London, 5 March 2011

Commodities Now: Unrest in the MENA region, regulatory uncertainty, high unemployment, inflationary pressures, sovereign debt crises ... just a few of the uncertainties making markets nervous, sending commodity prices higher, and compounding price volatility.

What began as one man’s grievance against the authorities in Tunisia has quickly revealed a boiling cauldron of malcontent on the part of Bahrainis, Egyptians, Algerians and others across the Middle East and North Africa (MENA). Recently, the problems associated with ever increasing agricultural prices have been compounded (and usurped) by oil prices once again.

Markets, from copper and tin, to cotton, sugar, palm oil, coffee, and rubber, and now to oil ... have returned to (and in many cases surpassed) the peaks of 2008. And this time it is different.

Where once the raw materials sector used to perform best in the later stages of the economic cycle, this time round shortages, lack of investment, increased production costs, resource nationalism, and the almighty demand from the emerging world has meant that natural resource prices are driving an inflationary nightmare for policymakers in the early part of recovery. This means that the expansionary phase of economic activity in the OECD (and there are clear signs in a number of sectors) will put even more pressure on prices. That is, of course, unless much higher oil prices cut short the recovery phase.

The Coming Inflation

The resurgence in demand for a host of commodities in 2010 took markets by surprise. Oil demand growth was the second strongest in 30 years. Corn demand broke records and copper demand was up 10% – the highest ever. And there are many more instances (and little signs of a retreat) where the demand for commodity inputs into the global economy are continuing to grow beyond the ability of industries to produce them.

Food prices around the world have surged with the FAO’s Food Price Index at its highest level since the agency started measuring food prices in 1990. “The new figures clearly show that the upward pressure on world food prices is not abating. These high prices are likely to persist in the months to come,” said Abdolreza Abbassian, an FAO economist and grains expert.

Recent increases in agricultural commodity prices mainly reflect supply shocks, which have been compounded by export bans and hoarding. Extreme weather conditions last year damaged crops in many parts of the world, notably harvests of wheat and sugar. And the resulting increases in food prices have contributed to social unrest in many MENA countries.

To compound events, governments in the Middle East and elsewhere, fearful of contagion, are responding by restricting exports of agricultural commodities and/or increasing imports to add to precautionary stockpiles. “In the near-term however, these individual actions simply make the global problem worse,” according to Julian Jessop of Capital Economics. This suggests that actions taken by governments elsewhere to prevent similar uprisings in their own countries will add to the upward pressure on global agricultural commodity prices, adding to the upward pressure on food price inflation.

So, the common global economic concern right now is commodity price inflation. Rising food, energy and raw material costs feed into core inflation and drive up underlying price trends. Commodity price gains also create a drag on growth, because for many companies the prices of essential inputs are unavoidable. And it is the price of oil which has now taken its place back centre-stage in the debate.

In Historical Oil Shocks James D. Hamilton, economist at the University of California, San Diego shows that, “Every [US] recession (with one exception) was preceded by an increase in oil prices, and every oil market disruption (with one exception) was followed by an economic recession. Moreover, supply disruptions arising from dramatic geopolitical events are prominent causes of a number of the most important episodes.”

If events in the MENA region do conspire towards a dramatic rise in oil prices the global recovery will be quickly scaled back, especially in OECD markets. Fortunately so far, events are not of anything like the same magnitude as the major historical oil supply disruptions, and are unlikely to produce big enough economic multipliers that could precipitate a new economic downturn. [The MENA situation remains a ‘tail risk’ outcome as we discuss on page 44].

Party On

So the commodity party remains in full swing. ‘Super-cycle’ is back on the newspages. But this party has attracted too many unwanted guests according to the regulatory authorities. These ‘speculators’ who do little more than gate-crash proceedings without contributing in any way (and supposedly slink of with the prettiest girls) are to some the villains of the piece and one of the root causes for the current commodity inflation sweeping the globe. And with paper assets looking increasingly unattractive, who can blame them? We don’t, and reason that there remains a fundamental misconception of the role of financial players in the commodity complex and their affects on prices.

As inflation bites, the conditions for sustained price increases could be coming to an end. However, with emerging market growth remaining strong, the US economy on the up, and European sovereign risk under control – and given the expected tightness in many commodity sectors over the next 18-24 months – we will likely see a number of commodities extending their gains.

As we have contended since the massive sell-off in commodities in 2008, the financial crisis was merely a temporary respite from the inexorable rise in demand for most natural resources. Thus, 2011 promises to be just as volatile, if not more so, than 2010.

This commodity bull market has been over 10 years in the making and driven more recently by loose monetary policy. Or has it? Fed Chairman Ben Bernanke disagrees. “I think it’s entirely unfair to attribute excess demand in emerging markets to US monetary policy,” he recently remarked. Those nations can use their own monetary policy and adjust exchange rates to deal with their inflation problems, he insists. “It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Many agree with him believing the central bank ‘money printing’ link to commodity prices to be tenuous. They see the extent and pattern of commodity price increases as being largely consistent with the usual supply and demand fundamentals. That, in turn, means that those commodities now rising due to supply disruptions can (all else being equal) fall as supply normalises. And other commodity prices will respond to slower growth in consumer economies, if policymakers in those economies slow growth.

This last point is critical, according to Gerard Minack at Morgan Stanley in Australia. “If commodity prices – particularly for industrial commodities and energy – are rising due to conventional supply and demand factors, then accelerating growth in developed economies will likely push prices higher. This is what our commodity strategists expect this year. But this is a conventional problem for policymakers, and not a leading signal for a broad-based money-driven surge in inflation. Given excess capacity in most developed economies, it seems unlikely that core inflation rates will accelerate by much over the coming 12-18 months, in my view. Beyond that, I can get more worried.”

The global economic recovery is advancing at different speeds. IMF forecasts are for emerging markets to grow by an average of 6.5% this year whilst growth in Europe and Japan to be 1.5%. The US recovery stands somewhere in between (in the 2.0-2.5% range), with growth gathering momentum and inflation risks modest, but unemployment stubbornly high.

Hopefully, the world is moving gradually to building a consensus on ways to address current imbalances. This is a necessary foundation on which effective international policy action cooperation can help pre-empt or diffuse these imbalance imperatives. As the G-20 note, this process will take time, but it “will happen” because all countries, particularly the emerging economies in the G-20, have a strong interest in reducing the risk that their future growth and financial stability is undermined by large global imbalances. But there is no sign that the major players have a shared understanding of the problem, let alone any willingness to change their policies to meet common objectives. On commodity markets the latest communiqué simply promised further study and analysis, together with a cursory reference to the importance of a prompt conclusion to the Doha negotiations ... but nothing to suggest that substantive progress is being made.

This leaves different parts of the world adopting different policy responses to commodity price related events in an attempt to shield their populations and maintain political credibility. Another dilemma for the developing world is the extent to which it can allow some currency appreciation to deflect rising import prices and developed world criticism without harming competitiveness.

Even in the absence of an oil price shock, the global recovery faces several major challenges which are discussed in the pages that follow. These include an effective response for increasing long-term investments in agriculture in low income countries, through mechanisms such as the Global Agriculture and Food Security Program, raising productivity and improving rural infrastructure.

One sector sure to reap the rewards of higher fuel costs will be new investment in clean energy which last year smashed through previous levels to reach US$243bn – up 30% from 2009 and nearly five times that from 2004, making 2010 easily the strongest year so far for investment in clean energy, according to the latest figures from research company Bloomberg New Energy Finance. The main drivers of the rapid growth in investment were China (up 30%), European offshore wind, European rooftop solar and research & development. Increasing funding of projects could be one of the positive trade-offs of US$100/ bbl+ oil.

As 2011 unfolds, many of the drivers of uncertainty remain. Currency valuations are still in transition with expectations that the US dollar will start to appreciate if recovery in the US takes hold. Eurozone economies remain highly indebted and some will be forced to refinance. And if inflation becomes entrenched there is a risk of a policy reaction – overzealous monetary and fiscal tightening (whilst somewhat ineffectual on cost-push inflation) which together would suffocate the recovery.

What is certain is that emerging market economies will further tighten their grip on the global commodity markets. However, events in the MENA region could transpire to put an abrupt halt to current price proceedings if oil prices reach levels consistently above and beyond US$120-130/bbl for a prolonged period [where oil’s share of global GDP starts to move above 5.5% historically a point where global growth has come under pressure].

Expect, therefore, inflationary concerns and monetary tightening to dominate government economic priorities and market attention. In the short-term, until the market itself becomes uncomfortable with present commodity price trends it is hard to fight against them, no matter how jaundiced a view one might take of their underlying rationale.

So beware. As Sean Corrigan at Diapason Commodities aptly recommends; “The best we can do is to keep stops tight and thinking flexible, especially where some of the rates of ascent are becoming so very demanding and/or where relative behaviour between commodities may be starting to signal exhaustion.”

Ends --

By Guy Isherwood, Editor, Commodities Now.

The March 2011 edition of Commodities Now is available online:

www.commodities-now.com