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From SCDigest's On-Target e-Magazine

Sept. 8 , 2011

Supply Chain News: Can Commodity Prices Continue to Soar Amidst Weak Economic News?

Some Predict Prices for Metals, Agricultural Goods Headed for Big Fall, but Others Note China Keeps Buying, Food Demand Outstrips Supply

SDigest Editorial Staff

IFinancial market watchers have been noting an unusual phenomenon: given economic weakness across the globe, banking and financial turmoil in Europe, fears of a "double dip" recession in the US and Europe, and a dropping stock market, the prices of most commodities are still surging, with many near historically high levels.

In general, both stock and commodities prices move roughly in tandem, especially relative to economic data, where a slowdown in growth generally sends both stock commodity prices headed south.

SCDigest Says:

So who is right, those that see a big disconnect between economic conditions and rising commodity prices, expecting a big crash fairly soon, or those say a variety of factors will keep pushing prices higher?

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But not so right now, with stocks reacting negatively to the worrisome economic news, while commodity prices for the most part keep jugging along, with slight signs of modest weakness recently, but in general remaining in an upward trend (see graphic below).

Global food prices in July hit the highest levels ever recorded, for example, with staples such as wheat and sugar a third more expensive than they were a year ago, and some categories up even more. Company after company continues to cite rising inputs costs as a key factor challenging their bottom lines.

"Never before have we seen commodity prices so high when prospects for global growth appeared to be so weak," wrote Daniel Dicker of theStreet.com last week. He notes that many economists claim we are already in another recession, and that recessionary conditions are almost never accompanied by screaming commodity prices, as we are seeing now.

How can this be? A couple of potential answers. One is that as global stock markets struggle, many investors are putting their money into commodities instead of stocks, not only pushing commodity prices up for companies, but becoming something of a self-fulfilling prophecy, as additional investors keep coming into commodities, creating more demand that continues to send prices higher.

In a similar vein, many as usual are pointing to the role of "speculators" as driving up commodity prices far beyond where they would be based on "fundamentals" alone, or basic supply and demand.

Earlier this year, a report from the Bank of Japan noted that "the increasing share of investors who are less concerned about the fundamentals of each commodity has diluted the link between the return on commodities included in the major indices and supply-demand fundamentals. Given such evidence, the "financialization: of commodities has caused commodity prices to diverge from the level explained by fundamentals."

That's a mouthful that in the end says that speculators are having an increasingly important role in how commodities are priced, and supply and demand less so.

The CRB Index of a Basket of Various Commities Shows the Steep Rise in Prices

Since the Bottom of the Recession

As an example of that, Dicker notes that right now, prices for many commodities such as copper, corn and others, are more expensive in the short term than they are priced for futures contract four months out. That's in part a sign of the role of short term speculation, and also a condition that in the past has been associated with sharp drops in commodity prices down the road.

In Dicker's view, "the prices we are seeing in these commodities are overextended and destined to crash." That may be bad for speculators and producers but good for companies procuring these commodities directly or indirectly. A coming major drop in most commodity prices would of course also impact corporate procurement strategies, causing them to be more hesitant to lock in prices through contracts now if a sharp drop is around the corner.

(Sourcing and Procurement Article Continues Below)

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But not everyone sees it this way. First, the value of the dollar is an important driver of commodity prices, and many believe the expansionist monetary policy in the US will continue, driving the value of the dollar down and thus putting upward price pressure on commodities.

Other say demand from China and other developing economies will continue to soak up much supply for many commodities, and not only keep prices high now but drive continued price increases going forward.

On the metals side, for example, mining company Joy Global, in a recent quarterly earnings announcement, said that "The fundamentals in the commodity markets have continued to remain strong. The seaborne markets for copper, coal and iron ore continue to be driven by strong demand from China, India and other emerging markets. Although industrial production and export growth is showing signs of slowing in China, massive infrastructure programs should sustain GDP growth at high levels. Imports were reduced as China worked down inventories of copper and coal in the first half of this year, but recent increases of imports have started to replenish these stocks. This move from de-stocking to restocking for copper and coal will support commodity demand even if growth slows."

The company noted, for example, that Chinese copper imports grew sequentially in June and July, with June up 10 percent and July up 9.5 percent, and that China’s imports copper are expected to remain strong for the balance of the year.
On the agricultural side, others note the relative inelasticity of food prices on demand, and that growth in emerging markets and demand for food is also likely to keep pushing agricultural commodities higher in the face of supply levels not keeping up with demand. (Some note this upward pressure on final food prices is likely also to lead to social unrest in some parts of the world).
In fact, a recent report from JP Morgan suggested that commodity prices are only around half way through a 25 year super-cycle, with increasing costs of commodity production being a key driver of rising prices.

Are bet would be that both have a point. There may in fact be a bit of a bubble in many commodities, and would not be surprised to see a 20% pullback sometime in the next year, absent an unexpected economic resurgence.

Do you expect commodity prices to take a sharp fall soon in the face of poor global economic conditions? Or is it different this time? How should procurement managers play this out? Let us know your thoughts at the Feedback button below.

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