Forgive the jargon, but as someone with a degree in math, I’m partial to the term “six-sigma” to connote events that veer sharply—on a statistical basis, by a factor of more than six standard deviations—from the norm or from anything you’d expect. A six-sigma event demands instant and close attention.

Jack Welch, former chairman of General Electric (GE), also liked the six-sigma concept. He used it to judge his managers: he wanted their performance to be above average by at least six-sigma. For example, if on average there were 6,000 defects per 1 million products, a six-sigma improvement would mean fewer than 4 defects per million. Such drastic improvement wouldn’t happen out of the blue. Rather, it would reflect the value of new procedures managers were tasked to implement.

Why do we bring this up? In recent years the behavior of commodities has exhibited six-sigma shifts, and changes that profound aren’t likely to be random or meaningless. The challenge is to know how to interpret them—in particular, to assess whether they foretell inexorably rising shortages in commodities. We think the answer is yes.

 Grantham: What He’s Missing

Not everyone agrees. Jeremy Grantham, a hugely successful and thoughtful money manager, initially had the same idea. In 2011 he argued that price gains in commodities like iron ore were so extreme as to suggest a “paradigm shift” signifying that more than 100 years of declining commodity prices had come to an end. Iron ore prices had climbed about six-sigma above their long-term downward sloping trend line. The average of more than 30 other commodities was about four-sigma above the downward sloping line. Such extreme deviations led Grantham to predict a future of ever rising commodity prices.

But with commodities then sharply declining, Grantham mostly reversed his position. He now believes that apart from oil, the 2011 high in commodities was merely a bubble, not a signpost that pointed to ongoing scarcities. As for oil, he still sees its price action as an indication of future scarcities and much higher prices. But he attributes the soaring prices seen pre-2011 in other commodities to China’s demand for minerals. When that faltered, the bubble burst. In other words, Grantham sees no case for ongoing commodity scarcities.

In backpedaling, however, Grantham is missing a key point: that it has become impossible to separate oil from other commodities. The correlations are just way too high—way higher, in fact, than the four- or six-sigma events that Grantham initially cited as evidence that a paradigm shift had occurred.

Specifically, since this century started, the correlation between changes in oil prices and changes in raw industrials except oil (burlap, cotton, copper scrap, print cloth, steel scrap, tin, zinc and others) is 0.77. With nearly 200 data points, the chances that such a number would occur by chance would equal about a 50-sigma event. It’s more likely that an asteroid will hit the earth in the next few minutes than not to have some relationship between the prices of oil and raw industrials.

In other words, while it was possible to separate oil from other commodities prior to this century, that’s no longer the case. The implications for all commodities are enormous.

As we’ll show shortly, the correlation between iron ore and the raw industrials index is equally compelling and important. Here there is a little overlap in that iron ore is a major component of scrap steel, which is one of the raw industrials in the index.

Cakes and Correlations

High correlations always demand explanations. Plenty of economic variables highly correlate with each other—consumption and income, for example. The connection here seems obvious: people who make more money will spend more money.

SAT scores and income are also highly correlated. The ready explanation is that greater income means better education and the ability to pay for SAT tutoring.

In looking at the oil/raw materials correlation, the first explanation that comes to mind is that mining raw materials requires energy; therefore, higher oil prices will likely translate into higher raw material prices.

The problem, however, is that if you look at the data relating to commodities prior to this century’s start, that explanation starts to fall apart. For the 15 years prior to 2000, there was no correlation between the index of raw industrials and oil. Similarly, iron ore had a near-zero correlation with raw industrials.

In other words, whatever now ties oil and raw industrials together occurred near the beginning of the century. And just for the record, the differences in correlations between those before and after the century’s start are also crazy-high sigma events.

To sort all this out, we must realize that just because one thing is necessary for another doesn’t ensure a high correlation between the two. Oil is a necessary ingredient in mining other commodities—among other things, without oil you can’t transport iron ore, or other commodities for that matter, over long distances. But that still wasn’t enough to lead to a high correlation between oil and other commodities pre-21st century. Why? Because oil wasn’t perceived then to be in danger of becoming scarce or unobtainable.

As an analogy, consider that butter may be a necessary ingredient for certain cakes. But the correlation between butter prices and the cake’s price, especially if you’re ordering it in a restaurant whose costs include such big-ticket items as rent and labor, might be very weak. In fact, butter could probably double in price without affecting the price of the cake.

But if butter suddenly became unnervingly scarce, available only from some rare and ecologically threatened cows raised in small herds in remote mountainous regions halfway around the world, the situation would change. The scarcity of butter, and even more, the looming possibility that it might become unavailable altogether, would doom any ability to turn out cakes and make butter a far more important factor directly linked to the price of the cake. No butter, no cake.

China’s Impact

Clearly, we imply this is occurring—that worries about oil scarcity have grown severe enough to become a major factor in determining those other commodities’ prices. And that is indeed true. China has been a big part of the reason.

Concern about oil scarcity isn’t something new under the sun. Since the 1970s, writers and philosophers from E.F. Schumacher to Buckminster Fuller have warned of the dangers of relying on finite balance sheet items like oil and other hydrocarbons, as opposed to income items like the sun and wind. But back then it still seemed to be a problem for the future.

Around the turn of the century, that future arrived. China became a big enough factor in the oil and commodity markets to suggest that true scarcities (not the phony kind caused by OPEC production cuts) were arriving. China’s late 2001 entry into the WTO meant China not only would be a major consumer of oil for its own use, but that oil consumption throughout the developing world, from Pakistan to Africa, would be burgeoning as China pursued its plans to help develop those regions. Recently, India has also entered the picture. This year and possibly for the foreseeable future, increases in demand for oil from Asia outside of China will exceed demand for oil in China.

China’s development banks, primarily the China Development Bank and the Export-Import Bank of China, have about $2 trillion in development loans to both domestic and foreign borrowers, almost seven times World Bank loans. This is extraordinary in that the World Bank, with 189 members and a provenance that goes back to Bretton Woods in 1944, has been the “go to” institution for economic development for about 70 years. The Chinese banks, with a very similar mission to that of the World Bank, have about a 20-year history.

It’s staggering to think what it will mean for commodities as the developing world seeks to catch up to the developed world. Developed economies today have about 17 percent of the world’s population and nearly 70 percent of the world’s income. For the developing world to reach a comparable per-capita income level, the world’s overall GDP would have to grow more than fourfold, and that is assuming no growth at all in developed economies. A world that needs just twice as much oil as it needs today, never mind four times, is a world that will need more oil to produce whatever marginal oil we need than we would obtain – in other words, game over. Moreover, oil scarcity translates readily into scarcity of virtually every commodity.

Returning to iron ore, what’s remarkable is that its price has actually outperformed oil for much of the 21st century even though it is one of the most plentiful commodities on the planet, likely the major commodity that will be the last to experience real scarcities. Its price is based almost solely on the price and scarcity of oil.

Renewables and Resource Scarcities

We believe much of China’s focus in helping the development of countries from the Republic of the Congo to Pakistan relates to securing the resources that will be needed to replace oil and other hydrocarbons. Last issue we honed in on copper’s role in a world ever more powered by electricity, as the roads increasingly get taken over by electric vehicles requiring lithium, graphite, cobalt, and three times as much copper as gas-powered cars. Scarce oil, in other words, translates into massive demand for a multitude of other materials. Indeed, you could even argue that China’s recent surge in oil imports—far past previous records and certainly at variance with all the talk about an imminent hard landing in the country—comes from its need to secure enough oil to obtain the replacements for oil.

Another commodity that will play a critical role in replacing oil is silver, which I discussed recently in an interview on King World News. Silver is both a precious and industrial metal—and it may surprise you to know that its production is peaking. According GFMS, a division of Thompson Reuters, silver production is unlikely ever to surpass today’s levels of about 27 thousand tons a year.

Silver’s superior ability to conduct heat and electricity has made it a key metal in photovoltaics, among other uses. Growth in photovoltaics has been rapid but from a tiny base, and it currently represents less than 1 percent of energy use. In a world weaned at least in part from fossil fuels, electricity, which now accounts for about 18 percent of world energy, will have to take on a far larger role—ideally nearly 100 percent. Solar will have to generate a large part of that electricity.

In other words, there is massive room for further growth in solar, and that means a massive future call on silver. Forecasters including Bloomberg and the IEA expect solar power—led by China, where solar has grown several hundredfold over the past decade but still represents just a small portion of the country’s total energy usage—to increase by several hundred gigawatts over the next five years. That means the amount of silver needed over that period will amount to one year’s production or more. And with growth in photovoltaics likely to increase by a far greater number of gigs in the next five years and to continue to increase after that, we have a major scarcity problem in the making.

Indeed, barring a worldwide recession or a technology miracle, this translates into silver scarcity before solar has even begun to make a meaningful impact on the world’s energy supply. We will probably be able to cover the coming five-year deficit with aboveground inventories, but after 2020, finding enough silver anywhere will be a major challenge, to say the least. It’s one example, but not the only one, of what we mean when we say the attempt to trade scarce fossil fuels for a new energy system is likely to create a brand new sets of scarcities.

The overall message: an awareness of scarce oil has segued into a realization that almost all commodities are scarce and getting scarcer. The major reason commodity prices have fallen since 2011 was a protracted recession in Europe—longer than any in modern times—followed by a geopolitical event within the club of major oil producers that led to a collapse in oil prices. But that collapse in oil emphatically had nothing to do with systemic surpluses and everything to do with geopolitics. Indeed, the past few years have likely been the only time since the Industrial Revolution began that all major producers of the world’s most important energy source have produced at well below breakeven levels. In 1986, a year often compared to the current period, the Saudis sharply increased oil supply but with the knowledge that they had roughly 10 million barrels of excess capacity. Today there are at most a few million barrels of excess capacity. Frighteningly, even with oil supply near full capacity, oil demand is catching up with supply.

The actions of the oil producers represent at least a six-sigma event whose final explanation probably won’t be clear anytime soon. But while we don’t know for sure what lies behind it, we doubt that the entire answer turns on efforts by the Saudis and others to hurt the frackers. Instead, part of the answer may turn on whom the Saudis are trying to help. As evidenced by China’s surging oil imports, that would be China.

Investment Bonanza

For investors, this is an unusual time. Don’t let it pass you by. Commodities that are both cheap and getting scarcer are as close as you get to eating your cake and having it too. Barring an unexpected bolt from the blue, we think oil and other commodities have made a bottom and over the next several years will likely reach new highs.