In this article, part of a series in which we cover commodities, energy, shipping and technology, media and telecom, we look at the commodities sector and asses the sources of volatility and uncertainty it faces.
Commodities: a longer-term cycle
For some observers, the precipitous decline of many commodity prices in the post-crisis period typifies the economic uncertainty and financial instability that characterise the current era. However the reality is more complex. “The commodities investment and price cycle is much longer than the economic cycle: in the past 100 years or so there have been just four or five commodity cycles but many more recessions,” explains Alastair Houlding, head of trade and commodity finance at ING Wholesale’s Geneva branch.
The reason for the broader arc of commodities is straightforward. “For most commodities, production requires significant capital investment over a long timeframe,” notes Houlding. “Consequently, decisions must be taken based on long-term expectations and not when the next recession might occur. Once the investment has been made, it often makes financial sense to carry on producing rather than cease production.”
The interaction of the long-term commodities cycle and more frequent economic booms and busts results in periods of relative surplus of commodities and relative deficits when the economy accelerates, prices rise and new incentives are created for further commodity investment. “In the current context, the decline of growth in emerging markets – most importantly in China – has resulted in a surplus of commodities and declining prices,” says Houlding.
The periodic surpluses and deficits in the commodities market are reflected in extreme price volatility. Until the 1990s, the real price of oil (adjusted for inflation) had fallen for two decades but it then proceeded to increase dramatically until it hit a peak of $147 in 2008. A subsequent crash was stemmed by strong demand from China. The more recent slump in price, although partly reversed in recent months, is likely to be more long-lasting.
“China, which accounts for half the world’s demand of some commodities, is not in a position to rescue the global economy at the moment,” says Houlding. “It’s part of the problem as much as the solution.” Nevertheless, relative stability in China is essential for the commodity market. “Infrastructure and housing investment are important drivers of commodity demand so investment levels in China are critical to future performance.”
Financial market depth
The commodity market is unique because of the scale of trading in commodities and related financial instruments, is facilitated by their fungibility. “The liquidity of commodity markets gives the sector depth and makes it easier to trade and hedge. The forward market can also enable traders and investors to lock away excess production when prices are low,” says Houlding. “However, interest from financial players also amplifies price movements because markets tend to move like a herd when there are booms and busts.”
While closing down mines and capping oil wells may be impractical given the high levels of capital already invested during development, producers are able to adjust supply to market conditions to some extent. There may be ways to shutter production sites temporarily and some uneconomic production may be closed earlier than originally anticipated,” says Houlding. “Alternatively, assets may be sold with the potential to become economic once they are free from the high debt-servicing requirements associated with building them, and this limits supply reductions.”
While the commodities sector will continue to be driven by its long cycles, it is being disrupted by new technology and geopolitical uncertainty. “Fracking has been a game changer,” says Houlding. “In contrast to the high capital investment required by traditional oil, fracking is relatively cheap and mostly operational in nature, with costs such as drilling rigs, personnel and chemicals only incurred when production occurs. As a result, the upside to oil is likely to be limited to around $60 a barrel because at that price fracking firms will simply increase production.” Meanwhile, some traditional sources of oil supply, such as Libya and Nigeria, have been reduced due to geopolitical instability.
Over the longer term, changing technology could have a major impact on demand for some commodities. “At some point, batteries will evolve to the point where electric vehicles become a mainstream choice and oil demand will subside,” says Houlding. “Of course, that will be accompanied by soaring demand for commodities associated with battery production.”