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Commodity prices on the rebound

After hitting a low earlier this year, are commodity prices on the brink of a sustained rise? Daniel Ben-Ami investigates

Commodity prices look like they could be heading back up. After hitting a low in early 2016, all the main classes of commodities – agricultural, energy and metals – have spent most of the rest of the year rising (see figure). Judging by historical averages they could still go some way up.

On the face of it, this should be a simple question to consider. Assume, for the time being, the textbook models are correct and that prices are the result of the interaction between supply and demand (although this will be questioned later on). Surely determining price should simply be a matter of identifying the supply and demand factors then weighing them up against each other?

Of course, it is not so simple. For a start, some factors operate over the long term, while others are short-term. Demography is often identified as an important determinant of prices but it is hard to see it having a short-run impact. Population growth is slow relative to the sometimes frenetic pace of the markets. 

“I don’t agree that demographics plays a role in the short term,” says Andreas Marcinkowski, a commodities fund manager at Pioneer Investments in Munich. “Even if you are talking about long-term horizons, say five or 10 years, you would have to ask yourself if demographics are going to play the major role.”

In the longer term, all other things being equal, population growth can be important. It means more people eating more food, consuming more energy and using more metals.

However, all things rarely are equal. If the population becomes more prosperous, which would be expected with economic growth, that would push consumption levels up further. On the other hand, more people and better technology creates the possibility of increasing production levels. Under such circumstances, if supply growth outstrips demand, prices could well fall.

Then there is always the possibility that short-term factors will cause price volatility. For instance, a war in the Middle East could push up oil prices or severe weather could hit agricultural production. Once these factors pass, there is then the potential for a quick recovery.

Despite the multiplicity of factors at work it is possible to identify two relatively new ones that have had a substantial effect recently.

On the supply side, the advent of shale oil has altered the dynamics of that particular market. In effect, it has put a ceiling on the level of crude oil prices. If conventional producers, most notably the Organization of the Petroleum Exporting Countries (OPEC), try to push prices too high then new supply is likely to come on line quickly.

Real commodity price indices

“There’s a lot more oil supply than there used to be,” says Dirk Schumacher, an economist at Goldman Sachs in Frankfurt. “The interesting thing is that it can be switched off and on relatively quickly. In the old days if you wanted to build up capacity it took years. Now if you have access to capital it’s quite easy to increase production.”

As things stand, the US is the dominant shale producer. But if crude prices were to go significantly higher, then other countries, such as Argentina and China, would have greater incentives to develop their shale industry.

Even within the OPEC cartel there are conflicting pressures. Those producers with relatively small populations, most notably in the Saudi peninsula, are better able to constrain their production. In contrast, the likes of Iran, Iraq and Nigeria are evidently keen to ratchet up production. 

Dirk Schumacher

An added complication is that China and India have been taking advantage of cheap crude prices to build up their strategic petroleum reserves. Jodie Gunzberg, the global head of commodities and real assets at S&P Dow Jones Indices in New York, describes this as a “wild card”. It means that if crude prices start to rise the two Asian giants have the option of releasing oil from their reserves, which would then put them under downward pressure.

On the demand side, the changes to China’s model of economic development are being closely watched (see Special Report on China). For many years China’s ravenous appetite for raw materials played a key role in pushing up prices. But this is changing as it moves away from an extreme emphasis on building infrastructure towards more of a focus on services. 

Schumacher points out that those raw materials that are geared towards capital investment, such as cement and crude steel, has been particularly hard hit. In contrast, those geared more towards the consumer market, such as aluminium and gasoline, are less affected.

The question now is whether a new player can replace China as a key new source of demand for raw materials. “Many people are pointing to India but people have been doing this for 10 years or more,” says Marcinkowski. “But it doesn’t seem to be able to get infrastructural projects going in a similar way to what China started 15 years ago.”

Apart from supply and demand, there is an additional explanation of how commodity prices are determined. An influential school of thought contends that speculation plays a key role. In other words prices can become detached from fundamental factors. Such arguments have fallen out of favour with low commodity prices but they could easily come back if prices rise.

No less a figure than US President Barack Obama has often railed against alleged speculators in the past. For example, back in 2012 he criticised the manipulation of the oil market. “We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher – only to flip the oil for a quick profit. We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.”

Marcinkowski, in contrast, is sceptical of the notion of speculation. “The question is what you define as speculation,” he says. In his view the fundamentals always drive what is sometimes perceived as speculation. “If you have a fundamental view on a commodity, let’s say oil, and you position yourself because of this, you do not manipulate the market.”

There is always likely to be considerable scope for debate about the possible trajectory of commodity prices. However, market observers should at least have a systematic framework to examine the factors involved.

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