What drives commodity prices: Financial Express 8th September 2008

Commodity cycles are known to appear every 25-30 years. Looking around, and at the way commodity prices have been moving in the last year, the question that arises is how long this cycle will last. Normally, as long as there are excess supplies in the market, prices tend to get tempered down. But, given the global economy’s growth, oversupply indications could very well be only temporary occurrences in the midst of a longer phase of excess demand conditions in a cycle of increased amplitude.
Prima facie, it appears that with the world economy growing at nearly 5% per annum, and new nations joining the high-growth bandwagon, the boom has to continue for long. This is the view held by experts based on fundamentals as they exist today and the factors in operation over the next decade that would drive trends forth.
Commodities can be classified into precious metals, non-precious metals, energy and agricultural products. It is widely believed that all these segments would be guided primarily by the growth process as well as critical changes taking place in the political arena and the adaptations being made by society to them.
Gold, the leader in the precious metals segment, has its price determined by two factors. There is a demand side factor, where demand is rising at a steady rate with the supply being more or less limited (with fewer new explorations). Though there is the possibility of central banks releasing gold reserves into the system, this is unlikely in the foreseeable future in significant quantities. The other factor influencing the price of gold would be the US dollar rate. There is a high correlation between the price of gold and that of the dollar—estimated at around 0.95—and this has been breached only twice in the last decade and a half. The stronger the dollar, the lower is the demand for gold, seen as a store-of-value substitute. But the dollar is weakening against the euro. This is so because of the large current account deficit of the US, estimated at around $850 billion now and nearing 7% of its GDP. A correction involving a sharp dollar fall appears distant, and the euro zone economies would resist such an event that would weaken their export competitiveness. Yet, one can expect the dollar to weaken, which would impact gold.
Prices of other metals such as steel, copper, aluminum, zinc and lead are contingent on usage demand on account of commercial activity and the pace of industrialisation. Emerging markets such as Russia, India and China, as well as Brazil, Chile and Argentina, have embarked on a growth path that has industrialisation as the driving force. This, alongwith urbanisation, which are the centrepieces of this growth doctrine, also have infrastructure as a priority on the development agenda. This would support metal prices over the next decade or so. There is also an investment backlog across most commodity subsectors after over 20 years of low and range-bound commodity prices. High prices are needed to attract more investment in these commodities.
Energy prices will be driven by ever-increasing demand and the response of producers. Demand per se would take the same incline as the economy. This means robust demand over the decade, with only a few aberrations coming in the form of occasional growth slowdowns. Note that central banks today are quite reluctant to allow recessions and are willing to step in with lower interest rates.
The bulk of energy supplies would have to come from Opec and other nations, and this makes for some uncertainty. The crisis in West Asia is unlikely to be resolved quickly, which raises the risk of supply shocks. The curious thing here is that supply at the moment is not really a problem, as reserves exist. But the willingness of suppliers to invest in output capacity is hard to determine.
Meanwhile, the use of alternative fuels and other energy sources is slowly catching on, and its proliferation would mean moderation in the demand for oil, which may put pressure on Opec to hold prices. Therefore, while in the short-run prices would tend to remain firm, once the switchover trend towards alternatives crosses a threshold, it would have a moderating effect on conditions in the international energy market.
Agriculture remains vulnerable to the vagaries of nature, and it was observed globally that a shortfall in prices of wheat and corn in 2006 has increased prices across all countries, thus making it a global concern. Add to this the fact that there would be considerable diversion of production of corn and sugarcane for the production of ethanol, a replacement fluid for crude oil, and one senses upward pressure on prices here too. Production will have to increase substantially to eschew this pressure, a possibility which cannot be ruled out. The optimism would be expected to continue until such time as these changes materialise.
Given these tendencies in the market, it appears that the bull run is here to stay in commodities, and while there could be deviations in the short run, it is more or less an unequivocal case in the longer run—at least for a decade.