Where are prices headed? Financial Express 12th June 2010

The global economic canvas is at an interesting stage for the artist who has to decide on the direction of the strokes of his brush. There are strong growth impulses in the emerging markets at one end and considerable uncertainty regarding the euro zone’s prospects at the other. Somewhere in between is the US, which appears to be in the take-off mode, with the Fed not really worrying about inflation. What does this portend for commodity prices?

Commodity prices have generally been driven by economic fundamentals of demand and supply, with the exception being 2008 when it was felt that ‘paper oil’ pushed up the prices. This had led to considerable discussion over the role of futures trading in increasing the price of crude towards the $150 mark. Today, however, with conditions easing following the financial crisis and economic downswing, commodity prices are more likely to be driven by fundamentals.

Energy prices are linked inexorably with the state of growth when the producers maintain a neutral stance. Here, there is hope that prices would remain within the present range of $70-80 a barrel as growth conditions are uncertain. The IMF expects growth to pick up this year. However, the kind of acceleration that was seen prior to the financial crisis is unlikely to be replicated to support such high prices. Further, the strengthening of the dollar would provide support to oil prices. It may be recollected that one of the reasons Opec gave in 2008 was that it had adjusted prices in terms of the euro to counter the declining dollar (up to around 25%). A stronger dollar should hold back prices to this extent. Therefore, a six-month view could be towards stability, which could change if there is a dramatic recovery in the euro zone.

The China factor has been quite decisive in pushing demand for metals, which has kept prices high. However, with the Chinese economy showing signs of heating, the government has taken certain steps like increasing interest rates and aligning the exchange rate, albeit marginally, to counter this pressure. Therefore, there could be a moderation in demand for metals, which, in turn, could temper their prices.

A major development in this context would be the steps taken by various monetary authorities. As of today, growth has taken precedence over inflation, which is a non-issue for most countries that are seeking to regain growth. The Fed has made it clear that it is not interested in increasing rates until early 2011, while the ECB will be focusing on growth against the background of the rescue packages that have been invoked in the region.

On the positive side, the prospects for prices of farm products are looking much rosier today, especially for grains and oilseeds. Prices of these products are primarily supply-driven as demand changes gradually over time in most cases. There were exceptions in 2007-08 when there was diversion of grains and oilseeds for the production of fuel oils, which, in turn, accentuated shortages and sent prices on a different trajectory. However, with crude oil remaining stable for the most part, this factor may be taken to be neutral for the year.

How about India? The concern today is that inflation appears to be emerging from two ends. Higher industrial growth and investment has triggered demand-pull forces that are being observed keenly by RBI, with core inflation increasing now. Food inflation remains the Achilles’ heel, which has to be tolerated until the harvest in October-December. Given the seasonal nature of our farm output, with most crops being largely single-season, a shortfall encountered in one season remains till the next harvest the following year. Therefore, the crux will be the monsoon. It is possible that keeping in mind this state of affairs, the government has deferred the idea of increasing fuel prices. Petrol and diesel together have a weight of around 2% in the WPI and also affect prices of other products through the transportation costs route. Generally, a 10% increase in these prices can have an impact of somewhere between 0.5-0.8% on overall inflation.

While fundamentals will drive prices of these basic commodities, gold will remain an investors’ delight. Normally, gold is a substitute for the dollar and people buy gold when the dollar weakens. Today, the dollar has strengthened mainly due to the weakness of the euro and not due to the inherent strength of the US economy. This being the case, gold has witnessed sharp movements in both directions as investors are moving funds across stocks, bonds, currencies and gold. Higher volatility in these markets has made gold a favourite for the more audacious investors, and while it would be difficult to conjecture the level to which this metal will reach, this game is not meant for the faint-hearted.