Today from the website that the Wall Street Journal and The Economist have called the best economics website on the Internet, www.rgemonitor.com:
Greetings from RGE Monitor!
"Today we turn our attention to commodities, which have been badly battered by the global financial crisis, deleveraging and a worsening economic outlook, with commodity indices having lost 50% of their value since the July peak. With the G10 in recession and many emerging economies slowing sharply, further demand destruction is likely, and it may continue to outpace production cuts. Once the price adjustment filters through to producers, they may account for another source of slower aggregate output.
Despite the steep price declines so far, commodities as a group have only fallen halfway to their 2001-02 trough, meaning they may have farther to fall. Among individual commodities, those that grew the most expensive in the shortest period of time have suffered the sharpest and fastest price drops. In fact, some investors are pricing in a temporary drop in the price of oil below $30 per barrel, far below marginal production costs.
Metals and energy led recent declines, after breaching nominal and inflation-adjusted highs earlier this year. Agricultural commodities took smaller hits as their price climbs were not as excessive – their peak prices this year remained 2-3x below their inflation-adjusted highs in the 1970s. Only newsprint has yielded positive returns this year as of November but its resilience seems unsustainable in the medium-term. Across the commodities group, inventory buildup and falling demand creates conditions ripe for a continuing current bear market despite the fact that some commodities, such as oil, seem to have fallen below production costs.
WTI crude oil futures have fallen from a peak of $147/barrel in mid July to around $55/barrel, well below the 2007 average price. U.S. government data suggest that demand for oil products is about 6-7% lower than last year, with the sharpest declines in jet fuel. Despite the fact that gas prices are now hovering at $2 a gallon and energy costs fell 18% nationwide in October, demand continues to fall. Forecasts from the EIA and OPEC suggest that 2009 might mark make the largest contraction in oil demand in decades, despite the recent price correction. EM oil demand will be insufficient to offset growing declines in the OECD countries. For now, financial market trends and macro fundamentals might point in the same direction, towards weaker energy prices.
Yet, output cuts are reducing supply, removing the surplus reached earlier this year, even as OPEC’s surplus capacity increases. Non-OPEC supplies continue to disappoint. Oil production has declined in Russia, the North Sea and Mexico while new production in Kazakhstan and Brazil has yet to come on stream. In the short-term, it might take a major supply shock - say one that cuts off Iran’s oil supply or major output from the GCC - to really boost prices. The Somali pirate hijacking of a Saudi tanker might raise transport costs as insurance premiums rise and routings increase, and reminds observers of the energy supply chain’s vulnerabilities, but it may not have a major affect on oil market fundamentals. OPEC’s willingness to comply with current (and future?) production cuts may be the most significant supply side factor. Yet the elevated cost of new oil supplies may lead to future supply crunches. Canada’s oil sands are woefully expensive at today’s prices and projects are being deferred if not canceled.
Lower global energy demand, in the face of increasing supply, is also affecting current and expected natural gas prices. EIA has noted that the Henry Hub natural gas spot price projection for 2009 has fallen from $8.17 per Mcf to $6.82. The front month contract price of natural gas on NYMEX has steadily declined and the futures curve has sloped downward. Demand for alternative energy tends to move inversely to fossil fuel prices, so the deep cuts in oil and coal prices could pose a headwind for alternative energy, unless counteracted by climate change mandates. Fortunately for producers, falling grain prices will help relieve the profit margin squeeze, even if the credit crunch impairs borrowing for expansion.
Base metals prices have actually suffered steeper drops than oil. This commodity group is the most sensitive to the slowdown in industrial production. Nickel and zinc initially led the group’s decline, but were succeeded by copper and aluminum. Expectations that supply gluts will mount next year brought metals prices back to levels closer to operating costs. At 50% below historical averages, in real terms, nickel and zinc prices are already triggering production cuts. These two metals’ strongest sources of demand - stainless steel for nickel, auto parts for zinc – are withering, and the supply glut will be exacerbated by output from new mines. Meanwhile, copper and aluminum prices have yet to undershoot their historic? break-even levels. But, slowing housing and infrastructure construction activity worldwide, plus lower automobile demand, may more than offset the supply issues (i.e. labor disputes for copper, power shortages for aluminum) that kept copper and aluminum inventories from building up like other base metals.
Steel prices have nose-dived from above US$1,200/ton in June to below US$300/ton. Prices will likely resume crashing next year, on weakening demand, particularly from China, falling freight costs and lower cost of inputs (coal and iron ore). Like other base metals, the demand collapse has left steel producers with high order books, expensive inventory and limited near-term flexibility. Producers have begun cutting production, but lead times in the steel industry are around 8 weeks, which means production cuts will not materialize until around the turn of the year, meaning stockpiles might increase further.
Inflation hedging and flight-to-safety bids drove gold to a nominal all-time high price of $1033.90 per ounce on March 17, but faded away on deflation fears and broader commodity selloffs. The gold rally stopped far short of the inflation-adjusted high of $2115-2200/oz reached in 1980 and gold languished below $700/oz this summer. After a brief rally in autumn, gold now trades between $700-750, about 28% below the March peak. Slowing inflation and the U.S. dollar’s uptrend sapped support for gold as a store of value despite the possible inflationary consequences of massive fiscal expansion and monetary policy easing to counteract the economic and financial effects of the global credit crisis. Though gold tends to be less sensitive to a global economic slowdown than industrial metals or energy commodities, deflation is a clear and present danger for gold prices. Even physical demand for gold – mostly for decorative use – looks likely to weaken alongside consumer confidence.
Agricultural commodities have outperformed metals and oil, although that just means their prices dropped the least. Agriculturals are the commodity sub-sector least sensitive to the economic cycle, but have nonetheless suffered from the deleveraging which has seen investors move into cash. Cotton prices have fallen the most (-45.29% ytd Nov 14), and sugar the least (-3.96%). Livestock prices plunged on faltering protein demand as the global growth slowdown reduces incomes. While metals and energy prices struck both nominal and real all-time high prices, agricultural prices just rose above the historical lows of the 1980s, remaining far below the inflation-adjusted highs of the 1970s. Fundamental drivers such as biofuel production, population growth, and the rising income and protein demand of developing countries, argue for a secular bull market. In the medium-term though, the exit of speculators and the supply overhang from production growth may bring downward pressure – especially in grains. As the global economy recovers, agricultural prices should speed their uptrend, tempered by the fact that agricultural commodities are renewable resources unlike metals and fossil fuels.
Long-run fundamentals of supply and demand suggest a resumption of the uptrend in commodity prices in a few years, but a global recession, a strong dollar and forced fund liquidations in the medium-term will keep prices under pressure until late 2009. True, the commodity slump sows the seeds of its own destruction, by causing producers to cut back or delay investments, thereby raising the risk of a future supply crunch. This pro-cyclicality is nothing new. Nonetheless, the anticipated price recovery will be gradual if the current financial crisis permanently restricts the ability to leverage, which was key to the world’s high growth rates posted in the past few years.
Slowing Chinese economic growth has contributed to the collapse in commodity prices, just as expectations of Chinese demand growth drove the recent bubble. Imports of key metals have slowed sharply since July, and the slackening industrial production growth – 8.2% in October, a 7-year low – indicates no reversal. Meanwhile, Chinese electricity production actually fell in October, the first such contraction in a decade, suggesting that China’s slowdown might be more pronounced and that the price of coal, the prime fuel for power plants, could fall further.
While the infrastructure focus of China’s recent fiscal stimulus may support commodity demand, especially for some base metals, it may only offset the reduction in demand from the property and manufacturing sectors. Meanwhile, Chinese stockpiles of many commodities may take time to absorb, meaning that Chinese commodity demand might remain weak until the second half of 2009. This changing dynamic has, however, changed the pricing power in the iron ore market, a reversal from some months ago when global companies like Rio Tinto, BHP Billiton and Vale sought very large iron ore price hikes from China and other Asian customers.
The reduction in global commodity demand is now providing headwinds for shipping. The Commodity boom of recent years sparked a global trade and shipping boom, reflected in the surge in the Baltic Dry Index which almost doubled between 2006 and 2007. In spite of easing global manufacturing trade since early-2008, global freight and the Baltic Index proceeded to hit an all time high in May 2008, buoyed by high commodity prices. But since then, easing food shortages, commodity price correction, and the slowdown in industrial activity across the G-7 and in EMs have reduced demand for key industrial commodities and raw materials, pulling down the Baltic Dry Index by over 90% ytd. Moreover, the escalation of the credit crisis has blocked access to trade credit for commodity importers and exporters, posing the risk of stalling the movement of goods across the global manufacturing supply chain.
Capacity shortages in bulk and oil drilling, shipping, inadequate port facilities and longer shipping duration between commodity importers and exporters have raised transportation costs, boosting the final price of commodities. Even as shipping companies face the credit crunch and high oil prices, existing investment in ship building by commodity-related firms and countries might somewhat improve shipping capacity by 2010 to match the demand. Moreover, global trade and shipping face an impending demand slowdown in the coming quarters, as output slows further and recovery may lag the global economic recovery. The reduction in demand from commodity producers for other goods may accentuate the effect of the commodity correction on global manufactured goods.
The recent sharp decline in the price of oil is now starting to hit the fiscal bottom line of key oil exporting economies, meaning some of them could run fiscal deficits next year, if oil prices remain at yesterday’s ($55) level. On average, Middle Eastern oil exporters require a $50-55 a barrel oil price to balance their budgets – and countries like Russia, Iran, Iraq and Venezuela require a higher price. As a result, to maintain current spending (a likely political necessity) several oil exporters might have to issue more domestic debt or spend their accumulated savings. Oil output cuts only raise the break-even price, a fact of which OPEC members are no doubt very aware, as they prepare for yet another meeting later this month. Further production cuts seem (again) to be almost a foregone conclusion though. Meanwhile, with current oil prices, oil exporters may no longer be a surplus region next year. The erosion of their current account surpluses, sparked in part by the pressure to spend more at home to support domestic asset markets, should reduce their purchases of foreign assets. It may be no surprise that GCC oil exporters have been lukewarm in their support of Gordon Brown’s IMF fundraising.
The fall in commodity prices has varied effects on Latin America. Chilean exports have been hit by the falling price of copper, of which it is the world’s top supplier Copper exports fell 28.6% y/y to USD 2.7bn in October, consistent with the downward trend and the sharp drop in copper prices of 29.5% y/y. Chile's peso has felt the pinch of the sliding global economy and copper prices.
Current oil prices will curtail ambitious plans to cushion the impact of a U.S. recession through public infrastructure investment in Mexico. Estimates show that a $10 drop in the price of Mexico’s crude oil mix leads to a drop in public sector revenues of approximately 0.3% of GDP . Using a price forecast of $60.0 for the WTI in 2009, the shortfall in revenues, relative to budget estimates, would be equivalent to 0.7% of GDP, or roughly $7.6bn. Meanwhile, the oil price collapse will also hamper Venezuela's wide-ranging petro-diplomacy. Venezuela's capacity to borrow abroad to finance ambitious social programs may well atrophy, reinforcing the decline in President Hugo Chavez's standing at home on the eve of local elections.
The downward trend in commodity prices will clearly affect Brazil, through a decrease in exports. Unlike commodity driven countries like Chile and Peru, Brazil has a more diversified export base. Meanwhile, the decrease in commodity prices should reduce inflationary pressures, which in turn may give more freedom to the Brazilian Central Bank, which may not need to hike interest rates at the same rate as in 2008. The expected further reduction in growth or negative growth in emerging and developed economies, rather than the fall in commodity prices alone will have more effect on Brazil’s economic outlook.
Major exporters like Canada and Australia which experienced major terms of trade bumps during the commodity boom are also vulnerable, even if commodities make up a smaller portion of their growth and exports than the fuel exporters in the emerging world.
If commodity prices remain weak, producers will lower consumption over time, removing a source of aggregate demand that offset slowing growth earlier this year. For example, export growth from Middle Eastern, Latin American and African economies helped Asian goods exporters to offset slowing demand from the U.S., and more recently the EU. If that demand slows, it may be the final nail for many Asian exporters."