Satyajit Das
Oils Ain’t Grains – The Outlook for Commodities
Feb 9, 2009
Laws of Financial Gravity
Commodities posted their worst performance on record in 2008. Commentary on commodity markets reflects Mark Twain’s remark that: "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 go quite well on corn tortillas!
The key to commodities is demand. Higher prices, for example in oil, 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 is not clear how much 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 (buy "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. In 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 is not 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.
Individuals All!
Oil prices may have further downside, in the short run, reflecting continued reduction in demand as growth slows. Production cuts by OPEC may not be effective as revenue strapped sovereign producers adjust volumes to generate cash flow. Ultimately, the laws of supply and demand, production costs and a finite, constrained resource will support the price.
The outlook for alternative energies is less sanguine. Most alternatives require high oil prices to be economic. Support for alternative cleaner energy is likely to wane as the GFC forces governments to defer climate change initiatives in the face of harsh economic conditions.
The dislocation in financial markets has benefited gold. The gold price has performed well reflecting increasing suspicion about "paper" money and lower interest rates. Governments continue to attempt to reflate domestic economies by traditional Keynesian spending, increasing concern about possible inflation providing support for gold. There is a fear of a return to a gold standard leading to hoarding of gold stock. Emerging market demand for gold, a traditional store of purchasing power, may be fuelled by the threat of increased social unrest.
Other precious metals, platinum, palladium and silver, are likely to be affected by decreased demand, especially the problems in the automobile sector globally.
Industrial metals (aluminium, copper, lead, nickel, zinc and tin) and bulk commodities (iron ore and coking coal) have been a major proxy for global economic growth, particularly demand from a rapidly industrialising and urbanising China and India. Slower growth and problems related to inventories and oversupply may mean a continuation of weakness.
The performance of agricultural prices is puzzling. After falling in line with commodities generally throughout 2008, in December agricultural products decoupled from other assets. For example, some grains rose sharply in prices by 10% to 20%.
Prices (adjusted for inflation) are around 40% below long run average prices. Grain inventory levels are low – around 2 months of global demand. Problems affecting financing of crops and trade, low prices and difficulty of hedging (increased in margins and hedging costs) have meant that plantings have been low. Major seed producers report a sharp decline in sales. The increased problems of food production from climate change also means the risk of supply disruption cannot be discounted.
Historically, agricultural products have performed well in economic recessions. Tightening supply, risk of supply shocks and the appeal of a recession resistance asset may underpin prices in relative terms.
Agricultural products that have been linked to oil prices (such as corn, palm oil, soybeans and rapeseed) will be dependent on the broader performance of energy prices.
Backwards and Forwards
The current realignment affects financial investments in commodities. The case for commodities as a separate investment asset class has been undermined. Commodities have proved to be highly correlated to other financial assets. The volatility of commodity prices, traditionally high, has proved to be extreme.
One significant change has been the shift in the relationship between spot (immediate) commodity prices and forward (or future) prices. Historically, commodity prices for some commodities, especially non-financial commodities like gold, have exhibited ‘backwardation’; that is, forward prices have traded below spot prices. This allowed investors to earn the ‘roll’; that is, they bought forward and then sold the commodity to accrue ‘the convenience yield’ as the contract shortened in maturity. This income, first explained by Keynes, has been a significant source of gain for financial investors.
As commodity prices fall as a result of reduced demand, the ‘backwardation’ changes into ‘contango’; that is, forward prices are above spot prices. The contango reflects the cost of holding the physical commodity adjusted for holding costs (storage, insurance, interest rates etc). Weak demand exacerbates the contango as excess supply goes into storage. Financial investors cannot benefit from the convenience yield reducing one of the sources of return. The long-term effect of these dislocations on financial investment in commodity markets is unknown.
Bridges to Nowhere & Velocity of Pigs
During commodity booms excesses abound. Oil rich countries enjoying rapid growth in commodity revenues embarked on grand and expensive projects. For example, in this cycle, Dubai undertook an ambitious expansion program based on real estate, luxury hotels, airlines, financial services and English premier league soccer clubs.
The excesses are notable. The recently opened Atlantis Hotel is at the end of the first (and so far only completed) Dubai Palm, a piece of reclaimed land designed to resemble a palm tree. The Atlantis has its own theme park next door, every shop and restaurant conceivable and a mammoth aquarium (featuring 65,000 marine animals). The Palazzo Versace hotel, currently under construction, features a beach with artificially cooled sand to save guests from the hot sand as they walk from water to the hotel.
The most emblematic project of this cycle is a project proposed by Tarek bin Laden, one of Osama bin Laden’s many half-brothers. The project entails twin cities on either side of the Bab al-Mandib (Gate of Tears) strait at the mouth of the Red Sea linked by a 29 km bridge across the strait. The project cost was estimated at $200 billion.
Recently an acquaintance in financial markets announced his retirement to a life of rustic simplicity in Umbria, Italy. He had acquired a farm and was restoring it with the help of local ‘serfs’ (his word not mine!). The farm would be self sufficient producing essentials of life - wheat, milk, wine and meat. The plan was to avoid the coming financial Armageddon in financial markets and the money economy.
The newly minted farmer was especially excited by the farm’s black pigs that reproduce three times each year. He referred to this as the ‘velocity’ of the pig population. The porcine velocity is much greater, ironically, than the current velocity of money in financial markets as the recession sets in and the implosion of the financial system becomes institutionalised.
Grandiose plans tend to be launched towards the end of the boom cycle. Pigs and food may be well be where the smart money heads in these troubled times.
Fundamental demand for food and energy may emerge as key investment drivers – everybody needs to eat and we are still a fossil fuel driven society.
© 2009 Satyajit Das
Satyajit Das is a risk consultant and author of a number of key reference works on derivatives and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
