Sector, Macro

Commodity Prices - More Downside Risk than Upside Potential

May 11th, 2011 | By Nick Sargen

At this time, I believe commodity prices are more at risk for price pressure over the coming years. Prices are most likely to be tested when the Federal Reserve and other central banks normalize interest rates in the next few years.

What’s Up (or Down) with Commodity Prices?

This topic has taken on added significance recently amid heightened volatility in commodity prices. After rising by 20% in the first four months of this year, Standard & Poor’s GSCI index of 24 commodities sank by 10% in the past week. The downturn was led by a $15 dollar drop in the price of crude oil, which closed the week near $100 for WTI. The plunge left investors wondering whether the secular rise in oil and commodity prices over the past two years is over.

My assessment is that it’s too early to tell. The run-up in commodity prices has been driven by global economic recovery, supply shortages, and record low interest rates, as well as by speculative factors. In my view, economic fundamentals have changed very little recently, and the heightened volatility mainly reflects speculative influences, which are difficult to predict.

Whatever the near term holds, there is also a growing debate about the long-term prospects for commodity prices. Jeremy Grantham recently published a report in which he concludes the world is using up its natural resources at an alarming rate, and he asserts this has caused a permanent shift in their value.[1] However, the researchers at Bank Credit Analyst (BCA) arrive at the opposite conclusion – namely, there is a high probability that commodity prices (other than oil) could plummet in the next few years.[2]

Where do I come out in this debate? I am more persuaded by the arguments that BCA musters, and think the test will come when the Federal Reserve and other central banks normalize interest rates in the next few years.

Near-term Prospects for Commodity Prices

Over the past decade, the principal driver of oil and commodity prices has been the global economic cycle and the emergence of China as a global economic power. Prior to the onset of the financial crisis in September 2008, commodity prices had increased nearly uninterrupted from 2003 on the back of strong global demand, with China becoming the dominant buyer of natural resources. During the financial meltdown from mid-2008 to early 2009, commodity prices plummeted in response to the severe global recession, but they rebounded subsequently as the world economy recovered.

Supply shortages have also played a role in the surge in food prices, owing to widespread crop damage in Russia, floods in Pakistan’s food belt, and flood damage in Australia and China. At the same time, some observers contend the U.S. corn-based ethanol mandate imposed in 2005 has contributed to the run-up in corn prices from $2 per bushel pre-2005 to more than $7 per bushel today.

In addition, speculative forces have been at play. The surge in oil prices this year, for example, from $90 per barrel to $115 per barrel was linked to political unrest in the Middle East and heightened risk of supply disruptions. More generally, the spike in prices of gold, silver and other precious metals appears to be linked to weakness of the U.S. dollar and to perceptions that the Federal Reserve and other central banks have been too accommodative.

Given this array of factors, why did oil and commodity prices suddenly plummet this past week? I am hard pressed to come up with an explanation based on fundamental factors. The news this past week did not alter my expectations about the U.S. and global economy, inflation or the conduct of monetary policies in the advanced economies. The more likely explanation is that some traders closed out positions and took profits when it appeared momentum was beginning to shift. If that, indeed, is the explanation, it is quite possible the same traders could reinstate positions if prices hold above certain technical levels.

As discussed below, my assessment is that commodity prices most likely have over-shot their long-term equilibrium levels and are now trading on momentum. That said, however, prices could still move higher until perceptions change about the global recovery (and demand forecasts moderate) or central banks tighten monetary policies, which would boost the cost of carry for commodities.

Long-term Prospects for Commodity Prices

Whatever the near-term prospects, the long-term trend in commodity prices is now receiving considerable attention. One reason: The Federal Reserve is basing its conduct of monetary policy on the premise that the surge in commodity prices is unrelated to its actions and will likely be temporary. If that assumption is incorrect, however, Fed policy may be too accommodative, and the U.S. could be headed for significantly higher inflation.

For the time being, the bond market has voted with the Fed: Treasury yields have stayed very low, despite an increase in headline CPI inflation to 2.7% recently. According to researchers at BCA, moreover, there is a reasonable expectation that commodity prices could decline after the next 2-3 years:

  • On the demand side, BCA points out that per capita consumption of base metals has been flat in developed economies, and its researchers believe growth in China’s demand will moderate over time, as it becomes more efficient in resource usage.
  • On the supply side, BCA concedes that the supply response to higher prices has been anemic thus far. However, its researchers do not view this as evidence that the world is running out of natural resources, and they point out that proven reserves have been increasing. In their view, new projects are now being launched that will come on stream in the next 2-3 years. However, they concede that the shortfall in crude oil could last much longer.
  • BCA also believes the interest-rate environment will become less favorable for commodity prices in the next few years, when rate levels are likely to be considerably higher.

By comparison, Jeremy Grantham takes a completely different stance, arguing that the “days of abundant resources and falling prices are over forever.” He points out that accelerated demand from developing countries, especially China, has produced a surge in commodity prices in the last eight years that have completely reversed a secular decline over the previous 100 years.

One way of approaching the investment decision is to assign probabilities to various outcomes, as are shown below based on Citi's research:

Moreover, Grantham contends that the recent uptrend is likely to continue. He foresees continued strong growth of demand for commodities as a result of rapid growth in China, India and other emerging economies. And he argues that natural resources are becoming finite. On this score, he marshals data showing a leveling in global oil production, declining recoverable copper oil quality, and falling growth in crop yields amid rising fertilizer use. He concludes: “How we deal with this unsustainable surge in demand and not just “peak oil,” but “peak everything” is going to be the greatest challenge facing our species.”

The main qualifications Grantham makes are (1) improved weather could cause food prices to decline temporarily and (2) a growth recession in China could result in a broader-based commodity sell-off. He asks how an investor today should handle the tension between “brilliant long-term prospects” and very high short term risks. His answer: “with great difficulty…my foundation, for example, is taking a small position (say, one quarter of my eventual target) in ‘stuff in the ground’ and resource efficiency.” He wraps up with the following conclusion: “The U.S. and every other country need a long-term plan, especially for energy, and we need it now!

Where Does This Leave Me?

I find myself more in agreement with BCA’s findings than with Grantham’s, largely for two reasons. First, I remember the 1970s period of surging oil and commodity prices, when prestigious institutions such as the World Bank and others forecast finite supplies of commodities and steadily rising prices. These forecasts, however, were subsequently discarded when the Federal Reserve and other central banks boosted interested rates in the early 1980s to control inflation. These anti-inflation policies ushered in a period of disinflation that has lasted for three decades. In the event the Fed’s current assessment of commodity prices is wrong, moreover, I am confident it would alter its stance and tighten policy to choke off inflation.

Second, I am also cognizant of how rapidly the prices for oil and other commodities plummeted in 2009, when the global economy was in the midst of the worst recession since the Great Depression. I do not foresee a repeat of the financial crisis, but there is a natural adjustment mechanism to rapidly rising prices – either demand softens to curb the rise or prices reach levels that are unsustainable. While it is difficult to know when economies reach such a point, the recent pullback in commodity prices indicates that investors are well aware of this possibility.

[1] GMO Quarterly Letter, “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever,” April 2011.

[2] The Bank Credit Analyst, “The Long-Term Outlook for Commodity Prices,” April 2011.