Global commodity markets are notoriously volatile, but even by their turbulent standards Thursday, May 5 was a remarkable day.
Brent crude oil prices fell by 10%, the sharpest one-day drop on record; silver plunged by almost 20%; and almost all major agricultural and industrial commodities saw sharp falls. Further falls followed on May 6, erasing a substantial part of the gains of an eight-month commodities bull market that had rekindled talk of a multi-year super-cycle of high commodity prices.
The sharp reversal left commodity traders bewildered and, in many cases, nursing large losses. It also raised questions over the future of commodity prices. Could the sell-off signal a turning point for frothy commodity markets that have been driven by speculative punts on what was seen by many to be a one-way, long-term bet? Or was this just a temporary blip, in the wake of which growing concerns over energy supply and rising demand from emerging markets would continue to push commodity prices higher?
Subsequent price movements have proved inconclusive: early gains the following week were followed first by price falls and then a brief rally at the end of the week.
For policymakers across the emerging world in particular who are scrambling to contain rising commodity-driven inflation, such sharp commodity price volatility and uncertainty raises difficult questions about the policy response needed to stabilize prices, economies and terms of trade.
CONSENSUS VIEW
Opinions differ on what caused the market reversals, but consensus suggests the trigger was a combination of negative economic data, confusion over policy direction and wild currency swings.
A larger than expected rate hike by the Reserve Bank of India on May 3 was followed by weaker than expected German industrial order numbers on May 4, and by comments from European Central Bank president Jean-Claude Trichet on May 5 which investors interpreted as an indication that the ECB would hold off on a further rate rise in June and possibly also July. Rumours were swirling about the growing probability of Greek debt restructuring. Disappointing US employment data released hours after the ECB statement added to this general air of economic pessimism.
Substantial speculative investment in commodity markets, as well as the increased reliance by traders on automated trading systems, exaggerated the scale of price falls.
“These factors coming together within such a short space of time meant that the market had a fair bit of hot money taking flight, triggering stop-loss, and algorithmic selling that accelerated the fall and made it more sensational than it should have been,” Mark Lewis, managing director of commodities research at Deutsche Bank, tells Emerging Markets.
According to Julian Jessop, chief economist at Capital Economics, there is little to explain the extent of the fall: “It was right that commodity prices should have fallen, but there was nothing on that day [Thursday May 5] to justify price falls of the magnitude that we saw.
“Speculation tends to amplify price moves in both directions and risks in both directions as well.”
TURNING POINT?
But opinion is more divided over the broader significance of the mass sell-off.
Some argue the price reversals were long overdue – an indication that investors recognized that economic fundamentals point to lower commodity demand and prices in the coming months. “The fundamentals are increasingly negative for most commodities,” says Jessop. “There is some continued underlying support for commodity prices, but the list of negatives is much longer than the list of positives.”
His list of negatives includes monetary policy normalization in developed markets; a rebound in the US dollar; moderating growth in emerging markets; and expectations of declining commodity intensity in China, whose investment-led, double-digit growth has been a primary driver of demand over the past decade.
Increased commodity price volatility and further sharp sell-offs are likely in the coming months, says Jessop, as investors begin to lose faith in commodity markets as a one-way growth bet. “It’s possible to dismiss one or two days of steep falls as an aberration, but the more days you get like you saw [on May 5 and 6], the harder it is to dismiss as some untoward blip in an upward trend – it’s something much more fundamental,” he says.
But even if commodity prices rebound in coming weeks, lower energy prices may nevertheless be on the way in the second half of the year, amid increasingly constrained global liquidity, mounting economic uncertainty and in the wake of sustained high energy prices that will have destroyed demand.
“The bottom line is that volatility signals change, whether it is driven by technicals or by more fundamental factors,” says Francisco Blanch, head of global commodity research at Bank of America Merrill Lynch (BAML). “At the end of the day, we are setting ourselves towards a path for lower energy prices in the second half of the year.”
The extent to which recent price falls signal a fundamental turning point for commodity markets is far from agreed. While prices may fluctuate in the short term, some say the long-term bullish case for commodity prices remains intact.
“In the grand scheme of things, what happened [on May 5] has no impact on the super-cycle, which I don’t think ever went away,” Lewis says. “Whether you’re bullish or bearish over the next three months is one thing. But if you look at the long-term view, whether over five, 10, 20 or 40 years, it’s very difficult not to be super-bullish on any major commodity asset class, as, ultimately, they’re finite resources with a finite limit.”
UP AND DOWN
The cost of bringing sufficient new supply onto the market to satisfy a projected increase in demand will almost inevitably rise in the future, says Lewis. Output from active fields currently in operation will likely fall from current 85 million barrels per day to 75 million barrels per day by 2015 as reserves are depleted, while rising demand in emerging markets in particular will mean that the potential supply gap could be as large as 15 million barrels per day by 2015. While it will be physically possible to find sufficient new sources of oil to plug this gap, Lewis believes that the cost of bringing this new supply online in time will be increasingly hefty, as cheap and readily accessible sources of oil have already been exploited.
“You can go out and find more oil, but it will cost you more and more over time to find the incremental sources of supply needed to meet growing demand,” he says. “It’s the equivalent of finding one new Saudi Arabia every five years, and there aren’t that many Saudi Arabias out there.”
For agricultural commodities, continued supply constraints due to the cumulative impact of a series of bad weather and natural disasters over the past three years means that many analysts expect continued high prices.
“With fundamentals remaining positive and weather-related supply problems looming, we expect prices to remain firm albeit amid choppy moves,” says Sudakshina Unnikrishnan, agricultural commodities analyst at Barclays Capital. “The long-term positive trend remains in place, and we continue to expect a higher trading range for ags on demand growth driven by emerging markets, biofuels and increased import reliance by China.”
Others are more circumspect in their long-term price outlooks, arguing that, in the case of industrial commodities in particular, increased capacity for a number of key metals, including iron ore and copper, should help to contain any significant price rises.
“This idea that prices can just keep on going up and up and up – I’m not sure,” says David Wilson, director of metals research at Société Générale. “There may well be a super-cycle, but by its very nature a cycle has an upside and a downside.”
But for some, recent price falls also call into question the very notion of a commodities super-cycle. Jessop charges that many analysts are guilty of looking at data through tinted lenses to suit their outlooks. “The idea of a super-cycle is in the eye of the beholder,” he says. “Prices falling by 20–30% is inconsistent with a super-cycle. It’s what you’d call a bear market in other asset classes.” He expects commodity price falls in the region of 20% over the next 12 months.
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HIGHER FLOOR, INCREASED VOLATILITY
Yet while prices are likely to fall over the next year, most analysts agree they are unlikely to revisit lows seen in 2005–6, when oil prices fell to below $35 a barrel. “The price floor has moved higher and, in time, prices may well revisit [recent] highs,” says Jessop. Whatever the case, recent sharp price movements are likely the precursor to increased price volatility in the coming months, as jittery investors grapple with an increasingly complex and fraught global economic environment.
Wilson at SocGen believes that the increasing importance of speculative investors in commodity markets is likely to amplify price swings in the coming months, as commodity markets have become a mainstream asset class in general investor portfolios.
“The big change over the last 18 months to two years is that we are increasingly seeing issues that would traditionally have been exogenous to metals markets being priced into these markets,” he says. “Events that you would think shouldn’t really have much of an impact do, and I think this is definitely going to bring a lot more volatility into pricing.”
For BAML’s Blanch, the end of the second round of quantitative easing by the US Federal Reserve at the end of June and the likelihood of monetary tightening in Europe over the next six to 12 months will engender greater volatility across global financial markets in general during the second half of the year.
“Less liquidity equals more volatility, and that is why we should be prepared for a period of greater volatility in commodities and across all asset classes during the second half of 2011,” he says. “Since [Fed chairman Ben Bernanke’s speech announcing QE2 at] Jackson Hole last August, it’s been really easy for investors: equities, commodities have all gone up, but it won’t be as simple in the next 12 months.”
Mounting eurozone uncertainty is also likely to rile commodity markets in the coming months. “The spectre of a Greek default is probably the biggest risk to the continuing bull story, not just for commodities but for any asset class that has benefitted [from the upturn over the past six to nine months],” says Deutsche Bank’s Lewis.
Increased volatility and uncertainty could increase support for precious metals, and gold in particular, however. “Gold thrives on uncertainty, and there’s certainly enough uncertainty out there to support further increases,” says Wilson.
POLICY UNCERTAINTY
Commodity prices have been the primary driver of inflation across emerging markets, so cooling of prices could curb the inflationary pressures facing much of the developing world, thereby lessening the need for immediate policy action.
But if commodity prices fall and inflation rates ease, the effect could become amplified. Says Jessop: “Ironically, the trend by investors to see commodities as an inflation-hedge has been one of the primary drivers of inflation. However [if commodity-driven inflation falls] people will have less demand for commodities as an inflation hedge.”
Increased volatility and uncertainty could make the task for policymakers that much more difficult. “Volatility in commodity markets will make life a lot more difficult for policymakers in the emerging world,” says Blanch. “The kind of volatility we’ve seen in energy prices [over the past few years] makes it very difficult for policymakers to adjust interest rates, and I think the challenges here are that cycles are getting shorter and more pronounced.”
Because commodity price swings have a significant impact on terms of trade, any further price increases for oil in particular “could put peripheral Europe, or other oil-importing countries running current account deficits, at risk,” says Blanch.
The concern is most acute for debt-ravaged Greece. “Greece can’t turn itself around if oil prices are as high as they have been in recent weeks,” says Blanch. “If oil prices keep on going, the country can’t keep on going.”
Greater volatility will also make life more difficult for businesses across supply chains, thereby exacerbating economic uncertainty.
“For downstream consumers, such as the auto industry looking to try and hedge metal consumption over the life cycle of a model, it’s going to be very difficult to develop effective hedging strategies,” says Wilson. “They’re going to have to pay more attention to market moves than had been the case in the past, because we are going to have a lot more market volatility.”