Is there a bubble in commodities markets, and if so, is it waiting to burst?
There certainly has been volatility after this decade's rising prices: In March, global commodity prices tumbled nearly 10% over a week before recovering more than that amount since then.
And more volatility appears likely. With financial markets shuddering worldwide, such volatility is natural.
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The commotion on commodity markets began the day the U.S. Federal Reserve announced a rescue package for Bear Stearns, mediating a firesale of the investment bank to its Wall Street rival JPMorgan Chase. That day the Reuters-Jefferies CRB index of commodities tumbled 4.6%, the sharpest single-day fall in 50 years.
Two days later the index dropped another 4.1%. The index, which had reached a record 420 points by mid-March, was trading at around 390 points by the end of the month. Now it has returned to its record highs and is up over 30% on the year. It has more than doubled over the past seven years.
But is it a bubble? Not necessarily. Although commodity prices have been on the rise since 2001, there is plenty of economic justification for it. Seven straight years of rising prices does not constitute a bubble. That would require plenty of economically irrational activity, and so far, this doesn't seem to be the case.
Most consumers and manufacturers around the world are managing somehow to absorb the sharp price rises in energy and food. People continue to fill their gas tanks as they have in the past - for the most part - and have not stopped buying food. And of course, the falling dollar has substantially contributed to rising commodity prices. Because prices of most commodities are listed in dollars, rising prices are to a great extent an optical illusion.
Nevertheless, talk of a possible commodity-market bubble has been going on for some time. With the divorce between commodity prices and other financial assets, particularly real estate and stocks, the talk is becoming louder.
Indeed, while share prices around the world have tumbled 15% to 25% since the beginning of 2008, and with real estate in the U.S. and U.K. falling, the CRB index continues to climb, oblivious to the other markets.
The commodities index was pushed up in part by the price of oil, which has soared above $120 per barrel; gold, which rose to over $1,000 an ounce; and agricultural commodities such as wheat and corn, which are at record highs.
So where are commodity prices really going? Are the record levels of the past few months an indicator of a new ceiling? Are prices now set to fall? Will they stabilize at current levels? Or perhaps the recent tumble is just a hiatus before renewed increases in the coming months - precisely what happened in the second half of 2006.
The following are a few arguments in the world financial press predicting the direction of commodity prices. Of course, there is no single, clear-cut conclusion. It's up to investors to choose the most persuasive argument for themselves.
1. An economic slowdown is expected
The rise of commodity prices since the low point of 2001 began during the last recession, but it gained steam during the global economic growth of 2003 to 2007. Now the situation is different. The United States is apparently already experiencing a recession, and West Europe is following suit.
U.S. and West European economies still constitute half the global economy. A slowdown in these regions would greatly decrease global demand for finished products and the raw materials they are made of. Global demand for commodities would fall, causing a significant fall in prices.
2. Supply will increase
Surging demand has led raw-material producers to invest huge amounts to increase output. Oil companies have invested in exploration, mining companies have expanded their mining facilities and farmers have cleared new land and invested a fortune in increasing automation and yield-efficiency.
Yields have not grown the same way among all commodities, but some may manage to catch up with the excess demand. For some commodities, demand has decreased. This is the essence of every economic cycle. When supply meets demand, there will be a sharp and swift fall in commodity prices.
3.Speculators will flee
One argument for a bubble in the commodity market is based on the speculative component. Many analysts are saying that surges in commodity prices often result from wildly speculative gambles, leveraged in part by low dollar interest rates.
For example, some analysts say the "true" price of oil is not $100 a barrel, but just $80 to $90. This price, they believe, is in keeping with production costs of about $40 to $60 per barrel.
And why has the price of gold gone up? Because investors have chosen gold for the same reason they have chosen government bonds - to seek stability and security. Because of this, current gold prices do not truly reflect a balance between supply and demand, but of fear and speculation.
Like the real estate market which has been dominated in recent years by leveraged financial instruments, the commodity market now has such instruments, which inflate prices. Over the past two years exchange traded funds (ETFs) based on commodity indexes have joined the melee, allowing ordinary investors to take part in the sector's speculative bubble.
At the end of the day, speculators' money will seek an exit, and when that day comes, commodity prices will sink sharply.
4. The dollar will change tracks
The rise of global commodity prices is a mirror image of the falling dollar. The U.S. currency is now at rock-bottom levels, and is expected to strengthen with the intervention of central banks worldwide, as well as interest-rate cuts in Europe. When the dollar regains strength, commodity prices will drop.
1. China and India are still hungry
The last surge in the commodity market began in the 1970s and ended in the early 1980s. Then it was a result of supply-side problems, mainly of oil (the oil embargo and reduced production by OPEC nations). The current surge is a healthier one, because it results from ever increasing demand, particularly in the large emerging markets of China and India.
China and India were very minor players in the global economy in the 1980s. Today they are key elements. China alone accounts for about one-third of the global demand for iron-mining output, demand that is expected to increase by another 50% within five years. China is also a large importer of oil and food.
India is quickly developing a broad middle class seeking to raise its standard of living. Indians are consuming more cars, more fuel, more steel and more food.
About a quarter of the world's population now lives in China and India. China has grown at an annual rate of 11% to 12% in recent years, and India by 8% to 9%. Even if economic growth rates drop to between 6% and 7% annually in these countries, the demand they create will continue to propel commodity prices higher in the long term.
2. Supply has not grown fast enough
In recent years, the supply of raw materials has been unable to meet demand. For example, oil companies reported that production was actually down last year, despite rising demand. This is partly because oil fields and equipment are aging, and there difficulties in locating new and accessible oil fields. Many countries refuse to allow oil companies to drill along their coasts, concerned about pollution and safety. Many also have stringent environmental regulations that limit the establishment of new refineries.
In the area of metals, many countries place environmental restrictions on mining companies, making it more difficult to dig new mines or expand existing ones. In agriculture, cultivable land area is shrinking amid desertification and various environmental restrictions. Similar limitations also weigh on the fisheries industry, which is struggling to increase output.
The difficulty in increasing supply quickly will continue to create shortages, increasing prices further.
3. Interest rates are falling
In ordinary times, the soaring price of commodities creates inflationary pressure and central banks begin to raise interest rates. But with serious recession concerns, the U.S. has already cut interest rates sharply, the U.K. has trimmed rates, and there are expectations that the European Central Bank will finally be forced to follow suit.
Lower interest rates will help speculators continue to fuel demand for commodities and increase prices. Lower rates in the U.S. also weigh down on the dollar, so the price of dollar-traded commodities will continue to rise.
4. Not all commodities are created equal
Commodity prices behave differently; there is energy, food, base metals and precious metals. Each of these commodities represents a different market and a different type of supply and demand.
Some commodities are exposed to speculation - mainly oil and gold. But there are others which are not traded on the exchange (lead, iron, potash and various chemicals), whose price is set by negotiation between manufacturers - who have become more powerful - and their customers.
Removing the speculative component from the equation, demand for many commodities is real and coming from the world's emerging markets - from Main Street, where real supply and demand are king, not Wall Street and its speculators.
Because the world economy will continue to grow, even if at a slower rate in the next year or two, demand for commodities is not expected to ebb. The current economic cycle could be a long one, and investors in commodities will enjoy it for many years more.
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