An oil rig
As infrastructure aged and investment waned, so did the old economy’s ability to supply and deliver the commodities underpinning many finished products © Universal Images Group/Getty

The writer is global head of commodities research at Goldman Sachs

It is tempting to blame today’s shortages in the “old economy” — everything from energy to other basic materials, and even agriculture — on a series of temporary disruptions driven largely by the Covid-19 pandemic.

But outside of a few labour issues, these bottlenecks have little to do with Covid-19. Instead, the roots of today’s commodity crunch can be traced back to the aftermath of the financial crisis and the following decade of falling returns and chronic under-investment in the old economy.

As infrastructure aged and investment waned, so did the old economy’s ability to supply and deliver the commodities underpinning many finished goods. After years of neglect, today’s rising gas prices, copper supply shortfalls and China’s struggles with power generation are the “old economy’s revenge”.

In the economic stagnation following 2008, policymakers focused recovery efforts via central bank quantitative easing programmes to support markets. Lower-income households faced sluggish real wage growth, economic insecurity, tighter credit limits and increasingly unaffordable assets. Higher-income households, on the other hand, benefited from the financial asset inflation caused by QE.

This disparity in outcomes hit the old economy hard. In the old economy, price appreciation results when the volume of demand outstrips the volume of supply. Higher-income households may control the dollars, but lower-income households control the volume of commodity demand given their greater number and propensity to consume physical goods over services.

As the volume of demand for commodities waned, so did the returns for old economy sectors. Lower returns led to less long-cycle old economy capital expenditure — which traditionally requires a five to 10-year horizon of sufficient demand — in favour of short-cycle “new economy” in investment in areas such as technology.

Line chart of Global equity return indices, Q1 2002 = 100 showing 'Old economy' stock underperformance has damped capital expenditure

By 2013, this weakness backed up into China. As the world’s manufacturing engine slowed and commodities began their historic slide, the old economy’s capital flight intensified.

Indeed, the old economy was overbuilt, debt-laden and over-polluted. While the old economy only represents about 35 per cent of global gross domestic product, it generated at least 2 times the corporate losses, had about 90 per cent of the non-financial debt and created 80 per cent of the emissions. It is no wonder why investors preferred Big Tech to oil and copper.

After the oil price collapsed in 2015, markets were fed up with wealth destruction, nearly halting deal flows across the old economy. China stopped aggressively stimulating lossmaking enterprises such as coal mines. And as climate change became top of mind, investors put greater weight on environmental, social and governance issues, further restricting capital.

The resulting decline in investment prevented capacity growth in commodities. This has been particularly the case in hydrocarbons where divestiture by investors for ESG reasons compounded an already growing under-investment problem.

Column chart of US households' commodity demand, by income decile (commodities as a % of total consumption) showing Lower-income households have most influence on commodity demand

The severity of these supply constraints has been underlined as countries have moved into recovery mode from the pandemic, exposing just how stretched the old economy has become.

The pandemic also had a further effect, placing social needs more at the centre of policymakers’ agendas. Such inclusive growth has only accentuated the demand for physical commodities.

Shocks to one part of the system are now creating ripple effects elsewhere. Reduced coal output in China hit aluminium smelting capacity, creating shortages in aluminium. Reduced gas availability forced gas-to-oil substitution, generating shortages in oil. The rolling impact of smaller, frequent shocks on a stretched system generates the emergent phenomenon in which transitory shocks lead to persistent physical price inflation — the start of which we are seeing today.

This is where the revenge of the old economy will leave its mark. Periods of commodity price pressure will reoccur as broad-based demand meets inadequate infrastructure.

If policymakers’ goals of broad-based prosperity and a massive buildout in green infrastructure are to be met, commodity prices will need to significantly overshoot to the upside to provide the incentive for investment. This is needed to compensate for the growing risks involved in long-cycle capex projects and the inherent complexities surrounding the green energy transition. As we argued a year ago, a new commodity supercycle is upon us.

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