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Popping Perceptions
A confluence
of historic conditions bloated commodity prices before last
fall’s massive rupture, but long-term demand suggests prices
will still trend higher than folks are used to or want.
by:
Wes Ishmael |
Sometimes, the long-shot wins.
Mine That Bird, an unheralded Thoroughbred gelding from New
Mexico, by way of Canada, entered the starting gate of the 2009
Kentucky Derby as a 50:1 afterthought. He was such a long-shot
that he didn’t merit any practical consideration.
He trounced the field.
The commodity bubble that blew up in everyone’s faces and bank
accounts last year was a whole lot like that.
Chances were too slim for the necessary stars to align perfectly
at exactly the required time for any but the most irrational to
seriously consider it a possibility.
Then it happened, before we were even aware it was taking place.
Between January 2002 and July 2008, the International Monetary
Fund (IMF) price index for food commodities rose 130%, according
to the USDA Economic Research Service (ERS). The index for all
commodities was almost triple that, soaring 330%; crude oil was
of the charts at 590%.
Before the bubble popped last fall corn futures flirted with $8/bu.,
crude oil prices rubbed hocks with $140 per barrel, and deferred
live cattle futures soared to near $120/cwt.
Those are a far cry from the $4.20/bu. $68 per barrel and
$89/cwt., respectively as of the first week of June. Even as
producers and speculators were still trying to absorb the
mind-numbing relationship distortions of such head-snapping
volatility, there were already rumblings that a new commodity
bubble was simmering as oil prices surged during early spring,
despite increased inventory, decreased use and the struggling
global economy.
Less Supply + More Demand = Higher Prices
Trying to get your brain wrapped around exactly what happened,
though easier in hindsight, requires attempting to sort the
fundamental drivers from the non-fundamental ones.
There’s no denying that commodity demand had grown significantly
ahead of the bubble. In fact, demand for most everything was
growing at a heady pace thanks to the purchasing power of
multiplying global per capita Gross Domestic Product (GDP). In
the U.S. and much of the developed world, per capita GDP, on the
basis of what the IMF terms Purchasing Power Parity (PPP) at
least doubled between 1990 and 2007. Likewise, it at least
doubled in most developing economies. In India and China—where
40% of the world’s population resides—it was even stouter. In
India, per capita GDP tripled between 1990 and 2007. In China,
it grew more than five times in the same period of time.
Bottom line, more people than at any time in history had more
money than at anytime in history to buy more goods at higher
prices. For the first time in memory, rather than being the
global price-maker, the U.S. had lots of competition for
commodities from folks with plenty of cash.
At the same time, global agricultural production was declining.
According to ERS analysts, the global annual growth rate in the
production of aggregate grains and oilseeds increased an average
of 2.2% annually from 1970 to 1990. Since then the average rate
of production growth has declined to about 1.3% annually and is
expected to decline further. The reasons have to do with
everything from bad weather, to land being taken from
agricultural production, to scarcer more expensive water for
irrigation.
However, Ronald Trostle also pointed out in a special ERS report
last July, “Reduced agricultural research and development by
governmental and international institutions may have contributed
to the slowing growth in crop yields. Stable food prices during
the last two decades have led to some complacency about global
food concerns and to a reduction in R&D (research and
development) funding levels. Although private sector funding of
research has grown, private sector research has generally
focused on innovations that private companies could sell to
producers. These have often been cost-reducing rather than
yield-enhancing technological developments. Publicly-funded
research might be more likely to focus on innovations that would
increase yields and production, particularly in parts of the
world where farmers are unable to pay royalties for new
varieties of seeds.”
All the while, the global population continues to swell.
Remember, only about 4.5% of the world’s population of 6.79
billion lives in the United States. Here and in most of the
other wealthiest nations, population growth is next to zero or
declining. Especially in the poorest countries, though, the
number of people continues to explode. By 2030—just 20 more
years—many estimates peg the global population at about 8.3
billion, 20% more than today.
Plus, on the grain side of the ledger, competitive use has grown
dramatically, thanks largely to nations using corn to defray
reliance on crude oil. According to USDA, ethanol production in
the U.S. accounted for 23% of the nation’s corn use in
2007-2008, though ethanol represented less than 7% of gasoline
usage during the same period.
So, demand was increasing at the same time that global reserve
stocks of agricultural commodities were dwindling, the sure
recipe for increased prices.
We’ve seen it all before
In that regard, this most recent bubble was similar to the two
previous commodity bubbles that have occurred since 1970.
Analysts at ERS point out the first began in 1971, with corn and
soybean prices reaching record levels in 1974. The second time,
prices for most crops began rising in 1990; peaking in 1995 for
corn and wheat, and in 1996 for soybeans. In both instances,
rapid increases in international demand were part of the
precipitating driver.
What’s different this time around is the external shock that
punctured the balloon and the sheer magnitude of the stakes.
According to ERS, the 70’s bubble began leaking air as global
economic expansion slowed, due in part to increasing debt loads
and domestic policies implemented by a host of countries to stem
inflation.
Conversely, it was the Asian financial crisis that upended the
1990’s bubble. Heady growth in that part of the world included
developed and developing countries. When the crisis hit,
economic growth plummeted, taking the froth of commodity price
expansion with them.
This time around it was the economic depression on a global
scale with virtually every nation and industry caught in the
maelstrom set churning by unraveling credit markets last fall
(see We are the Entitlement Generations, page 16). Unlike the
Asian financial crisis, this one took root in the developed
countries first and most harshly, at least in the beginning.
Effects of the U.S. depression have been exacerbated by equity
lost in the housing crash that preceded it.
Perhaps more than any before, this commodity bubble was that
perfect storm of events that made the seemingly impossible
outcome far worse than anyone thought possible.
Blasted, Greedy Speculators
Still, doubling the prices of some commodities so quickly, then
cutting their value by about half just as fast suggests
non-fundamental forces were adding octane to the bubble surge.
In prepared remarks last September to the Swiss Futures and
Options Association, Michael Dunn, commissioner of the
Commodities Futures Trading Commission (CFTC) explained, “There
are two sides to this debate. One side says that fundamentals
such as the weakening of the dollar, tight supplies, and
increasing demand sufficiently explain the price increases. The
other says the increases are driven by a tidal wave of
speculative trading by banks, hedge funds and institutional
investors. And some say that it is a combination of these
driving prices.”
There is no question more traders and money gushed into
commodities markets during the bubble phase. Last June, as
commodity prices, especially oil, continued their nose-bleed
trajectory the CFTC formed the Interagency Taskforce on
Commodity Markets (ITCM). Its first charge was to examine the
oil futures markets.
According to the ITCM preliminary report, “WTI (West Texas
Intermediate crude oil) futures and futures-equivalent (or
“adjusted”) option contracts traded on the New York Mercantile
Exchange (NYMEX) more than tripled from around 900,000 contracts
in January 2004 to more than 2.9 million contracts in June 2008.
During the same period, the number of large traders has also
grown – almost doubling since January 2004, from approximately
220 to just under 400 reporting traders.”
In the remarks cited earlier, Dunn explained, “Commodities
appear have become an asset class in their own right. More and
more investors, both retail and institutional, are allocating
part of their portfolios to investments that are tied to the
performance of commodity futures. The performance has been good,
especially compared to the more traditional asset classes. They
add diversification to investment portfolios, and they provide a
hedge against inflation.”
But there remain plenty of questions about what if any effect
increased speculation has on commodity price levels.
According to the ITCM report, “…preliminary assessment is that
current oil prices and the increase in oil prices between
January 2003 and June 2008 are largely due to fundamental supply
and demand factors… preliminary analysis to date does not
support the proposition that speculative activity has
systematically driven changes in oil prices… imbalance between
scarce supply and growing demand, and expectations that this
imbalance will persist in the future, have led to upward
pressure on oil prices…it is often the case that only large
price increases can re-establish equilibrium between supply and
demand… large or rapid movements in oil prices are not
inconsistent with the fundamentals of supply and demand…
consumption growth has simply outpaced non-OPEC production
growth every year since 2003.”
For perspective, authors of the report say the run-up in prices
were the extension of developments in the crude oil market that
began in the 1990’s.
“…as leading OPEC members shifted toward a tight inventory
policy and global oil demand recovered from the slowing effect
of Asia’s financial crisis, the global market balance tightened
and inventories declined sharply at the beginning of the present
decade,” explain the authors. “By 2003, inventories were drawn
down sufficiently such that subsequent increases in global
demand stretched oil production to levels near capacity. The
large, unexpected jump in world oil consumption growth in 2004,
fostered by strong growth in economic activity in Asia, reduced
excess production capacity significantly. Now, in mid-2008,
despite high prices, world oil consumption growth remains
strong, overall non-OPEC production growth continues to slow,
and OPEC oil production has not grown sufficiently to fill the
gap.”
Since 2003, the ITCM says, “World oil consumption growth has
averaged 1.8% percent per year, representing an estimated 1
million barrels per day in 2008. OPEC oil production grew by
only 2.4 million barrels per day while the “call on
OPEC”(defined as the difference between world consumption and
non-OPEC production) increased by 4.4 million barrels per day.”
With demand so strong and supplies so tight, any supply
disruption wreaks exponential impact on price. According to ITCM,
through July of last year there had been 24 such disruptions in
as many months.
“Observed increases in the speculative activity and the number
of traders in the crude oil futures market do not appear to have
systematically affected prices,” concludes the report.
“Moreover, if speculative activity has pushed oil prices above
the levels consistent with physical supply and demand, increases
in inventories should emerge as higher prices reduce consumption
and investment in productive capacity is encouraged.” That
hasn’t been the case.
Higher but Slower
Even if you accept all of that, albeit grudgingly, you’re no
closer to understanding how the economy in general or the
commodity markets, specifically, might play out from here.
If previous post-bubble history is any indication, prices
stabilize at a higher level than when they began to rise, and
fundamentals coax them higher over time. Growing global
population and demand, combined with supply challenges make that
likely this time around, too.
Consider corn, as an example. Nearby futures contracts in June
this year were trading for almost 32% less than their
stratospheric highs a year ago. But, they were still 31% more
than in July of 2007 (see Table 1, page 60). And, no one knows
yet how long or deep the current economic depression will be.
Neil Harl, Charles F. Curtiss Distinguished Professor in
Agriculture and Emeritus Professor of Economics at Iowa State
University provided keen insight in a recent issue of that
university’s Ag Decision Maker.
“Higher commodity prices in 2007 and 2008 and modest debt levels
(compared to the 1980s era) have helped the farming sector in
many areas of the country avoid the worst effects of the global
meltdown and have enabled agricultural lenders, in general, to
maintain healthy balance sheets. But the sharp declines in
commodity prices in late 2008, the economic and financial woes
of the ethanol industry and the falling demand for agricultural
products, especially in developing countries, are impacting the
sector to a much greater extent in 2009,” says Harl. “My biggest
concern is that the global meltdown that is being experienced
has not displayed the features of a normal economic decline. The
drop in economic activity that began in late 2007 appears to be
more of a downshifting of the economy, due principally to a
revolutionary shift in thinking by consumers about debt, the
likely result of companies curtailing the use of high levels of
debt and the corralling of patently unwise strategies employed
on a widespread basis to deal with risk. Consumers, companies
and governments have all been living beyond their means. That
bubble has now burst. Adjustments in economic activity promise
to be profound and far-reaching as the world’s economy comes to
reflect a more cautious use of debt at all levels, at least for
the foreseeable future. That is likely to affect the buoyancy of
the general economy for several years.”
If you’re optimistic by nature, use history as your guide, we’ll
emerge from economic depression, sooner or later. And, we’ll
grow again, stronger or weaker compared to the past.
Table 1
Commodity Roller Coaster
July July Compared June Compared June ‘09
16 15 to 5 to versus
2007 2008 Previous 2009 Previous July ‘07
Futures
1Corn-Jul $3.41 $6.57 +92.7 %$4.48 -31.8% +31.4%
1Corn-Sept $3.54 $6.63 +87.3% $4.58 -30.9% +29.4%
1Corn-Dec $3.68 $6.82 +85.3% $4.71 -30.9% +28.0%
2Live Cattle-Aug. $91.62 $99.12 +8.2% $80.02 -19.3% -12.7%
2Live Cattle-Oct. $96.30 $106.40 +10.5% $81.00 -23.9% -18.9%
2Feeder Cattle-Aug. $113.85 $110.17 -3.2% $96.60 -12.3% -15.2%
2Feeder Cattle-Sept $114.67 $112.70 -1.7% 96.82 -14.1% -15.6%
3Oil-Aug $74.15 $138.74 +87.1% $69.35 -50.0% -6.5%
3Oil-Sept $74.23 $139.37 +87.8% $70.24 -49.6% -5.4%
3Oil-Oct $73.97 $139.83 +89.0% $71.07 -49.2% -3.9%
Dow Jones 13950.98 10962.54 -21.4% 8763.13 -20.1% -37.2%
1CBOT
2CME
3ICE-WTI
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