Overview: Commodity Bust

After languishing for decades, commodities sprung to life at the end of 2001. The CRB index soared 132%. Crude oil spiked 250% since January 2003. Copper soared 460% during the same interim and gold jumped 174%. Grains, metals and energy posted new highs. Growing demand from Asia, greater prosperity across the emerging world and a heady pace of activity in the developed countries pushed raw material prices higher. The spike in commodity prices was a God-send for most developing countries. Countries, such as Chile, Peru, Brazil, Kazakhstan and Russia saw their international reserves balloon and currencies appreciate. However, the commodity party came to an end last week, and prices will over-correct before they recover.

Despite all of the decoupling hype, the global economy is suffering from the after-effects of the U.S. slowdown. The deleveraging of the U.S. financial system is resonating throughout Europe, Asia and parts of Latin America. A recent study by the Bureau for Economic Policy Analysis reported that global trade for the three months ending in January was flat, in comparison to an increase of 6.9% y/y for the period ending in October. Unfortunately, for commodity producers, there were no tears among the policymakers of the largest economies. From China to the U.S. to Mexico, policymakers are calling for lower commodity prices. Rice prices are at a 20-year high. This is creating social problems in India. Soaring corn prices are pushing Mexican tortilla prices higher. Rising energy and food costs are fueling inflationary pressures in China. As a result, government officials are taking steps to reign in demand. All across the board, households are tightening their consumption of basic goods and energy in response to higher prices, slower growth and tighter credit. While this should force commodity prices to soften, the correction will be severe.

One of the inherent characteristics of the commodity sector is the long lag between changes in demand and output. Given the prodigious outlay needed to increase commodity output, producers usually wait to see if the increase in demand is sustainable to warrant more investment. The delay usually pushes prices higher, creating greater incentives to proceed with the projects. There are also the lags produced by the exploration and build-out phases. It takes years to find new oil fields, reopen mine shafts and prepare farmland. It takes even more time to make the new facilities operational. Furthermore, roads, railroads, pipelines and ports must be built to bring the commodities to market. Unfortunately, economic cycles tend to sour by the time that the new supply comes on line. However, once the sunk costs are made, production will remain on line—as long as market prices remain above variable costs. Given that variable costs tend to be low, commodity producers will dump their output onto the marketplace in a desperate attempt to recover their sunk costs–converting an orderly adjustment into a rout.

To make matters worse, there is also the issue of speculation. The commodity rally was initially driven by an improvement in global demand, but the persistent rise in metal, energy and grain prices brought a wave of speculative activity. In addition to riding the crest, concerns about the dollar and the stability of the financial markets spurred a frenzy of speculative buying. Brokers reported that more than half of the commodity trades were speculative. However, the souring of global demand and the deleveraging of the financial system turned the commodity correction into a bloodbath. The annals of commodities are filled with boom/bust stories. Unfortunately, given the depth of the looming slowdown and the massive deleveraging of the global financial system, this bust will be severe. It will have a dire effect on many emerging market countries, particularly those that thought that the commodity boom would last forever. Brazil is a case in point. At the very moment when commodity prices are tanking, local economists are projecting a sharp decline in Brazil’s trade surplus due to a large increase in domestic demand. The collapse of the commodity markets will surely create interesting bargains for investors, but it will take some time for the dust to settle.

7 Responses to "Overview: Commodity Bust"

  1. Nicolas Magud   April 3, 2008 at 10:51 am

    Hi Walter,Thanks for a great piece. I am really interested in these topics. Do you have any sense of the specific length of the lags (demand-output)?

  2. Anonymous   April 3, 2008 at 11:03 am

    Is gold demand likely to react different than other commodities? What is the likelihood of a near future flight to safety in gold?hlowe

  3. Eduardo   April 3, 2008 at 11:21 am

    WalterWhat is your take on Fitch decision about Peru?Why upgrade Peru when the commodity boom is about to end?Best regards,Eduardo

  4. Juan   April 3, 2008 at 9:23 pm

    EduardoIt’s my understanding that Fitch now considers Peru’s growth to be less primary sector dependent hence less affected by falling commodity prices.Whether this turns out to be correct remains to be seen, especially as price decline may prove more severe than most yet expect.RegardsJuan

  5. carmelus   April 3, 2008 at 9:39 pm

    No new information provided by you.It is easier to forecast a commodity collapse now that the us economy is slowing. On the contrary, check your information, because long positions on commodities where written by commercials and not by speculators.The most important bubble is the credit one feeding all type of assets, but hard assets will weather this crisis much better than financial assets.

  6. RL   April 4, 2008 at 3:00 am

    Yes a correction in commodity prices is coming, but I agree with the last post, It is not here yet. We must remember that the rise in prices has been really spectacular the past years so to make an effect in Latam it has to be a drastic correction of prices. Until we see some significant deceleration in Asian growth rates this won’t happen.

  7. Anonymous   April 4, 2008 at 1:36 pm

    Walter,I’ve just read a very interesting essay on speculation in the commodities market, and it supports what you say…http://www.economiaymercado.com.pe/index.php?option=com_content&task=view&id=104&Itemid=1