Articles:
The confounding commodity boom

In the first edition of this column in January 2007, it was noted that having enjoyed a boom of about five years, commodity prices had begun to fall. Prices of oil and of most metals had peaked in the middle of 2006 and since then had fallen in price by up to 30%. The column explored the question of whether this might be a turning point, of whether oil and metals prices might continue to fall. On balance, your columnist said he was inclined towards bearishness, as supply was likely to increase and demand growth to ease.

            This prediction does not, however, look terribly good right now, 15 months later. January 2007 did prove to be a turning point, but in the opposite direction. The IMF commodity price index rose by 44% between February 2007 and February 2008. The price of crude oil, which had fallen from $78 a barrel in June 2006 to a little over $50 six months later, has since more than doubled again, reaching more than $115.

            Economists and other commentators tend, for understandable reasons, to focus on the issues on which they are proved right. Yet it is often more interesting and instructive to examine those cases in which you have been proved wrong. Why did commodity prices resume their boom and confound this columnist’s pessimism?

Follow the money

“Deep Throat”, the confidential source for Carl Bernstein and Bob Woodward of the Washington Post when they uncovered the Watergate scandal in the early 1970s, offered advice that is helpful now for understanding the commodity boom: “Follow the money”. To that one should add a further suggestion: “Also follow the politics”.

            At first sight, an injunction to pay attention to money might be taken as implying that financial speculation has been the cause. But that would be wrong: although weak prices for equities and debt securities may have encouraged investors to devote more cash to commodities, especially at a time when declining dollar interest rates have made non-interest-bearing assets such as gold and oil look more attractive, the boom has lasted for too long to be explained in that way.

            Rather, the money that matters is represented by the savings glut in the world’s emerging economies, especially China, its East Asian neighbours, Russia, and the Arab oil-producing countries. For the other surprising trend that lies behind the commodities story is the fact that emerging economies have so far been unaffected by slowing growth in the West. As the rich world began to slow during 2007, most economists’ eyes turned to the trading links between America, Western Europe and the emerging economies, in order to see which countries might be most affected. But this under-rated the importance of trade between the emerging and developing economies themselves: according to the IMF more than half of exports from those economies are now towards other such economies. It also, however, under-rated the importance of money.

            The main fuel for China’s GDP growth rate of 11.9% in 2007 and for India’s growth of about 8.6% has not been exports but rather investment, made possible by abundant domestic savings and by a credit boom. Until the past decade, most developing countries needed foreign capital to finance their growth, which made them vulnerable to Western downturns and to losses of confidence among Western bankers and investors. Since the late 1990s, however, many have built up their own capital surpluses. So they are no longer vulnerable. And they can continue to build new roads, factories, office blocks and airports regardless of what is happening in America’s economy.

            According to the IMF again, since 2002 emerging economies have accounted for more than 90% of the rise in consumption of oil and of metals, and for 80% of the rise in consumption of grains. No one need look much further than that source of demand growth to comprehend the long-term boom in commodity prices. Yet the fall from mid-2007 and the subsequent resumption of the boom happened despite that long-term demand growth.

            In the crucial case of oil, this is where the politics comes in. For as well as demand, we must look at supply. Worldwide demand for oil rose from 84.9 million barrels a day in 2006 to an estimated 85.8 million in 2007, a rise of 1.1%. Yet worldwide production of oil rose by only 0.2% last year. The cost of finding and developing new oilfields has been soaring, thanks to a shortage of rigs and engineers, but that is not the explanation. The reason why output rose so little is that the oil-producers’ cartel, OPEC, decided not to increase their supply but actually to reduce it, by 1%. Since OPEC accounts for more than 40% of global oil output, this mattered a great deal.

            Back in early 2007, it looked as if the politics of OPEC might favour a rise in output and fall in prices, for Saudi Arabia, the country with the world’s largest oil reserves, was concerned about the growing regional strength of its rival, Iran, which was being reinforced by high oil prices. But Saudi Arabia lacked enough spare production capacity to bring about an output rise on its own, and the arguments of Iran and Venezuela won the day. Both have governments desperate for oil revenue, and happy to see high prices sap the strength of the United States. High energy prices have in turn encouraged food prices to soar, for farmers’ fertiliser costs have risen as energy became dearer.

            So what might happen now? Given the accuracy of the prediction made in January 2007, it would be unwise to be too bold. One can, however, note the following points. The first is taken from a chart in the IMF’s recent World Economic Outlook. From 2003 until 2008, the OPEC countries’ total spare production capacity, as a percentage of world demand, has been well below the 4% average of 1996-2007. It will remain below 4% during 2008. But it is expected to rise back to that level in 2009, thanks entirely to extra capacity in Saudi Arabia.

            The second point is an observation about economic conditions in the emerging economies that have driven the overall commodities boom. In both China and India, inflation is the most prominent economic issue: it has risen about 8% in China and (depending on the preferred measure) 7% in India. Rising energy and food prices are the immediate reason. But rapid money-supply growth, helped by buoyant credit expansion, provides the underlying reason.

 In both countries, politics and economics are combining to make a crackdown on inflation look vital during the rest of this year. Inflation has also become a larger concern in Latin American countries and in many other parts of Asia. It is pretty unlikely that inflation will be tamed without some slowdowns in economic growth in emerging economies, for that will be the consequence of costlier credit and other measures to reduce monetary growth. How far this cuts the growth in demand for commodities will depend on how severe the slowdown in domestic investment proves to be.