Oil that glisters

Oil that glisters

Commodities
Jul 20th 2006From The Economist print edition

How high can they go? Speculators love commodities right now. But what do the fundamentals say?
WHEN commodity prices slipped from their giddy highs in May, many observers hailed the beginning of an inevitable correction after four years of rapid ascent. But the markets, it turns out, were simply pausing for breath. On July 14th the price of a barrel of West Texas Intermediate oil reached a new record in nominal terms of $78.40, although it has since fallen a little. Nickel followed, topping $26,000 a tonne for the first time. Even some agricultural commodities are starting to get caught up in the boom. Rapeseed oil, for example, is fetching unprecedented sums. The price of food crops has risen by 40% since the beginning of 2002, although that increase is dwarfed by huge run-ups in the prices of oil and metals, as the left-hand chart, below, shows.
Some analysts believe that investors have inflated a speculative bubble in commodities. Hedge funds' investments in energy markets rose from $3 billion in 2000 to about $90 billion last year, according to the International Energy Agency, a think-tank. Trading of commodities at exchanges doubled between 2001 and 2005, according to International Financial Services London, an industry group. Over-the-counter trade has risen faster still.
Other pundits think piling into commodities is justified, because the world has embarked on a “super-cycle”, in which commodity prices rise far higher and for much longer than is normal in a business blighted by frequent busts. The boom is certainly exceptionally long and lucrative. A recent report by Société Générale, a French bank, analysed five others since 1975. They lasted 28 months, on average, during which prices rose 35%. The present run, by contrast, has lasted 56 months, during which prices have doubled.
The super-cyclists put all this down to a simple mismatch between supply and demand. During the 1980s and 1990s, when commodity prices were low, mining and oil firms invested too little in new mines and wells, leaving them with little or no spare capacity. Although they are now rushing to increase their output, it takes years to find and develop new seams and fields. In fact, it takes longer now than it used to, because environmental regulations have become more onerous and activists more obstreperous around the world. With everyone trying to dig and drill at the same time, costs are rising and shortages of such things as huge tyres for mining trucks are hampering progress.
Meanwhile, on the demand side, the world as a whole, and China in particular, has been growing much faster than expected and consuming lots of raw materials as it does so. In the past 15 years China's imports of commodities have risen more than tenfold (see right-hand chart, above). One recent forecast, by Deutsche Bank, says that they will continue to grow by more than 10% a year for the next decade. At any rate, China's economy shows little sign of slowing. GDP grew at an annual rate of 11% in the first half of the year, according to official figures published on July 18th—the fastest pace in over a decade. This combination of feeble production and feverish consumption, the argument runs, means that demand for commodities will outpace supply for years to come.
But it is hard to apply this logic to all commodities. The supply of agricultural ones, for example, increases much more readily when prices rise, because farmers can plant more of them. Take maize (corn, to Americans) which is used both to make ethanol and to feed livestock. China's exports of maize are shrinking, as its herds multiply to cater to its citizens' growing appetite for meat. At the same time, the high price of oil is fuelling demand for ethanol, which is used as both a substitute for and an additive to petrol. Ethanol is expected to consume about a fifth of America's maize harvest next year. Both trends have helped to propel the crop's price to dizzy heights, with the prices of other commodities from which fuel can be made, such as sugar and rapeseed oil. But not for long: American and Chinese farmers are already planting more maize.
Gold is another exception. It is dearer than it has been for decades, yet jewellers and industrialists would need years to use up all the world's stocks. Gold is valued not for its scarcity, but as a hedge against inflation. Its price has duly risen, as worries about inflation have grown (thanks partly to the expense of oil) and central banks have raised interest rates. Higher interest rates, however, should eventually slow global growth, and so crimp demand for other commodities. The prices of gold and more mundane metals may therefore start to move in opposite directions.
Not even oil, the archetypal industrial commodity, quite conforms to the super-cycle theory. Granted, consumption continues to rise, especially in China, where imports have grown by about 10% so far this year. Furthermore, the industry can muster only about 1.5m barrels a day of spare pumping capacity—a tiny fraction of the 84m-odd barrels the world consumes daily. That makes the price sensitive even to relatively minor interruptions in supply. Iran, which exports 3.4m barrels a day, has threatened to use oil as a weapon in its disputes with America and the European Union. So oil traders twitch every time the two sides exchange barbs.
Nonetheless, during the past year spare capacity has actually increased marginally, as have stocks. This cushion should expand further over the next couple of years, as production starts from oilfields now being developed. Meanwhile, there are signs that demand, although not falling, is growing more slowly in the face of high prices. Supply and demand will certainly remain finely balanced for several more years, but the outlook is improving for consumers—even if this is not yet detectable in the price of oil.
It is hard, concedes Frédéric Lasserre, the author of Société Générale's report, to translate nebulous fears about future supply into prices. In the long run, the price of any given commodity should revert to the cost of producing an incremental unit of supply. By that measure, Mr Lasserre calculates, oil is overvalued by 50%, and zinc and copper by almost 40%. In the short term, the level of stocks plays an important part. But again, relative to the historical relationship between stocks and prices, Mr Lasserre reckons copper is 148% too dear; zinc, 122%; nickel, 70%; and oil, 49%.
Other analysts see parallels with the dotcom bubble of the late 1990s. After all, plenty of people are opining that “things are different this time”. Pension funds and individual investors are keen to get in on the action. CalPERS, America's biggest pension fund, is due to decide soon whether to put money into commodities. If such a conservative operator is eyeing commodities, cynics say, then a correction must be close at hand.
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