No doubt you will have noted the collapse in commodity prices that accelerated on Friday night, even as equity markets remained flat. Just in case you are unaware, here are a couple of quick charts. First the CRB:
And its more volatile cousin, the CCI:
The crash is across the commodity spectrum but is especially severe in metals (as a quick aside, I’d say Australia’s terms of trade have definitely peaked for this cycle).
A number of reasons have been put forward for the rout by any number of analysts. The most popular is that nice easy sound bite, easing global growth means the less demand and greater surplus of supply. This quote from Bloomberg is typical:
“We are seeing commodity prices correcting, so they are more compatible with the global economy,” said Christin Tuxen, a senior analyst with Danske Bank A/S in Copenhagen. “When we have fears over the economic cycle as we have now and a higher probability of contraction, it hits industrial metals and commodities.‘‘
And no doubt this is true to an extent. The analysis was most oft coupled with the explanation that last week’s concerned assessment of growth prospects by the Federal Reserve has turned sentiment. But another question we might ask is, if it was growth worries alone that suddenly smacked commodities, then why did the equity market hold up? Moreover, there was no news on Chinese growth, the key source of demand, to trigger the bust.
In my view, therefore, it’s not enough to say that diminishing growth prospects triggered the rout.
To me, it’s was not what the FOMC meeting said, but what it did that made the difference. Its decision to proceed with Operation Twist, rather than ramp up another round of asset purchases that expands its balance sheet (ie, no more money printing) deeply disappointed commodity markets. Why so?
With no more money printing, the $US is now liberated from the simplistic monetarist view that more dollars means cheaper dollars. And global markets, which run on a simplistic monetarist paradigm, are responding accordingly, with a $US rally.
That means all things ‘undollar’ must fall. That is, all things that are priced in the $US are suddenly getting cheaper, and that includes, above all else, commodities. What I am basically describing here is the monetary deflation of commodities. We might also call it a reversal of the ‘financialisation’ effect.
So, is there no fundamental supply and demand paradigm at work here too? Yes, there is. The Economist has a nice article this week which picks up on a theme I’ve discussed before too, the crowding out of developed economies:
Broader measures of raw-material costs have jumped as well. The Economist’s index of non-oil commodity prices has trebled in the past decade. The recent surge has reversed a downward trend that had lasted a century. Industrial raw-material prices fell by around 80% in real terms between 1845, when The Economist began collecting data, and their low point in 2002 (see chart 3). But much of the ground lost over 150 years has been recovered in the space of just a decade.
This has raised the incomes of commodity-rich countries such as Brazil and Australia as well as parts of Africa. It has also caused even sober analysts to speak of a “new paradigm” in commodity markets. Even though GDP has slowed to a near-standstill in many parts of the rich world, the price of crude oil is close to $100 a barrel—as high in real terms as after the oil shocks of the 1970s.
What accounts for this turnaround? The price spikes over the past century were linked to interruptions in supply, notably during the first world war. But recent price rises have been too broad-based and long-lasting to be adequately explained by frost or bad harvests. Nor is it obvious that producers are hoarding supplies. At Tubarão everybody is straining to get the ore onto the ships more quickly. Valuable time is lost in docking and in starting the loading.Optimists bet on human ingenuity to spring the Malthusian trap, as it has done so often before
There is a more straightforward explanation for the scarcity: the surge in commodity prices is simply the result of exploding demand and sluggish supply. The demand side has been boosted by industrial development unprecedented in its size, speed and breadth, led by China but not confined to it. Growth in emerging markets is both rapid and resource-intensive. The IMF estimates that in a middle-income country a 1% rise in GDP increases demand for energy by the same percentage. Rich economies are far less energy-hungry: the oil intensity of OECD countries has steadily fallen in recent years.
China’s appetite for raw materials is particularly voracious because of the country’s size and its high investment rate. Though it accounts for only about one-eighth of global output, China uses up between a third and half of the world’s annual production of iron ore, aluminium, lead and other non-precious metals (see chart 5). Most of the energy for Chinese industry comes from coal—a dirty fuel that contributes to China’s poor air quality. Its consumption of oil roughly tallies with the economy’s size but is likely to grow faster than GDP as China gets richer and buys more cars.
Supply has struggled to keep pace with this burgeoning demand. The world’s iron-ore production has doubled over the past decade but prices have risen 13-fold. The metal content of copper ore has been falling since the mid-1990s as existing mines are depleted. This mismatch between demand and supply is an age-old problem in commodity markets. It takes years to find and develop new mines and oil reservoirs and to build the infrastructure (rigs, pipelines, railways, ports) to bring the commodities to market. Supply responds slowly to price increases and delay often leads to excessive investment which then depresses prices.
So now I am blaming supply and demand! How inconsistent. Well…no. Both financialisation and the supply/demand imbalances are at work. Let me explain.
A year or so ago, Der Speigel carried a brilliant story on the rise of copper which included this era-defining chart from Bloomsbury Mineral Economics:
It shows that there is undoubtedly a demand boom. But it also shows an extraordinary explosion in price, beyond historical precedent. To me, it is absolutely no coincidence that the break with traditional fundamentals (and the beginning of financialisation) occurred in 2007 when the $US first began to substantially weaken as the housing bubble began to burst and US monetary policy headed south.
There is, of course, another element to the financialisation process; the accompanying transformation of commodity markets themselves into speculator casinos. The crash in metals has surely been pushed along by some nasty margin calls, not to mention the reversal of such schemes as Chinese ‘copper as collateral‘, as the new Fed position filtered through trader’s minds. But that is not my focus today.
My main point is that analysis of commodity markets tends to finger either the supply/demand imbalances or financialisation exclusively for sky high commodity prices. I think they do so for political reasons, adding another layer of complexity. But there is no reason for them to do so. Classical economic theory clearly explains the twin and simultaneous effect of financialisation and supply/demand imbalances (one of the few things it does get right!). To my mind, the following chart is the most important in contemporary commodity markets. As I have written before:
Like housing supply in Australia, commodity supply is inelastic. That is, it cannot respond quickly to a sudden surge in demand. The chart offered below (and mentioned above) shows the effects on any given market if supply cannot respond quickly. Don’t be scared of it, it is easier than it looks:
Q0 and P0 represent the initial equilibrium situation in any market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted).
Following an increase in demand, such as a surge of emerging markets looking to engineer an historically swift catch-up in living standards through mass urbanisation, the demand curve shifts outwards from D0 to D1. When commodity supply is restricted, prices rise sharply from P0 to PR. By contrast, when supply is unrestricted, prices rise more gradually from P0 to PU.
The situation works the same way in reverse. For example, if there was a sharp fall in demand following a contraction like that of the GFC or an inflationary bust causing commodity demand to fall from D1 to D0, then prices fall much further when commodity supply is constrained.
The graph illustrates that demand shocks combined with inelastic supply do not result in a one way bet of upwards price movements. Rather, such economic settings produce volatility, with steeper price rises and spectacular collapses.
Why you might ask? It’s pretty simple. This is a mathematical representation of human panic. When a market is perceived to be unable to increase supply easily then speculators move in. In strategic markets like oil, governments begin to fret about security of supply. They stockpile. More speculators enter the market. So on, and so forth.
So long as the perception that supply is constrained remains, the frenzy continues until it exhausts itself in a new crash.
In other words, in markets that can be represented as supply constrained, you get rolling bubbles and busts. Or, put another way, at the heart of every bubble is a grain of truth, but that does not mean that it is not a bubble.
Right now we are seeing the reversal of commodity prices pumped by financialisation and by growing concerns over growth. But China is so far growing well and many analysts still seem to think Western economies can dodge a Western recession. This leads me to conclude two things. One, the collapse in metals markets is overdone in the short term (although the CME’s move to raise position limits after the close on Friday is a blowfly in ointment). Two, if a Western recession comes (still my base case) and Chinese growth is dented, the ultimate downside for the broader commodities complex (grains, energy) will make the last couple of days look like a Sunday picnic.