caused
by what I think of as the Hydrocarbon
Revolution rather than the Industrial Revolution. The unprecedented
broad price rise would seem to confi rm this.
Three years ago I warned of “chain-linked” crises in commodities,
which have come to pass, and all without a fullyfl
edged oil crisis. Yet there is so little panicking, so little analysis
even. I think this paradox exists because of some
unusual human traits.
The Problem with Humans
As a product of hundreds of thousands, if not millions, of years of
trial and error, it is perhaps not surprising that
our species is excellent at many things. Bred to survive on the open
savannah, we can run quite fast, throw quite
accurately, and climb well enough. Above all, we have excellent
spatial awareness and hand/eye coordination. We
are often fl exible and occasionally inventive.
For dealing with the modern world, we are not, however, particularly
well-equipped. We don’t seem to deal well with
long horizon issues and deferring gratifi cation. Because we could not
store food for over 99% of our species’ career
and were totally concerned with staying alive this year and this week,
this is not surprising. We are also innumerate.
Our typical math skills seem quite undeveloped relative to our nuanced
language skills. Again, communication
was life and death, math was not. Have you not admired, as I have, the
incredible average skill and, perhaps more
importantly, the high minimum skill shown by our species in driving
through heavy traffi c? At what other activity
does almost everyone perform so well? Just imagine what driving would
be like if those driving skills, which refl ect
the requirements of our distant past, were replaced by our average math skills!
We also became an optimistic and overconfi dent species, which early
on were characteristics that may have helped
us to survive and today are reaffi rmed consistently by the new breed
of research behaviorists. And some branches
of our culture today are more optimistic and overconfi dent than
others. At the top of my list would be the U.S.
and Australia. In a well-known recent international test,1 U.S.
students came a rather sad 28/40 in math and a very
mediocre eighteenth in language skills, but when asked at the end of
the test how well they had done in math, they
were right at the top of the confi dence list. Conversely, the Hong
Kongers, in the #1 spot for actual math skills, were
averagely humble in their expectations.
Fortunately, optimism appears to be a real indicator of future
success. A famous Harvard study in the 1930s found
that optimistic students had more success in all aspects of their
early life and, eventually, they even lived longer.
Optimism likely has a lot to do with America’s commercial success. For
example, we attempt far more ventures in
new technologies like the internet than the more conservative
Europeans and, not surprisingly, end up with more of
the winners. But optimism has a downside. No one likes to hear bad
news, but in my experience, no one hates it as
passionately as the U.S. and Australia. Less optimistic Europeans and
others are more open to gloomy talk. Tell a
Brit you think they’re in a housing bubble, and you’ll have a
discussion. Tell an Australian, and you’ll have World
War III. Tell an American in 1999 that a terrible bust in growth
stocks was coming, and he was likely to have told
1 P.I.S.A. Test 2003, OECD.
GMO 8 Quarterly Letter – Time to Wake Up – April 2011
you that you had missed the point, that 65 times earnings was justifi
ed by the Internet and other dazzling technology,
and, by the way, please stay out of my building in the future. This
excessive optimism has also been stuck up my nose
several times on climate change, where so many otherwise sensible
people would much prefer an optimistic sound
bite from Fox News than to listen to bad news, even when clearly
realistic. I have heard several brilliant contrarian
fi nancial analysts, siding with climate skeptics, all for want of,
say, 10 or 12 hours of their own serious analysis.
My complete lack of success in stirring up interest in our resource
problems has similarly impressed me: it was like
dropping reports into a black hole. Finally, in desperation, we have
ground a lot of data and, the more we grind, the
worse, unfortunately, it looks.
Failure to Appreciate the Impossibility of Sustained Compound Growth
I briefl y referred to our lack of numeracy as a species, and I would
like to look at one aspect of this in greater detail:
our inability to understand and internalize the effects of compound
growth. This incapacity has played a large role
in our willingness to ignore the effects of our compounding growth in
demand on limited resources. Four years ago
I was talking to a group of super quants, mostly PhDs in mathematics,
about fi nance and the environment. I used the
growth rate of the global economy back then – 4.5% for two years, back
to back – and I argued that it was the growth
rate to which we now aspired. To point to the ludicrous
unsustainability of this compound growth I suggested that we
imagine the Ancient Egyptians (an example I had offered in my July
2008 Letter) whose gods, pharaohs, language,
and general culture lasted for well over 3,000 years. Starting with
only a cubic meter of physical possessions (to make
calculations easy), I asked how much physical wealth they would have
had 3,000 years later at 4.5% compounded
growth. Now, these were trained mathematicians, so I teased them:
“Come on, make a guess. Internalize the general
idea. You know it’s a very big number.” And the answers came back:
“Miles deep around the planet,” “No, it’s much
bigger than that, from here to the moon.” Big quantities to be sure,
but no one came close. In fact, not one of these
potential experts came within one billionth of 1% of the actual
number, which is approximately 1057, a number so vast
that it could not be squeezed into a billion of our Solar Systems. Go
on, check it. If trained mathematicians get it so
wrong, how can an ordinary specimen of Homo Sapiens have a clue? Well,
he doesn’t. So, I then went on. “Let’s
try 1% compound growth in either their wealth or their population,”
(for comparison, 1% since Malthus’ time is less
than the population growth in England). In 3,000 years the original
population of Egypt – let’s say 3 million – would
have been multiplied 9 trillion times! There would be nowhere to park
the people, let alone the wealth. Even at a
lowly 0.1% compound growth, their population or wealth would have
multiplied by 20 times, or about 10 times more
than actually happened. And this 0.1% rate is probably the highest
compound growth that could be maintained for
a few thousand years, and even that rate would sometimes break the
system. The bottom line really, though, is that
no compound growth can be sustainable. Yet, how far this reality is
from the way we live today, with our unrealistic
levels of expectations and, above all, the optimistic outcomes that
are simply assumed by our leaders.
Now no one, in round numbers, wants to buy into the implication that
we must rescale our collective growth ambitions.
I was once invited to a monthly discussion held by a very diverse,
very smart group, at which it slowly dawned on
my jet-lagged brain that I was expected to contribute. So fi nally, in
desperation, I gave my fi rst-ever “running out of
everything” harangue (off topic as usual). Not one solitary soul
agreed. What they did agree on was that the human
mind is – unlike resources – infi nite and, consequently, the
intellectual cavalry would always ride to the rescue. I was
too tired to argue that the infi nite brains present in Mayan
civilization after Mayan civilization could not stop them
from imploding as weather (mainly) moved against them. Many other
civilizations, despite being armed with the
same brains as we have, bit the dust or just faded away after the
misuse of their resources. This faith in the human
brain is just human exceptionalism and is not justifi ed either by our
past disasters, the accumulated damage we
have done to the planet, or the frozen-in-the-headlights response we
are showing right now in the face of the distant
locomotive quite rapidly approaching and, thoughtfully enough, whistling loudly.
Hubbert’s Peak
Let’s start a more detailed discussion of commodities on by far the
most important: oil. And let’s start with by far the
largest user: the U.S. In 1956, King Hubbert, a Shell oil geologist,
went through the production profi le of every major
Quarterly Letter – Time to Wake Up – April 2011 9 GMO
U.S. oil fi eld and concluded that, given the trend of new discoveries
and the rate of run-off, U.S. oil production was
likely to peak in around 1970. Of course, vested interests and vested
optimism being what they are, his life was made
a total misery by personal attacks – it was said that he wasn’t a
patriot, that he was doing it all to enhance his own
importance, and, above all, that he was an idiot. But he was right:
U.S. production peaked in 1971! This, typically
enough, did not stop the personal attacks. There is nothing more
hateful in an opponent than his being right. In 1956,
Hubbert also suggested that a global peak would be reached in “about
50 years,” but after OPEC formed in 1974 and
prices jumped, he said it would probably smooth out production and
extend the peak by about 10 years, or to 2016,
give or take. Once again, this could be a remarkably accurate estimate!
The U.S. peak oil event of 1971 is important in rebutting today the
same arguments that he faced in the 1960s.
This time, these arguments are used against the idea that global oil
is nearing its peak. The arguments back then
were that technological genius, capitalist drive, and infi nite
engineering resourcefulness would always drive back
the day of reckoning. But wasn’t the U.S. in the 1960s full of the
most capitalist of spirits, Yankee know-how, and
resourcefulness? Didn’t the U.S. have the great oil service companies,
and weren’t there far more wells drilled here
than anywhere? All true. But, still, production declined in 1971 and
has slowly and pretty steadily declined ever
since. Even if we miss the inherent impossibility of compound growth
running into fi nite resources, how can we
possibly think that our wonderful human attributes and industriousness
will prevent the arrival of global peak oil
when we have the U.S. example in front of us?
Exhibit 5 shows that global traditional onshore oil, in fact, peaked
long ago in 1982, and that only much more
expensive offshore drilling and tertiary recovery techniques allowed
for even a modest increase in output, and that
at much higher prices. Exhibit 6 shows that since 1983, every year
(except one draw) less new conventional oil was
found than was actually pumped!
Exhibit 5
Global Oil Production – Onshore and Offshore, Conventional and Unconventional
Source: Energyfiles, Energy Information Administration, BP Statistical
Review of World Energy, Wood Mackenzie As of 12/31/10
0
10
20
30
40
50
60
70
80
90
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Millions of Barrels per Day
Offshore Deepwater
Onshore Unconventional
Offshore Conventional
Onshore Conventional
GMO 10 Quarterly Letter – Time to Wake Up – April 2011
Global Oil Prices, the First Paradigm Shift
We have seen how broad-based commodity prices declined to a trough
from 2000-03. Oil however, was an exception
and, given its approximate 50% weight by value, a very important
exception. In 1974, it split off from other
commodities, which continued to decline steeply. It was in 1974 that
an oil cartel, OPEC, was formed. What better
time could there be for a fast paradigm shift than during a cartel
forming around a fi nite resource?
Exhibit 7, which may be familiar to you, was developed when the penny
fi rst dropped for me fi ve years ago, and was
soon after reproduced in the Sunday New York Times. It shows that for
100 years oil had a remarkably fl at real price
of around $16/barrel in today’s currency, even as all other
commodities declined. It was always an exception in that
sense. Oil has a volatile price series, which is not surprising given
supply shocks, the diffi culty of storage, and, above
all, the very low price elasticity of demand in the short term. Normal
volatility is, relative to trend, more than a double
and less than a half, so that around the $16 trend we would normally
expect to see price spikes above $32 and troughs
below $8. Drawing in the dotted lines of 1 and 2 standard deviations,
it can be seen that the series is well behaved: it
should breach the 2-sigma line about 2.5 times up and 2.5 times down
in a 100-year period (because 2-sigma events
should occur every 44 years), and it does pretty much just that. It is
also clear that this well-behaved $16 trend line
was shifted quite abruptly to around $35/barrel in 1974, the year OPEC
began. And OPEC began in a very hostile
and aggressive mood, resulting in unusual solidarity among its
members. Oil prices remained very volatile around
this new higher trend, peaking in 1980 at almost $100 in today’s
currency (confi rming, to some degree, the new higher
trend) and falling back to $16 in 1999.
Today, looking at the oil price series from about 2003, it seems
likely that a second paradigm jump has occurred, to
about $75 a barrel, another doubling. Around this new trend, a typical
volatile oil range would be from over $150 to
under $37. The validity of this guess will be revealed in, say,
another 15 to 20 years. Stay tuned. There is, though, a
different support to this price analysis, and that is cost analysis.
We are not (yet, anyway) experts in oil costs, but as
far as we are able to determine, the full cost of fi nding and
delivering a major chunk of new oil today is about $70 to
$80 a barrel. If true, this would make the idea of a second paradigm
jump nearly certain.
Exhibit 6
The Growing Gap – Regular Conventional Oil
Source: Association for the Study of Peak Oil and Gas
Note: “Regular Conventional Oil” excludes heavy oil (tar sands, oil
shale, etc.), deepwater oil, polar oil,
NGLs and refinery gain.
Quarterly Letter – Time to Wake Up – April 2011 11 GMO
The Great Paradigm Shift
So, oil caused my formerly impregnable faith in mean reversion to be
broken. I had always admitted that paradigm
shifts were theoretically possible, but I had fi nally met one nose to
nose. It did two things. First, it set me to
thinking about why this one felt so different to those false ones
claimed in the past. Second, it opened my eyes to the
probability that others would come along sooner or later.
The differences in this paradigm shift are obvious. All of the typical
phantom paradigm shifts are optimistic. They
often look more like justifi cations for high asset prices than
serious arguments. They are also usually compromised
by the source. It is simply much more profi table for the fi nancial
services business to have long bull markets that
overrun and then crash quite quickly than it is to have stability.
Imagine how little money would be made by us if the
U.S. stock market rose by its dreary 1.8% a year adjusted for infl
ation, its trend since 1925. Volume would dry up,
as would deals, and we’d die of boredom or get a different job. In
short, beware a broker or a sell side “strategist”
offering arguments as to why overpriced markets like today’s are
actually cheap. Finally, the public in general appears
to like things the way they are and always seems eager to embrace the
idea of a new paradigm. The oil paradigm
shift and the “running out of everything” argument is the exact
opposite: it is very bad news and, like all very bad
news, ordinary mortals and the bullishly-biased fi nancial industry
seriously want to disbelieve it or completely ignore
it. (Just as is the case with climate warming and weather
instability.) It is in this sense a classic contrarian argument
despite being a paradigm shift.
Metals
On the second point – looking for other resources showing signs of a
paradigm shift – the metals seemed the next most
obvious place to start: they are fi nite, subject to demand that has
been compounding (that is, more tonnage is needed
each year), and, after use, are mostly worthless or severely reduced
in value and expensive to recycle. Copper, near
the top of the standard deviation list, has an oil-like tendency for
the quality of the resource to decline and the cost of
production to rise. Exhibit 8 shows that since 1994 one has to dig up
an extra 50% of ore to get the same ton of copper.
Exhibit 7
At Last, a Paradigm Shift: Oil in 1974
Source: Global Financial Data, GMO As of 3/31/11
Jan-1875 1887 1899 1911 1923 1935 1947 1959 1971 1983 1995 2007
$75?
0
20
40
60
80
100
120
140
160
180
01/31/1875 01/31/1887 01/31/1899 1/31/1911 1/31/1923 1/31/1935
1/31/1947 1/30/1959 1/29/1971 1/31/1983 1/31/1995 1/31/2007
WTI Crude $ / Barrel
Avg.
All Oil Prices in 2010 Dollars
+2 Std Dev: 1875-1972
+1 Std Dev: 1875-1972
+2 Std Dev:
1973-2005
+1 Std Dev:
1973-2005
+2 Std Dev:
2006-2011
+1 Std Dev:
2006-2011
GMO 12 Quarterly Letter – Time to Wake Up – April 2011
And all of this 150% effort has to be done using energy at two to four
times the former price. These phenomena of
declining ore quality and rising extraction costs are repeated across
most important metals. The price of all of these
metals in response to rising costs and rising demand has risen far
above the old declining trend, at least past the 1-in-
44-year chance. (There is a possibility, I suppose, that some of the
price moves are caused by a cartel-like effect
between the few large “miners.” There just might have been some
deliberate delays in expansion plans, which would
have resulted in extra profi ts, but it seems unlikely that this
possible infl uence would have caused much of the total
price rises. These very high prices are compatible with such
possibilities, but I am in no position to know the truth of
it.) There also might be some hoarding by users or others, but given
the extent of the price moves, it is statistically
certain that hoarding could not come close to being the only effect
here. Once again, the obvious primary infl uence is
increased demand from developing countries, overwhelmingly led by
China; and that we are dealing with a genuine
and broad-based paradigm shift.
The highest percentage of any metal resource that China consumes is
iron ore, at a barely comprehensible 47% of
world consumption. Exhibit 9 shows the spectacular 100-year-long
decline in iron ore prices, which, like so many
other commodities, reach their 100-year low in or around 2002. Yet,
iron ore hits its 110-year high a mere 8 years
later! Now that’s what I call a paradigm shift! Mining is clearly
moving out of its easy phase, and no one is trying to
hide it. A new power in the mining world is Glencore (soon to be
listed at a value of approximately $60 billion). Its
CEO, Ivan Glasenberg, was quoted in the Financial Times on April 11,
describing why his fi rm operates in the Congo
and Zambia. “We took the nice, simple, easy stuff fi rst from
Australia, we took it from the U.S., we went to South
America… Now we have to go to the more remote places.” That’s a pretty
good description of an industry exiting
the easy phase and entering the downward slope of permanently higher
prices and higher risk.
Agricultural Commodities
Moving on to agriculture, the limitations are more hidden. We think of
ourselves as having almost unlimited land
up our sleeve, but this is misleading because the gap between fi
rst-rate and third-rate land can be multiples of output,
and only Brazil, and perhaps the Ukraine, have really large potential
increments of output. Elsewhere, available
Exhibit 8
Recoverable Copper Ore Yield Grade
Source: Barclays Capital As of 12/31/10
0.50%
0.55%
0.60%
0.65%
0.70%
0.75%
0.80%
1980 1985 1990 1995 2000 2005 2010
Quarterly Letter – Time to Wake Up – April 2011 13 GMO
land is shrinking. For centuries, cities and towns have tended to be
built not on hills or rocky land, but on prime
agricultural land in river valleys. This has not helped. We have,
though, had impressive productivity gains per acre
in the past, and this has indeed helped a lot. But, sadly, these gains
are decreasing. Exhibit 10 shows that at the
end of the 1960s, average gains in global productivity stood at 3.5%
per year. What an achievement it was to have
Exhibit 9
Iron Ore Prices (2011 $/dry metric ton)
Source: Global Financial Data As of 12/31/10
$0
$50
$100
$150
$200
$250
Jan-1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
1971 1976 1981 1986 1991 1996 2001 2006
10-Year Average Annual Growth in Crop Yields
10-Year Average Annual
Growth in Population
Exhibit 10
10-Year Average Annual Growth in Crop Yields
Source: Food and Agriculture Organization of the United Nations As of 12/31/09
GMO 14 Quarterly Letter – Time to Wake Up – April 2011
maintained that kind of increase year after year. It is hardly
surprising that the growth in productivity has declined.
It runs now at about one-third of the rate of increase of the 1960s.
It is, at 1.25% a year, still an impressive rate, but
the trend is clearly slowing while demand has not slowed and, if
anything, has been accelerating. And how was this
quite massive increase in productivity over the last 50 years
maintained? By the even more rapid increase in the
use of fertilizer. Exhibit 11 shows that fertilizer application per
acre increased fi ve-fold in the same period that the
growth rate of productivity declined. This is a painful relationship,
for there is a limit to the usefulness of yet more
fertilizer, and as the productivity gains slow to 1%, it bumps into a
similar-sized population growth. The increasing
use of grain-intensive meat consumption puts further pressure on grain
prices as does the regrettable use of corn in
ethanol production. (A process that not only deprives us of food, but
may not even be energy-positive!) These trends
do not suggest much safety margin.
The fertilizer that we used is also part of our extremely fi nite
resources. Potash and potassium are mined and, like all
such reserves, the best have gone fi rst. But the most important
fertilizer has been nitrogen, and here, unusually, the
outlook for the U.S. really is quite good for a few decades because
nitrogen is derived mainly from natural gas. This
resource is, of course, fi nite like all of the others, but with
recent discoveries, the U.S. in particular is well-placed,
especially if in future decades its use for fertilizer is given precedence.
More disturbing by far is the heavy use of oil in all other aspects of
agricultural production and distribution. Of all
the ways hydrocarbons have allowed us to travel fast in development
and to travel beyond our sustainable limits, this
is the most disturbing. Rather than our brains, we have used brute
energy to boost production.
Water resources both above and below ground are also increasingly
scarce and are beginning to bite. Even the subsoil
continues to erode. Sooner or later, limitations must be realized and
improved techniques such as no-till farming must
be dramatically encouraged. We must protect what we have. It really is
a crisis that begs for longer-term planning
– longer than the typical horizons of corporate earnings or
politicians. The bottom line is, as always, price, and the
recent signals are clear. Exhibit 12 shows the real price movements of
four critical agricultural commodities – wheat,
0
2
4
6
8
10
12
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Exhibit 11
Tons of Fertilizer Used Annually (per sq km of cropland)
Source: Food and Agriculture Organization of the United Nations As of 12/31/08
Quarterly Letter – Time to Wake Up – April 2011 15 GMO
rice, corn, and soybeans – in the last few years. Unlike many other
commodities, these four are still way below their
distant highs, but from their recent lows they have all doubled or tripled.
Bulls will argue that these agricultural commodities are traditional
bubbles, based on euphoria and speculation, and are
destined to move back to the pre-2002 prices. But ask yourselves what
happens when the wheat harvest, for example,
comes in. Only the millers and bakers (actually the grain traders who
have them as clients) show up to buy. Harvard’s
endowment doesn’t offer to take a million tons and store it in Harvard
Yard (although my hero, Lord Keynes, is
famously said to have once seriously considered stacking two months’
of Britain’s supply in Kings College Chapel!).
The price is set by supply and demand, and storage is limited and
expensive. All of the agricultural commodities
also interact, so, if one were propped up in price, farmers on the
margin would cut back on, say, soybeans and grow
more wheat. For all of these commodities to move up together and by so
much is way beyond the capabilities of
speculators. The bottom line proof is that agricultural reserves are
low – dangerously low. There is little room in that
fact for there to be any substantial hoarding to exist.
Weather Instability and Price Rises
But there is one factor big enough, on rare occasions, to move all of
the agricultural commodities together, and that
is weather, particularly droughts and fl oods. I don’t think the
weather instability has ever been as hostile in the last
100 years as it was in the last 12 months. If you were to read a
one-paragraph summary of almost any agricultural
commodity, you would see weather listed as one of the causes of the
price rising. My sick joke is that Eastern
Australia had average rainfall for the last seven years. The fi rst
six were the driest six years in the record books, and
the seventh was feet deep in unprecedented fl oods. Such “average”
rainfall makes farming diffi cult. It also makes
Exhibit 12
Real Grain Prices (2011 $/bushel)
Corn
$0
$1
$2
$3
$4
$5
$6
$7
$8
Jan-00 01 02 03 04 05 06 07 08 09 10 11
Wheat
$0
$2
$4
$6
$8
$10
$12
Jan- 00 01 02 03 04 05 06 07 08 09 10 11
Soybeans
$0
$2
$4
$6
$8
$10
$12
$14
$16
$18
Jan-00 01 02 03 04 05 06 07 08 09 10 11
Rice
$0
$2
$4
$6
$8
$10
$12
$14
$16
$18
$20
Jan- 00 01 02 03 04 05 06 07 08 09 10 11
Source: Global Financial Data As of 2/28/11
GMO 16 Quarterly Letter – Time to Wake Up – April 2011
investing in commodities diffi cult currently, for the weather this
next 12 months is almost certain to be less bad than
the last, and perhaps much less bad.
The Unusual Entry Risk Today in Commodity Investing: Weather …
For agricultural commodities, it is generally expected that prices
will fall next year if the weather improves. Because
global weather last year was, at least for farming, the worst in many
decades, this seems like a good bet. The scientifi c
evidence for climate change is, of course, overwhelming. A point of
complete agreement among climate scientists is
that the most dependable feature of the planet’s warming, other than
the relentless increase in the parts per million of
CO2 in the atmosphere, is climate instability. Well, folks, the last
12 months were a monster of instability, and almost
all of it bad for farming. Skeptics who have little trouble
rationalizing facts will have no trouble at all with weather,
which, however dreadful, can never in one single year offer more than
a very strong suggestion of long-term change.
Unfortunately, I am confi dent that we should be resigned to a high
probability that extreme weather will be a feature
of our collective future. But, if last year was typical, then we
really are in for far more serious trouble than anyone
expected. More likely, next year will be more accommodating and, quite
possibly, just plain friendly. If it is, we will
drown, not in rain, but in grain, for everyone is planting every
single acre they can till. And why not? The current
prices are either at a record, spent just a few weeks higher in 2008,
or were last higher decades ago. The institutional
and speculative money does not, in my opinion, drive the spot prices
higher for reasons given earlier, but they do
persistently move the more distant futures contracts up.
Traditionally, farmers had to bribe speculators to take some
of the future price risk off of their hands. Now, Goldman Sachs and
others have done such a good job of making the
case for commodities as an attractive investment (on the old idea that
investors were going to be paid for risk-taking),
that the weight of money has pushed up the slope of the curve. This
not only destroys the whole reason for investing
in futures contracts in the fi rst place, but, critically for this
current argument, it lowers the cost to the farmers of laying
off their price risk and thus enables, or at least encourages, them to
plant more, as they have in spades. Ironically,
institutional investing facilitates larger production and hence lower
prices! Should both the sun shine and the rain
rain at the right time and place, then we will have an absolutely
record crop. This would be wonderful for the sadly
reduced reserves, but potentially terrible for the spot price.
(Although wheat might be an exception because the
largest grower by far – China – is looking to be in very bad shape for
its upcoming harvest.)
… and China
Quite separately, several of my smart colleagues agree with Jim Chanos
that China’s structural imbalances will cause
at least one wheel to come off of their economy within the next 12
months. This is painful when traveling at warp
speed – 10% a year in GDP growth. The litany of problems is as follows:
a) An unprecedented rise in wages has reduced China’s competitive strength.
b) The remarkable 50% of GDP going into capital spending was partly
the result of a heroic and desperate effort to
keep the ship afl oat as the Western banking system collapsed. It
cannot be sustained, and much of the spending is
likely to have been wasted: unnecessary airports, roads, and railroads
and unoccupied high-rise apartments.
c) Debt levels have grown much too fast.
d) House prices are deep into bubble territory and there is an
unknown, though likely large, quantity of bad loans.
You have heard it all better and in more detail from both Edward
Chancellor2 and Jim Chanos. The signifi cance here
is that given China’s overwhelming infl uence on so many commodities,
especially in terms of the percentage China
represents of new growth in global demand, any general economic
stutter in China can mean very big declines in
some of their prices.
You can assess on your own the probabilities of a stumble in the next
year or so. At the least, I would put it at 1 in
4, while some of my colleagues think the odds are much higher. If
China stumbles or if the weather is better than
2 Edward Chancellor, “China's Red Flags,” GMO White Paper, March 23, 2010.
Quarterly Letter – Time to Wake Up – April 2011 17 GMO
expected, a probability I would put at, say, 80%, then commodity
prices will decline a lot. But if both events occur
together, it will very probably break the commodity markets en masse.
Not unlike the fi nancial collapse. That was
a once in a lifetime opportunity as most markets crashed by over 50%,
some much more, and then roared back.
Modesty should prevent me from quoting from my own July 2008 Quarterly
Letter, which covered the fi rst crash.
“The prices of commodities are likely to crack short term (see fi rst
section of this letter) but this will be just a tease.
[Editor’s Note: the section referred to is titled “Meltdown! The
Global Competence Crisis,” which discusses the
aftermath of the global fi nancial crisis.] In the next decade, the
prices of all raw materials will be priced as just what
they are, irreplaceable.” If the weather and China syndromes strike
together, it will surely produce the second “once
in a lifetime” event in three years. Institutional investors were too
preoccupied staying afl oat in early 2009 to have
obsessed much about the fi rst opportunity in commodities and, in any
case, everything else was also down in price. A
second commodity collapse in the next few years may also be
psychologically hard to invest in for it will surely bring
out the usual bullish argument: “There you are, its business as usual.
There are plenty of raw materials, so don’t listen
to the doomsayers.” Because it will have broad backing, this argument
will be hard to resist, but should be.
Residual Speculation
Finally, there is some good, old-fashioned speculation, particularly
in the few commodities that can be stored, like
gold and others, which are costly per pound. I believe this is a small
part of the total pressure on prices, and the same
goes for low interest rates, but together they have also helped push
up prices a little. Putting this speculation into
context, we could say that: a) we have increasing, but still routine,
speculation in commodities; b) this comes on top
of the much more important effects of terrible weather; and c) most
important of all, we have gone through a profound
paradigm shift in almost all commodities, caused by a permanent shift
in the underlying fundamentals.
The Creative Tension in Investing in Resources Today
As resource prices rise, the entire system loses in overall
well-being, but the world is not without winners. Good land,
in short supply, will rise in price, to the benefi t of land owners.
Technological progress in agriculture will add to the
value of land holdings. Fertilizer resources – potash and potassium –
will become particularly precious. Hydrocarbon
reserves will, of course, also increase in value. In general, owners
or controllers of all limited resources, certainly
including water, will benefi t. But everyone else will be worse off,
and a constrained-resource world will increase in
affl uence per capita more slowly than it would have otherwise, and
more slowly than in the past. Remember, this is
not simply a recycling of income and wealth as it was when Saudi
Arabia stopped some of its pumping for political
reasons. Then, we paid a few extra billion and they put money in the
bank for recycling. There was no net loss.
But now when they pump the last of the cheapest $5/barrel of oil and
we replace it with a $120/barrel from tortured
Canadian Tar Sands, the cost differential is a deadweight loss. GDP
accounting can make it look fi ne, and it certainly
creates more jobs but, like a few thousand men digging a hole with
teaspoons, it adds jobs but no incremental value
compared to the original cheap oil.
How does an investor today handle the creative tension between
brilliant long-term prospects and very high shortterm
risks? The frustrating but very accurate answer is: with great diffi
culty. For me personally it will be a great time
to practice my new specialty of regret minimization. My foundation,
for example, is taking a small position (say,
one-quarter of my eventual target) in “stuff in the ground” and
resource effi ciency. Given my growing confi dence in
the idea of resource limitation over the last four years, if
commodities were to keep going up, never to fall back, and
I owned none of them, then I would have to throw myself under a bus.
If prices continue to run away, then my small
position will be a solace and I would then try to focus on the more
reasonably priced – “left behind” – commodities. If
on the other hand, more likely, they come down a lot, perhaps a lot
lot, then I will grit my teeth and triple or quadruple
my stake and look to own them forever. So, that’s the story.
The Position of the U.S….
The U.S. is, of course, very well-positioned to deal with the
constraints. First, it starts rich, both in wealth and income
per capita, and also in resources, particularly the two that in the
long run will turn out to be the most precious: great
GMO 18 Quarterly Letter – Time to Wake Up – April 2011
agricultural land and a pretty good water supply. The U.S. is also
well-endowed with hydrocarbons. Its substantial
oil and gas reserves look likely to prove unexpectedly resilient,
buoyed by improving skills at fracking and lateral
drilling. And, by any standard, U.S. coal reserves are very large. All
other countries should be so lucky. Second, we
are the most profl igate or wasteful developed country and this fact,
paradoxically, becomes a great advantage. We in
the U.S. can save resources by the billions of dollars and actually
end up feeling better for it in the end, like someone
suffering from obesity who succeeds with a new diet.
The slowing growth in working age population has reduced the GDP
growth for all developed countries. Adding
resource limitations is further reducing it. If our GDP in the U.S.
grew 2% for the next 20 years, I think we would be
doing very well. Dropping to 1.5% would not surprise me, nor would it
be a disaster. In the past 28 years, we have
increased our GDP by 3.0% per year with only a 0.9% increase in energy
required. That is, we increased our energy
effi ciency by 2.1% without a decent energy policy and despite some
very ineffi cient pockets like autos and residential
housing. This would suggest that at a reduced 2% GDP growth rate, we
might expect little or no incremental demand
for energy, even without an improved effort. If in addition we halved
our defi cit in energy effi ciency compared with
Europe and Japan in the next 20 years, then our energy requirements
might drop at 1.5% a year. Given the plentiful
availability of low-hanging fruit in the U.S., this is achievable.
… as for the Rest
Other countries will not be so lucky. Almost all will suffer lower
growth, but resource-rich countries will have
a relative benefi t as the terms of trade continue to move in their
favor. Less obviously, those countries that are
particularly energy effi cient will also benefi t. If the Japanese,
for example, can produce over twice the GDP per unit
of energy than the Chinese, then, other things being equal, the terms
of trade will move in their favor as oil prices
rise. At the bottom of the list, poor countries with few resources and
little effi ciency, which already use up to 50% of
their income on the commodity “necessities,” will suffer. The irony
that they suffered the most having used up the
least will probably not make their misery less. Limited resources
create a win-lose proposition quite unlike the winwin
we are accustomed to in global trade. Theoretically, we all gain
through global trade as China grows. But with
limited resources, the faster they grow and the richer they get (and,
particularly, the more meat rather than grain that
they eat), the more commodity prices rise and the greater the squeeze
on the poorer countries and the relatively poor
in every country. It’s a gloomy topic. Suffi ce it to say that if we
mean to avoid increased starvation and international
instability, we will need global ingenuity and generosity on a scale
hitherto unheard of.
Conclusion
The U.S. and every other country need a longer-term resource plan,
especially for energy, and we need it now!
(Shorter-term views on the market and investment recommendations will
be posted shortly.)
Copyright © 2011 by GMO LLC. All rights reserved.
Disclaimer: The views expressed are the views of Jeremy Grantham
through the period ending April 25, 2011, and are subject to change at
any time based
on market and other conditions. This is not an offer or solicitation
for the purchase or sale of any security and should not be construed
as such. References to
specific securities and issuers are for illustrative purposes only and
are not intended to be, and should not be interpreted as,
recommendations to purchase or sell
such securities.