When commodity prices slumped in the aftermath of the global financial crisis in 2008, many market observers were quick to call an end to a sustained five-year commodity price bull market.
But as the post-crisis economic recovery gathers pace, prices have rebounded. Since the end of last year, agricultural, energy and industrial commodity prices have surged, in many cases bringing prices back to or above pre-crisis levels.
Talk is back of a super-cycle that will sustain commodity prices at historically high levels for years to come, thanks to rising demand and limited scope for an increase in supply for a number of key commodities. Brent crude prices broke through the $100 a barrel barrier in early February, copper prices hit a record high in mid-February, while the UN’s food price index rose to an all-time high in February.
In recent weeks, volatility in commodity prices has also come hurtling back. Energy prices have been roiled by unrest and contagion fears in the Middle East and North Africa, while the prices of some major industrial commodities have fallen back from their mid-February peaks, as investors sold off amid concerns that a sustained oil price shock and policy tightening across much of the emerging world could hit global manufacturing and investment growth.
Japan’s devastating earthquake and tsunami have raised fears about lower commodity demand from the world’s third-largest economy. Meanwhile, corn and oilseed prices ended their sharp, four-month bull-run in early March, amid positive acreage and harvest predictions in South America, but they remain at historically elevated levels, fuelling a surge in food price inflation across most emerging markets.
It now seems that the 2008–09 trough was merely a temporary blip in a larger commodities super-cycle which still has plenty left to run: the price of many major commodities is now approaching or tracking higher than pre-crisis levels; moreover, analysts increasingly predict continued strong demand and major uncertainty surrounding supply and future spare capacity of a number of key commodities, most notably oil, copper and corn.
If true, this has profound implications for future economic policy, trade and growth across both developed and emerging economies.
OIL PRICE CONCERNS
In the near term, the future direction of oil prices is the most pressing concern for policymakers and investors, given the political unrest across key oil producing regions in the Middle East and North Africa and the potential knock-on effects for global economic growth. As of close of trading on March 22, Brent crude ICE futures for April delivery were tracking at $114.40 a barrel.
The impact of high oil prices on inflation and growth will, to a large extent, depend on how high prices go. According to Hussein Allidina, chief commodities analyst at Morgan Stanley, barring a significant further spike in crude oil prices, sustained high oil prices would most likely result in higher inflation, not lower growth.
“If Brent stays at $115 or below, the impact on growth will be minimal, but inflation will be more pronounced,” he says. “Energy use is lower per unit of GDP today than in prior oil price spikes. Also, monetary policy today is quite accommodative, and initial conditions are better. But if the price of oil moves materially higher, the concern becomes front and centre.”
How likely is it that prices will move materially higher? Analysts remain extremely reluctant to make bold price predictions, though industry estimates for Brent crude range from $130 to in excess of $200 a barrel.
The political situation in Saudi Arabia is key. While disruption to oil production in Libya or even Algeria could be offset to some extent by increased production and Opec (Organization of the Petroleum Exporting Countries) spare capacity, a significant reduction or outright curtailment of production in the world’s leading oil producing nation would have a profoundly negative impact on global supply – and serious ramifications for global prices and growth.
But although most analysts are reluctant to make predictions on possible supply disruptions in Saudi Arabia, most agree that crude oil prices are in any case unlikely to fall back below $100 a barrel anytime soon.
“It’s impossible to say where oil prices will go, as no one really knows, but the way I interpret it is there’s a firm floor and a soft ceiling,” Gerard Lyons, chief economist at Standard Chartered, tells Emerging Markets. “There’s a firm floor because of strong global demand, and a soft ceiling because geopolitics could push the price up considerably further. And if the price of oil goes up further, it would have a profound impact on the global economy.”
Morgan Stanley’s Allidina warns that only recession or a significant slowdown in oil consumption could prevent oil prices from tracking above the historical average in the coming years. “I think for oil, the only solution to find equilibrium in the next three to five years is to slow consumption growth,” he says. “We can’t improve supply, and we can’t improve the efficiency of consumption by the magnitude needed in the short run.”
INVENTORIES
With food price inflation starting to bite across the emerging world, economists and policymakers are keenly awaiting the publication of the USDA (US Dept of Agriculture) planting intentions report on March 31, for signs of whether to expect a significant increase in wheat, corn and soybean planting acreage in the world’s largest agricultural commodities exporting nation.
An increase in both acreage and yields this year is vital. A combination of short-term supply shocks and long-term demand growth has depleted inventories and led to a sharp rebound in the price of most major food commodities in recent months. Drought, floods, fires, cyclones and frost across key growing areas over the past 12–18 months have significantly reduced output of wheat, corn and soybeans in particular, and have resulted in an increase in food price inflation across much of the emerging world.
At the same time, rising food consumption and growing disposable incomes across many emerging economies, most notably China and India, have increased demand for food crops, a trend likely to grow in the coming years.
Most analysts expect the USDA report to show an increase in planting acreage, and are also hopeful that South American corn and soybean harvest yields may also be higher this year.
“Our base-case scenario is that we see a big move up in terms of acreage and yield levels being good, which, coupled with supportive weather, should help to temper price spikes and lead to a moderation in food prices during the second half of this year,” says Sudakshina Unnikrishnan, agricultural commodities analyst at Barclays Capital.
However, she warns that further adverse weather could result in prices deviating from this base-case scenario. “Bad weather could really throw a spanner in the works,” she says.
Given repeated supply shocks and depleted inventories, many major agricultural commodity prices remain extremely susceptible to further supply shocks this year, even if planting yields for corn and soybeans increase as expected.
“Corn and wheat don’t have any cover to contend with any supply disruption,” Allidina says. “The USDA is looking at near-record high yields just in order not to further stretch supply. If there’s any downside surprise at all in terms of supply, it could be catastrophic.”
Both Unnikrishnan and Allidina agree that recent price falls are merely a temporary correction and don’t reflect supply/demand fundamentals. “The corn and oilseed sell-offs we have seen are an overreaction,” Allidina says. “The supply/demand balance is very tight, and we don’t see the sell-offs as indicative of underlying fundamentals. Corn inventories in the US are the tightest on record.”
As a result, higher prices are likely to continue for a number of years. “Even if we do see new supply by end of Q3–Q4, we would still see historically elevated price levels across the board for agricultural commodity markets in the coming years,” Unnikrishnan says.
SELL-OFF
Concerns about the potential for rising oil prices and monetary tightening in key industrial commodity consuming nations have resulted in a decline in copper and iron ore prices over the past few weeks, made worse by declines in Chinese iron ore and copper imports in February. Iron ore imports fell 29% month-on-month in February, while copper imports fell 35% month-on-month.
But here again, the sell-off is most likely temporary, analysts say, with Chinese import declines in February largely due to the week-long New Year holiday, and analysts see the risks of a significant drop-off in demand from China, India or other developing nations as small.
Alberto Bernal, head of emerging markets macroeconomic strategy at Bulltick Capital Markets says: “I see tightening in India and China as benevolent, not harmful.” In addition, demand and price falls in February are in line with a seasonal destocking trend, with most analysts expecting a rebound in demand in late Q1 and early Q2 as restocking kicks in.
The fact that three-month copper contracts on the London Metals Exchange are down almost 10% from the all-time high of $10,190 reached on February 15 may also tempt buyers back into the market.
Barring a major oil price shock, Allidina believes that tight supply and limited scope for capacity expansion will maintain upward pressure on copper prices in particular. “Resource availability is an issue. You can substitute out of copper to some extent, but there isn’t a host of new supply coming onto the market,” he says.
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The outlook for iron ore supply and prices is more mixed. The world’s big three iron-ore miners – BHP Billiton, Rio Tinto and Vale – all forecast in trading statements in February that iron ore prices will remain at current high levels for at least the next two years. However, Goldman Sachs predicted that the iron ore market will move into over-supply when new capacity comes online in 2014, and that “prices will fall significantly at that time”. Nevertheless, Goldman’s long-term iron-ore demand outlook remains bullish, while most analysts foresee continued strong emerging market industrial commodity demand, led by China, in spite of rising oil prices and monetary tightening.
“Metals-intensive emerging markets should be better able to handle a moderate oil price increase due to their strong budget positions. Hence the impact on 2011 metals demand growth should be marginal,” said Michael Widmer, a metals strategist at Merrill Lynch, in a recent research note.
Helene Williamson, head of emerging market debt at F&C Investments puts it another way: “China is building 16,000 kilometres of high-speed rail and metro systems in 28 cities,” she says. “It is hard to see demand slowing down.”
PRICE FLOORS
Looking beyond short-term volatility, the dramatic falls in commodity prices in late 2008 and 2009 are merely a blip in a longer-term upward commodity price cycle, analysts say.
“I don’t think the commodity super-cycle ever went away,” says Morgan Stanley’s Allidina. “All we saw was a cyclical pause owing to the financial crisis.”
He says that while long-term demand was a factor driving up commodity prices globally, short-term supply constraints and disruptions will be the primary driver of price movements in the short to medium term. He sees the industrial commodities cycle continuing for many years, with the agricultural commodities cycle lasting for three to five years.
“The extra acreage is there, but it’s an issue of economics. We have to have prices at high levels for three to five years in order to provide the market incentive for farmers to increase acreage,” he says.
Barclays Capital’s Unnikrishnan is more sanguine about the forecast for commodity prices in the short term, but agrees that prices are likely to remain above historical average. “The trading range for commodity prices has moved higher,” she says. “The downside is limited due to emerging market demand, biofuel demand, low inventory levels and high input costs.
But the upside has become very much more elastic. We are likely to see prices going in and out when structural factors move in tandem with more cyclical issues, and could see prices at the high end of the trading range or even setting new highs.”
Francisco Blanch, global head of commodities research at Bank of America Merrill Lynch, believes that commodity prices are in the middle of a super-cycle because of “extremely high commodity utilization rates” worldwide. He predicts a permanently higher price floor for oil and copper due to scarcity of supply, with aluminium and iron ore prices more likely to moderate in the medium to long term, provided that there is sufficient investment in new supply.
But although agricultural commodity prices are likely to remain high for “a number of years”, agricultural commodity prices will revert to the mean in the longer term, as market incentives, improved technology and the adoption of genetically modified crops in emerging markets would boost yields and output.
“For 200 years, people have been warning that we won’t be able to feed humanity, but they have always been proved wrong,” he says. “Agricultural prices are always mean-reverting, and the reason is very simple: when prices are high, people will plant.”
WINDFALLS
For Latin America’s net commodity exporters, higher commodity prices will have a positive impact on trade balances. But a prolonged commodity-fuelled trade boom risks further delaying vital fiscal and structural economic reforms and could leave economies vulnerable to serious fiscal difficulties, should commodity prices or demand fluctuate or fall in the future, says Gray Newman, senior Latin American economist at Morgan Stanley.
“Over the past six months, we’ve seen a commodity shock of the magnitude we haven’t seen in decades. It’s been even stronger than 2003–8, and it’s been much more accelerated, both in terms of magnitude and velocity,” says Newman. “This has strengthened currencies and boosted consumer demand and purchasing power, meaning that demand is growing too fast, and the pro-cyclical policy response has added more fuel to the fire. The very positive wealth shock has bolstered fiscal accounts and tax revenues and caused authorities not to do the work they need to do.
“Ultimately, at some point you will get a change in the cycle, and the question is how over-leveraged you are when the change comes.”
How policymakers deal with the higher floor for commodity prices in the coming years will be crucial to the long-term development of emerging market economies. And for South America, that means managing inflation and taking advantage of favourable terms of trade to enact meaningful fiscal and structural reforms.
“Nature has given Latin America rich endowments of commodities. If you manage this natural gift well, then you can leverage that opportunity. But if you manage this badly, then it can cause major imbalances,” says Alberto Ramos, chief Latin American economist at Goldman Sachs. “You have to take any swing in revenue as temporary, not permanent, and insulate or detach the business cycle from the commodity cycle. Fiscal policy has to become counter-cyclical.”