THE COMMODITIES BOOM

THE COMMODITIES BOOM

Commodity markets have been booming. Prices of many commodities, especially those of oil, corn, wheat, tin and nickel have reached record high recently, despite credit market turbulence and slowing activity in many major advanced economies. The current boom has also been broader based and longer lasting than usual.

The price boom has brought a sea change to the commodities landscape. Commodity exporting countries have benefited from rapidly growing export revenue. In fact, a number of analysts see high commodity prices as an important reason for the buoyant growth in many emerging and developing economies. At the same time, investment in the commodities sector has accelerated after a long period of lacklustre performance. In financial markets, commodities are now an established part of the wider class of alternative assets. At the same time, commodity importers and consumers have begun to feel the pinch from higher commodity process, with widespread concern about the impact on the poor in emerging and developing economies.

Although strong economic growth globally is one of the reasons for high prices, forecasts of slower globally activities in 2008-09 have prompted concerns about prospects for commodity markets. However, the current commodities boom reflects many cyclical and structural factors. The impact of this largely demand driven boom on the global economy has been limited so far, higher commodity prices have begun to pose inflation risks and may lead to external financing challenges for some countries, particularly low-income net commodity importers.

A look at demand and supply factors
Why are commodity prices so high? Besides commodity specific factors such as geopolitical risks, weather conditions, and crop infestations- the current price boom is driven by demand and supply forces that reinforce each other amid supportive financial conditions.

First, emerging economies have driven demand for various commodities- a trend that is likely to continue. Annual increases in the global consumption of major commodity groups recently have been larger than they were in the 1980s and 90s. And although buoyant global growth was a key contributor, it was reinforced by a combination of strong per capita income growth, and rapid population growth in some major emerging economies, notably China, India and in the Middle East. All of these factors have contributed to the rapid pace at which demand has grown in recent years.
In the oil markets, demand from China, India and Middle East accounted for more that 56 percent of the growth in oil consumption during 2001-2007. This growth was partly driven partly by the increasing vehicle ownerships associated with higher per capita income. Passenger car sales in China, for example, increased more than fivefold during 2001-07. At the same time, industrialization and urbanisation in emerging markets, particularly in China, have boosted demand for fuel based electricity. As a result, prices of other fuels particularly coal has also gone up.

Emerging economies are also playing a key role in the boom in non-fuel commodity markets. In particular, China’s industrialization and urbanization have galvanized consumption of based metals. For example, during 2000-06 China alone accounted for about 90% of the increase in the world consumption of copper, which is indispensable for construction. Also, as emerging economies become more affluent, they are not only consuming more food but shifting their diet towards high protein foods such as meat, sea food, edible oils and vegetables.

Second, biofuels have boosted the demand for specific food crops.
Another prominent factor underpinning the difference between this boom and earlier ones is the role of biofuels. High oil prices and policy support in the US and EU have ked to a surge in the use of biofuels as a supplement to transportation fuels particularly as a supplement to transportation fuels, particularly in the advanced economies. Biofuel production is seriously affecting food markets- 20-50% of feedstocks, especially corn and rapeseed, in major producing countries are being diverted from food to biofuels - but not affecting petroleum product markets, in which biofuels constitute a small fraction of transportation fuel supply. This means prices of petroleum products are determining retail prices of biofuels, and growth of biofuels, in turn, is strongly affecting feedstock prices (ethanol in particular which produced from corn and sugar).

Policies about biofuel in the US and EU imply that diverting crops towards biofuel production will continue for at least another 5 years, when new technology in the form of second –generation biofuel feedstocks- made of inedible vegetable matter that does not compete for land and water with major food crops become commercially viable. In the US, the 2007 energy Bill almost quintuples the biofuels target to 35 billion gallons by 2022 and the EU has mandates that 10% of transportation fuels must use biofuels by 2020. This means that upward pressures on prices of some of the major food crops will continue for some time.

Third, slow supply responses have amplified price pressures. Increased demand alone cannot explain the larger and persistent rise in commodity prices seen in recent years. Supply factors also play a role. The slow supply response in the initial phases of this primarily demand-driven boom did not come as a surprise, given limits to production increases in the short term, Excess demand is accommodated by inventory draw downs while price increase- a pattern that was seen in many commodity markets in recent years. Because demand for commodities tends to be price inelastic- that of, a large change in the price of commodities leads to only a small change in the demand for them, especially in the short term- the feedback effects of rapid price increases on demand during these phases tend to be limited, which partly explains the large spikes often seen in commodity markets.

Besides initial supply-response problems, however, a new key feature that has emerged in the current broad-based commodity market boom is the increasingly prominent role of the slow supply adjustment to increased demand.

Fourth, important linkages across commodities transmit higher prices. For example, demand for biofuels has propelled not only prices of corn but also those of other food products, because corn is used as input in their production (meat, poultry, dairy) or as a close substitute. In the US, for example, it has exerted significant upward pressure on prices of soybean means and soybean oil because corn and soy beans compete for the same acreage. This contributes to the price increased of other edible oils through substitution effects. To a lesser extent, demand for biodiesel has also affected prices of edible oils, because soybean oil and other vegetable oils such as palm oil and rapeseed are used as biodiesel inputs.

Higher oil prices have also had an important effect on other commodities, not only through the traditional cost push mechanism but also through substitution effects. For example, natural rubber price have risen because its substitute is petroleum based synthetic rubber, Uranium price increases have been driven by demand for nuclear energy, whereas coal prices have recently risen because of utilities switching from more expensive fuel oil to coal for power generation. And, of course, bio fuels are substitutes for gasoline and diesel at the margin

Fifth, low interest rates and effective dollar depreciation have been a supporting factor. With the rapid expansion of commodity financial markets in recent years, many commodity prices are more directly exposed to various macro economic and financial shocks. The main reason is that spot prices of a growing number of commodities are determined in exchange-based trading. Moreover, with many futures contracts settled in cash rather than through the delivery of the underlying commodity, investors outside the commodity business can now use commodities to diversify their portfolio, thereby more closely linking futures markets for commodities with other financial markets. This has opened up new opportunities for market participants but also let to challenges.

Commodity prices have also been supported by other conditions, especially low interest rates and the depreciating effective U.S dollar exchange rate. Low interest rates can spur aggregate demand, which would increase the demand for commodities. Besides this, the favourable liquidity conditions associated with low interest rates also tend to increase both asset demand for commodities and incentives for holding commodity inventories by lowering holding costs, everything else being equal.

The U.S dollar exchange rate affects commodity prices because most commodities are prices in UD dollars. The dollar depreciation seen over the past few years therefore has made commodities less expensive for consumers outside the dollar area, thereby increasing the demand for the commodities. On the supply side, the declining profits in local currency for producers outside the dollar area have put price pressures on the commodities. A decline in the effective value of the dollar also reduces the returns on dollar-denominated financial assets in foreign currencies, which can make commodities a more attractive class of ‘alternative assets’ to foreign investors.

Policy Implications
The commodity price boom has raised new policy issues. From a multilateral perspective, policy efforts should focus on ensuring the efficient functioning of market forces at the global level because markets for many commodities are highly integrated. At the same time improving market statistics could help by enabling market participants to make informed decisions.

In the markets for major food crops, policies that ensure efficient and realistic use of biofuels and discourage protectionist elements will help reduce the prices of corn and edible oil. Current policies in both the United States and the European Union would have to be adjusted substantially, given larger subsides and the preference for domestic production even if it is relatively inefficient. For example, broadly accepted estimates suggest that Brazilian ethanol (from sugarcane) is less costly to produce than US gasoline or corn based ethanol. Also, sugarcane ethanol produces 91% fewer greenhouse gas emissions per kilometre travelled than does gasoline, whereas the environmental benefits of corn and wheat based ethanol relative to gasoline are small. Therefore, a better policy would be to allow free trade in bio fuels while incorporating emissions costs into prices of all fuels. In addition, there is a legitimate role for governments of all countries to fund promising research in second generation bio fuels, given that they serve as a public good.

In addition to policies that can enhance the functioning of global commodity markets, mitigating the impact of rising food and fuel prices on poor households has become a major policy concern. Motivated by worries about food security, a number of countries have resorted to protectionist measures, which may have contributes to global market tightness. For example, in 2007, a number of countries imposed export taxes on grains and lowered tariffs on edible oils. Instead, countries should consider targeted cash transfers to poor households or temporary subsidies on a few selected food items consumed by the poor. Similarly, instead of granting general domestic fuel subsidies, which generate considerable fiscal cost, encourage excessive energy consumption, and tend to disproportionately benefit wealthier households, many oil exporting countries should minimize the effect of high fuel prices on poor households through well-designed and targeted safety nets.