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Will Commodity Prices Soften?

The recent flash correction has raised expectations of relief from high commodity prices….

“We now live in a different, more constrained world in which prices of raw materials will rise and shortages will be common.”

That’s Jeremy Grantham, the chief investment strategist at Boston-based Grantham, Mayo, Van Otterloo & Co., which manages $107 billion in assets, commenting on the rising prices of natural resources. The high current prices of commodities attest to the truth of Grantham’s statement. Commodities have been on a roll for some time now. The Thomson Reuters Jefferies CRB index (which tracks commodities) is up 35 per cent in the last 12 months. This is despite the sell-off seen in recent days. In spite of the correction, the index is only about 8 per cent below its 12-month peak.

What stoked the rally
Stronger than expected global economic resurgence after the recession of 2008 is one of the fundamental reasons why commodities have rallied so much. Supply constraints, arising due to dwindling crude supplies from Libya, are also responsible for the surge.
Another factor that is held primarily responsible for rising commodity prices is the $600 billion quantitative easing (QE2) programme of the US Federal Reserve. Coupled with a low interest-rate regime (in the US), it has flooded all asset classes with a deluge of liquidity — gold, silver, crude and financial derivatives of these and other commodities.
Economics 101 tells us that excess liquidity chasing limited supplies leads to rising prices. That is what is happening right now, reminiscent of the run up in crude in 2008 when it touched $150 per barrel and threatened to breach the $200 per barrel mark. Was that run up backed by real demand? Not many think so. Yet future contracts in crude jumped, leading to higher futures prices.
But the current rally in commodities is not merely liquidity driven. As mentioned earlier, real demand is also on the rise.
Moreover, a weakening dollar caused a “flight to safety” to gold and silver by investors looking to protect the real value of their investments. Rising global inflation also did its bit to contribute to the flight to these investments.

What could fuel the rally further
Global economic recovery: The growth engines of the major world economies are humming. The US is expected to report a GDP growth of 2.7 per cent this year, and UK 2 per cent. Japan, which is still battling the nuclear fallout, is the only major economy that saw its GDP de-grow by 3.7 per cent in the first quarter of this year.
The developing economies are zipping along much faster. China’s GDP is expected to grow by 9.7 per cent this year, just a shade beneath its long-term growth rate of 9.9 per cent. India’s growth is pegged at around 8.5-8.8 per cent. Brazil is likely to clock 5.5 per cent, while the Far Eastern economies like Singapore and Malaysia are expected to grow by 7 per cent and 6 per cent respectively. Such strong growth in the major economies will result in sustained demand, and hence high prices of commodities.
Libya effect: The Allied attack on Libya has led to diminished supply of crude from that country. Its output is down from 1.39 million barrels per day in February 2011 to an estimated 3,90,000 barrels per day in March. Libyan oil is expected to remain off the market for some time, putting upward pressure on crude prices.
Even though oil has fallen from its highs, analysts contend that this year’s peak prices could be breached again next year on sustained demand-supply mismatch.
Weakening dollar: One of the key reasons for the run-up in commodity prices has been a weakening dollar. Most commodities are traded in dollars. As the value of the dollar fell, the value of commodities appreciated. The U.S. Dollar Index is down 7.6 per cent since January this year, its steepest decline since 1995.
The pumping in of $600 billion through the QE programme alongside the low interest-rate regime in the US is one of the key reasons for this fall. Investors seeking to flee from a weakening dollar have found refuge in commodities like gold, which is up 32 per cent this year. Moreover, in a high-inflation scenario, gold, which was appreciating, proved to be the hedge against inflation. If the dollar continues to slide, commodities will continue to remain on a firm footing. But the ending of the QE2 programme may stem the dollar’s decline.
Firm inventories: Rising commodity prices create a huge incentive for suppliers and asset owners to hold on to their inventories of raw materials. This in turn exacerbates the demand-supply mismatch. That is what is happening now. In March 2011, investors were holding on to a record $412 billion of raw materials. That is nearly 50 per cent higher than the previous year’s level. In February this year, open interest in 17 of the 19 commodities tracked by the Thomson Reuters/Jefferies CRB Index reached 8.2 million contracts, close to the all-time high of 8.6 million.
Commodity companies have made a killing in this highly charged environment. Domestic commodities major Hindustan Zinc reported Q4FY11 PAT of Rs 1,771.27 crore, up 43 per cent y-o-y. Coal India, the country’s largest coal-mining company, reported a 24 per cent y-o-y jump in PAT in the same quarter. It will also enjoy the benefits of a 10 per cent hike in coal prices this year in keeping with robust global prices.

What could end the rally
The following factors hold the potential to put an end to the rally in global commodity prices:
End of QE2: The end of QE2 combined with Euro debt concerns could lead to strengthening of the dollar. A stronger dollar will in turn cool commodity prices. Lower commodity prices should in turn bring inflation down and charge up growth engines worldwide. But all this is contingent on a recovery in the US housing market, QE3 not being rolled out, and the European sovereign debt problem intensifying.
Tightening global monetary policy: After a period of expansionary credit growth and consequent high inflation, central banks are tightening their monetary policies. With the UK staring at consumer price index (CPI) inflation of 4.5 per cent in April 2011, the Bank of England is preparing for rate hikes. In the Euro zone, inflation hit 2.8 per cent in April this year, higher than the 2.7 per cent in March. Russia too faces a CPI of about 10 per cent and recently raised its rates by 25 basis points. This is a recurring pattern across the world. In most cases, a lax credit policy combined with rising commodity prices, especially that of crude, is being held responsible. If interest rates are hiked further, industrial growth may cool down, thereby lowering the demand for commodities.
Slower GDP growth in China and India: The GDP growth rates of China and India matter as these two countries combined are the major consumers of commodities. Consider the following: China alone accounts for more than a third of global oil demand. It is the world’s largest steel manufacturer, producing 46 per cent of global steel output. It produces a third of all the copper mined globally and consumes half of the global output. It is also a significant consumer of other commodities like soybean and rubber.
India is one of the largest importers of precious metals like gold and silver. Other big-ticket items that it imports include crude and palm oil. If these two economies slow down, it will dent the demand for various commodities and bring down their prices.
China has been battling inflation for some time now. Its CPI was up 5.3 per cent y-o-y in April this year, higher than the government’s target of 4 per cent. The People’s Bank of China (PBOC) has raised interest rates four times since October last year in a bid to rein in inflation, the last being in April this year. More interest rate hikes are expected in June. Higher interest rates threaten to slow down China’s growth rate to 9.7 per cent this year.
The situation in India is no better. Following the 9 per cent GDP growth in FY11, the Centre for Monitoring Indian Economy (CMIE) estimates that growth will fall to 8.8 per cent in FY12, chiefly on account of persistently high inflation. India’s WPI stood at 8.9 per cent in April 2011. In its recent annual monetary policy review, the Indian central bank discarded its calibrated approach towards rate hikes and opted for a steep 50 basis points hike in order to quell inflation. More rate hikes are expected. But what needs to be noted is that even the forecasts predict only a marginal slowdown in these economies.
Lower demand in the US: The price of crude could moderate if there is demand destruction in the US. Some signs of this happening are emerging: US average weekly gasoline demand fell by 1.2 per cent y-o-y, according to a Reuters report dated May 17. This is significant when you consider that the US alone accounts for 10 per cent of global oil consumption. If this trend continues, the price of crude could soften.
As QE2 ends (which means that the US stops flooding its own economy, and thereafter the rest of the world with more liquidity), commodity prices may soften from their current highs. The question is whether the reprieve will be short or long lasting. If what Grantham says about demand for natural resources being perpetually higher than supply in a resource-constrained world is true, then the relief may be only short lived.