Rajani Sinha & Udit Kumar
In last one-year commodity prices have displayed a remarkable rebound. The S&P GSCI commodity price index has risen by 36% since February 2016. This revival in prices recouped around one third of the price decline witnessed during 2014 and 2015. Met coke prices rose by an astronomical 250% in 2016. Iron ore prices rose by 120% and zinc and crude oil by more than 70% each in the last one year.
To put things in perspective, huge demand for metal, oil, coal from China coupled with decades of under investment in capacity creation had fuelled the commodity super-cycle in the first decade of the twenty first century. However, with China GDP growth reducing, the commodity rally petered down somewhere around 2011.
Global dynamics have changed significantly since the last commodity super-cycle. China, the big guzzler of commodities—accounting for 40% of global aluminium consumption, 50% of coal consumption—has cooled down. In 2016, China recorded GDP growth of 6.7% as against growth of 12-14% recorded at the peak of commodity super cycle (2006-07). Fixed asset investment growth in China has reduced to 8% in 2016 from 25% in 2006-07, with the government shifting focus to consumption led growth.
So, what really has been supporting the current commodity price rally? One, the supply-demand balance for commodities has turned favourable especially in the backdrop of continued low price levels in 2012-2015. China took recourse to fiscal and monetary stimulus in the last two years to support the economy. This improved economic sentiment in China and was also reflected in increasing commodity imports from the country. Imports of coking coal, copper concentrate and crude oil have jumped up by 34%, 31% and 14%, respectively, in 2016. Given the huge share of China in global commodity demand, the pick-up imports has been a big supporting factor for commodity prices.
China is also a huge supplier of commodities, hence supply rationalisation there has been the other big supporting factor for commodity prices. There have been supply cuts effected in some industries in China due to environmental concerns and to address issues of overcapacity. For instance, the National Development and Reform Commission mandated coal supply cuts in China pushing thermal coal and coking coal prices very sharply in 2016. Sharp rise in coking coal prices in turn pushed up iron ore and steel prices. Steel prices were also pushed up due to environmental crackdowns and temporary closures of steel plants in China. Even for aluminium market, there has been announcement of smelter capacity cuts towards the end of 2017, to take care of environmental concerns.
Apart from supply rationalisation in China, there was a supply cut by OPEC for crude oil. OPEC agreed to cut production by 1.2 thousand barrels per day (mbpd) over the first half of 2017. OPEC also convinced non-OPEC producers such as Russia to reduce the global supply glut, bringing the agreed cut in output to more than 1.7 mbpd. This has been a big supporting factor for the crude oil price rally.
Apart from demand-supply factors, increased investor interest in commodities has been strongly supporting the current commodity price rally. In fact, there has been a rise in risk taking sentiments globally, which is being reflected in sharp upswing in stock markets and commodity prices. Commodity is considered a high risk/high return asset, and hence benefits in times of risk taking. As per Commitment of Traders report, net long position for some commodities like copper and crude oil have reached record levels in last few months.
An interesting aspect of the current commodity price rally is that the inverse correlation between the USD and commodity prices seems to have broken. As commodity prices are quoted in USD, strengthening of USD generally implies lower price of commodities. However, in the last few months, we have seen increase in both commodity prices and USD index. This phenomenon could be attributed to improving economic condition in the US, and hence expectation of increased demand for commodities from the US.
As per a recent World Bank report, commodity prices are expected to continue rallying, with the energy index projected to rise by 26% and metal index by 11% in 2017. Rising global PMI since mid-2016 is also supportive of commodity prices. However, another commodity super-cycle is not visible on the horizons—at least not yet. First, the commodity price trajectory so far has been smoothly trending up due to extremely low starting points – where production cut backs had started meaningfully.
Second, supercycles (as against a bear market rally, or even a cyclical bull market) are rare without a large push form the demand side. From here, demand for commodities may improve but is unlikely to reach once-in-a-generation proportions. Indeed, there are some lingering threats to the commodity price rally which cannot be ignored. For instance, concerns on China’s huge debt problem could re-emerge. China has a high debt to GDP ratio of 258%. The government is trying to control the high leverage, and recently started tightening the monetary policy. If not managed effectively, this could have repercussions on China’s property market and overall growth.
Crude oil prices had risen sharply on the basis of supply cut announcement by OPEC. While there is risk of OPEC not sticking to the supply cut announced, there is also a risk that higher crude oil prices could result in high cost US shale producers coming back to the market. This would increase crude oil supply in the market and put downward pressure on prices. Incidentally, oil prices have seen a sell-off in the last couple of weeks. In line with the fall in crude oil prices, other commodity prices have also seen a correction in last few trading sessions.
Economic data from the US has improved, resulting in increased expectation of rate hikes by the Fed. Aggressive rate hikes by Fed could reduce investment inflows into commodities. The current sentiment of trade protectionism in the US could also have an impact on China growth and commodity prices in the medium to long-run. Lastly, the general upswing in the risk taking sentiment could be adversely impacted by the political risks in the EU and that would be detrimental to the commodity price rally.
The authors are corporate economists based in Mumbai.
Views are personal.