What’s Driving the Bull Market in Commodities?

Whats Driving the Bull Market in Commodities?

Eighteen months ago, when the world was awash in asset bubbles, there was
perhaps no market more overheated than commodities. Prices of everything
from iron ore to palm oil to corn reached dizzying heights. Crude oil nearly
quintupled in five years; rice tripled in only five months. World Bank
President Robert Zoellick called rising food and oil prices a “man-made
catastrophe” that had the potential to quickly erase years of progress in
overcoming poverty. Protests and riots over high prices for necessities
erupted across the developing world. Pundits dusted off Malthusian theories
that the planet was physically unable to support the burgeoning appetites of
an increasingly wealthy global population.

What a difference a financial crisis makes. After the worldwide economic
boom went bust, demand abruptly evaporated for many commodities that go into
the production of houses, cars, computers, and all kinds of durable goods.
The Dow Jones-AIG commodity price index has shed more than half its value
since mid-2008. Due to falling metal prices, BHP Billiton in January
announced the mothballing of an Australian nickel mine only eight months
after it officially opened. The most visible turnaround has been in oil. A
year ago, Western governments were pleading with Persian Gulf oil states to
ramp up production as oil sped toward $150 a barrel; today, OPEC is twisting
off the spigot in an attempt to support crude prices around $50. The
International Energy Agency expects oil demand to fall this year at the
steepest rate since the early 1980s. Some experts believe prices may stay
depressed for years to come, due to greater energy efficiency, technological
improvements in oil production and greater availability of alternative fuels
such as biofuels.

But over the last several months, something funny has been happening in the
commodities trade. After spectacular plunges, the prices of oil, copper,
palm oil and others are rallying. This shouldn’t be happening given the
parlous state of the world economy. The International Monetary Fund this
week cut its global growth forecast for 2009, predicting GDP would contract
by 1.3%, the most severe recession since the 1930s. Yet oil is some 50% more
expensive now than in December. Palm oil, which is used in a wide variety of
manufactured foods, has surged by about 50% this year. “The only area of the world
economy I know of where the fundamentals are improving are commodities,”
says investment guru Jim Rogers. “The fundamentals for General
Motors are not improving. The fundamentals for Citibank are not improving.
The fundamentals for cotton are improving.”

But why are prices rising for some commodities now, in the middle of the
worst recession in decades The answer: demand is recovering, slightly, for
some raw materials. In the case of oil, supplies have been reduced by OPEC
cutbacks. And commodities traders are bidding up market prices in general on
expectations that supply shortages will return with just a modest
improvement in demand.

That’s because miners, farmers and oil drillers, hit by the credit crunch,
can’t finance investments that would increase their production capacity.
Many won’t invest today even if they have access to financing because
depressed prices make projects uneconomic. Indeed, when prices spiked
sharply in 2007-08, it wasn’t because the planet was running out of natural
resources. The problem was that there hadn’t been enough investment in many
sectors to produce those resources and bring them to market. The recession
is making that situation worse. The amount of investment in the oil sector,
for example, will likely be 30% lower in 2009 and at least 40% less in 2010
than was expected before the financial crisis, according to Merrill Lynch.
In mining, investment could be 40% lower in 2009-10.

Since new oilfields and copper mines take years to get into full production,
lower investment today causes tighter supply down the road. At the same
time, there is every reason to believe that emerging markets such as China
and India will continue to be ever more voracious consumers of iron ore, oil
and food as their economies get bigger and their citizens richer. Palm oil
prices, for example, have been rising of late partly because demand from
India, with its population of 1 billion, is holding up. In March, China
imported a record amount of iron ore and coal, while imports of crude oil
hit a 12-month high. The binge is being fueled in part by optimism that
Beijing’s $565 billion stimulus program will drive a turnaround in the
sagging economy. “After a brief pause, China’s appetite for natural
resources has returned to buoyant levels,” Jing Ulrich, chairman of China
equities at J.P. Morgan in Hong Kong, wrote in a report this month.

Of course, different types of commodities will react differently as the
global economy improves, based on their own specific supply and demand
conditions. This makes timing a turnaround complicated. Rogers says he
expects commodities prices to be among the first to rise, out of all asset
classes, when economic growth begins to return. Other experts argue against
a rapid rebound, because inventories are high for commodities such as oil,
and because demand for natural resources has been so thoroughly squelched in
some industries that it may not fully recover anytime soon. Francisco
Blanch, head of commodities research for Merrill Lynch in London, says he doesn’t
expect overall demand will return to 2007 levels until 2011 at the earliest.
“Over a number of years we will get back to supply constraints,” says
Blanch, but “it won’t happen over the next six to 12 months.”

Still, bullish investors see little downside in commodities, although
returns may not come overnight. Some consider commodities a hedge against
another looming threat: inflation. If loose monetary policies implemented by
central banks around the world to stimulate growth eventually spark
inflation, commodity prices might escalate rapidly. “If the world economy is
going to improve, commodities are going to be the best place to be,” asserts
Rogers. “If the world economy doesn’t improve, commodities are going to be
the best place to be.” Anyone for a truckload of soybeans

With reporting by Tim Morrison / New York

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