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No Food for Oil: The Commodity Outlook


Fundamental demand for food, energy may emerge as key investment drivers.

Laws of Financial Gravity

Commentary on commodity markets, which posted their worst-ever performance in 2008, reflects Mark Twain's remark: "I am not one of those who, in expressing opinions, confine themselves to facts."

Unlike financial assets, commodities, for the most part, are subject to the laws of economic gravity - supply and demand. Individual commodities are also highly idiosyncratic - you can't drink oil, nor can you run your car on gold (though they seem to run quite well on corn tortillas).

The key to commodities is demand. Higher prices -- in oil, for example -- led to a sharp reduction in demand as people lowered consumption or used substitutes. Falling prices shift this balance, especially in energy importers such as China, Japan and India.

It isn't clear to what extent lower global growth is impounded in commodity prices. The fall-off in exports in Asian countries and the collapse in freight rates is especially worrying. Inevitable protectionism ("buying local" and currency manipulation to gain export competitiveness) is also a concern.

Ultimately, commodity prices will depend on recovery in growth, consumption, housing markets, durable goods (especially motor cars) and stability in financial markets and resumption of more normal financing activity. None of this seems likely in the short term.

A key dynamic is whether deflationary pressures (falling prices) emerge. In a deflationary environment, commodities will be hit hard as demand falls further. The lack of income and high real rates of interest will affect prices.

By contrast, inflation would be supportive of prices as investors switch from monetary to real assets. Despite strenuous rhetoric and monetary actions by central banks, it isn't clear whether debt deflation can be avoided.

Aberrant Tendencies

Short-term factors also affect the outlook. Falling prices have placed enormous pressures on companies and state treasuries dependent on resource based revenues.

Companies with large debt service commitments are being forced to produce at uneconomic prices simply to generate cash flow. Some oil exporters are producing below operating cost to maintain revenues to finance ambitious spending plans conceived in more prosperous times. This overproduction distorts prices.

There are growing supply constraints in some markets. Junior miners are unable to bring resource properties into production because of financing pressures. New investment and expansion has been deferred or abandoned. These bottlenecks may cause short-term supply disruptions creating significant volatility in prices.

A known unknown is the performance of the US dollar. There is a complex and unstable relationship between commodity prices and the dollar. An IMF study noted that a 1% increase in the value of the dollar results in a decrease in oil and gold prices of greater than 1%. This means the elasticity is around 1. It appears to be higher for gold than oil prices. Continued volatility in currency markets, reflecting pressures as sovereigns attempt to finance their budget and financial system bailout requirements, will be mirrored in commodity prices.

The impact of lower shipping costs on individual commodities is also a factor. At the height of the commodity boom, one apocryphal story told of containers shipping goods to America being scrapped upon arrival in the US. This reflected the lack of US-China traffic and the cost of shipping back the containers. Shipping resources that were previously uneconomic to ship, for example, bulky items with low price to volume ratios such as cement, are now tradable reflecting the collapse of freight rates. This means that local pricing variations and protected niches may be affected.
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No positions in stocks mentioned.

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