Someone Tell Commodities There’s a Slowdown Going on

(Peter G. Hall, Export Development Canada)

The marketplace is fast realizing that a global economic slowdown is in the works. Everyone seems to be convinced – except those irrepressibly bullish commodity markets. If slowdown is here, and key markets close to recession, why are commodity prices so high?

Not only are prices high, but many are close to peak levels. Oil prices closed at nearly US $108 per barrel two days ago. Gold is pushing US $1000 an ounce. Agricultural prices are soaring to unheard-of heights. Key base metals are hovering at peak levels, and even Dr. Copper, the metal with the PhD in economics, seems oblivious to the slowdown at over US $8500 per tonne.

These higher prices are no accident. The world economy reached the peak of its economic cycle a number of years ago, but a funny thing happened: instead of the typical slowing, world production continued to expand. Freer trade and increased technology opened up markets, like China and India, that formerly were much less involved in global commerce. This went a long way toward alleviating the shortages of labour and physical capital typical at the top of the cycle.

One key problem: production of commodities was not geared for this “extra” growth. A protracted period of low commodity prices actually suppressed investment in the exploration and development of a whole range of resources. Markets were lulled into thinking that supply was no problem. But shortages began to emerge in 2003, and the commodity boom was born.

If this “extra” growth is here to stay, then it is natural to conclude that commodity prices will be permanently higher. But at what level? Short-run price adjustments are almost always exaggerated, and this time is no exception. Perceived shortages lead to overbuying as producers lock in critical supplies. But sustained price increases also prompt producers to pre-buy, as what is bought can be stored and sold later at a higher price or mark-up.

These behaviours over-inflate prices, attracting a wider audience. Eager to ride the wave, speculators get involved, boosting prices even further. This activity has intensified in recent weeks as markets, spooked by troubles in the global financial sector, uncertain performance of equity markets and the eroding US dollar, have increasingly sought refuge in commodities.

At its core, the commotion is largely about perception. But the reality is that global slowdowns affect demand for commodities, and the present is no exception. How much? Consider copper. The US housing and auto sector corrections have chopped US copper usage back by over 10%, and world demand by 1.6%. Slower activity in other developed economies is having a similar effect. Copper demand could easily be off by up to 6% before taking slower emerging market growth into account. Similar logic applies to other base metals and the oil and gas sector. And the logic all suggests that prices are in for a sizable correction.

The bottom line? The recent bull run is delaying the typical effects of slower world growth on commodity prices. Commodities are unusually late in leaving the party this time around, but when they do, they will likely leave noisily, together, and quickly.