Commodity Price Directions

Commodity indices have lost 50% of their value since July 2008 in response to the global financial crisis, deleveraging and worsening economic outlook. With many developed economies in recession and emerging economies to follow, it seems quite likely that prices may even fall further, outpacing production cuts.

Those commodities that grew the most expensive in the shortest period have suffered the sharpest price drops in recent months. Metals and energy (oil) led the decline while agricultural commodities fell less as their price climbs were not as excessive. Across the commodities group, inventory buildup and falling demand creates conditions ripe for a continuing current bear market despite the fact that some commodities, such as oil, seem to have fallen below production costs.

Crude oil futures have fallen from a peak of $147/barrel in mid July to around $50/barrel, well below the 2007 average price. U.S. government data suggest that demand is about 6-7% lower than last year, with the sharpest declines in jet fuel. Forecasts from the EIA and OPEC suggest that 2009 might mark make the largest contraction in oil demand in decades, despite the recent price correction. EM oil demand will be insufficient to offset growing declines in the OECD countries. Financial market trends and macro fundamentals point in the same direction, towards weaker energy prices, at least for the foreseeable future.

In the short-term, it might take a major supply shock - say one that cuts off Iran’s oil supply - to boost prices. OPEC's willingness to comply with current production cuts may be the most significant supply side factor. The elevated cost of new oil supplies may lead to future supply crunches. Canada’s oil sands are very expensive at today’s prices and projects are being deferred if not canceled. Demand for alternative energy tends to move inversely to fossil fuel prices, so the deep cuts in oil and coal prices could pose a headwind for alternative energy, unless counteracted by climate change mandates. Fortunately for producers, falling grain prices will help relieve the profit margin squeeze, even if the credit crunch impairs borrowing for expansion.

Base metal prices have suffered even steeper drops than oil. This commodity group is the most sensitive to the slowdown in industrial production. Nickel and zinc initially led the group’s decline, but were succeeded by copper and aluminum. Expectations that supply gluts will mount next year brought metals prices back to levels closer to operating costs. These two metals’ strongest sources of demand - stainless steel for nickel, auto parts for zinc – are withering, and the supply glut will be exacerbated by output from new mines. Meanwhile, copper and aluminium prices have yet to undershoot their historic break-even levels.

Steel prices have nose-dived from above US$1,200/ton in June to below US$300/ton. Prices will likely resume crashing next year, on weakening demand, particularly from China, falling freight costs and lower cost of inputs (coal and iron ore). Like other base metals, the demand collapse has left steel producers with high order books and expensive inventory.

Inflation hedging and flight-to-safety bids drove gold to an all-time high price of $1033 per ounce on March 17, but faded away on deflation fears and broader commodity selloffs. Gold now trades between $700-750, about 30% below the March peak. Slowing inflation and the U.S. dollar’s uptrend diluted gold's store of value. Though gold tends to be less sensitive to a global economic slowdown than industrial metals or energy commodities, deflation is a danger for gold prices. Even physical demand for gold looks likely to weaken alongside consumer confidence.

Agriculturals are the commodity group least sensitive to the economic cycle, but have nonetheless suffered from the deleveraging which has seen investors move into cash. Livestock prices plunged on faltering protein demand as the global growth slowdown reduces incomes. Fundamentals such as biofuel production, population growth, and the rising income and protein demand of developing countries, argue for a secular bull market. In the medium-term though, the exit of speculators and the supply overhang from production growth may bring downward pressure – especially in grains.

Slowing Chinese economic growth has contributed to the collapse in commodity prices, just as expectations of Chinese demand growth drove the recent bubble. Imports of key metals have slowed sharply since July, and the slackening industrial production growth – 8.2% in October, a 7-year low – indicates no reversal. Meanwhile, Chinese electricity production actually fell in October, the first such contraction in a decade, suggesting that China’s slowdown might be more pronounced and that the price of coal, the prime fuel for power plants could fall further.

While the infrastructure focus of China’s recent fiscal stimulus may support commodity demand, especially for some base metals, it may only offset the reduction in demand from the property and manufacturing sectors. Meanwhile, Chinese stockpiles of many commodities may take time to absorb, meaning that Chinese commodity demand might remain weak until the second half of 2009.

Quoted from: RGE Monitor's Newsletter, 19 November 2008.