Digging up the dirt on commodities

The price of economic essentials are a pointer to global growth or the lack of it but they move for complex reasons, writes David Potts.

The price of economic essentials are a pointer to global growth or the lack of it but they move for complex reasons, writes David Potts.

Know where commodity prices are going and they will tell you all about next year.

The dollar, interest rates, inflation, your super ... you name it, commodity prices change it. They also explain why the share prices of BHP Billiton and Rio Tinto, the world's biggest and most profitable miners, are struggling.

The lower prices of commodities was one reason the Reserve Bank gave for cutting interest rates last week. But not all of the prices are falling. It's a different story for food and farm produce, for example.

While iron ore, coal and copper prices seem destined to end 2011 lower than they began it, prices for wheat, wool and beef will be higher.

They are up because of improving living standards in Asia, which generate more demand for protein and because of unusually bad weather almost everywhere this year.

Oil prices, a permanent special case, are about 10 per cent higher than this time last year, even though world economic growth slowed. But the market doubts there will be enough global growth to justify higher commodity prices for yonks, a view shared by the government's economic boffins.

Treasury forecasts commodity prices will fall 20 per cent over 15 years.

So have we seen the best of the commodity boom and is it all downhill from here?

That depends on whether recession in Europe swamps recovery in the US and how China manages its own controlled slowdown.

Since it's almost impossible to exaggerate the European sovereign debt crisis, I won't try.

Suffice to say the problem isn't so much in governments defaulting on their bond repayments - even Russia has been there, done that, with no lasting damage to itself or the global financial system - as who did the lending.

To wit, the biggest banks in Europe, especially French ones.

Predatory markets have homed in on easy pickings such as Greece, patiently biding their time for the big kill: a French bank.

Italy was sucked in because it owes almost 20 per cent of France's gross domestic product. Even the fate of the euro is a mere - but fascinating - distraction.

France is the second-biggest euro-zone economy and, if push came to shove, would be next-to-impossible to bail out.

Worse for us is that its banks are major players in international trade financing, as the biggest suppliers of letters of credit for commodities.

A bank's capital is eroded when there is a write-down in the value of the government bonds it holds, which are collateral for the money it raises to lend.

So there's a double whammy: finance freezing up because European banks can't afford to provide letters of credit, coupled with an unaccustomed bout of austerity in what is collectively the world's biggest economy.

Europe might not loom large in direct trade with us but it's a big market for our biggest trading partners. And most European economies are in or near recession.

Meanwhile, US growth is anaemic. The country is making agonisingly slow inroads into its high unemployment thanks to the collapse of housing prices - which might finally have bottomed but don't hold me to it - resulting in a spending strike by households and businesses.

Still, with next-to-nothing interest rates and the Federal Reserve printing all the money that's needed and then some just in case, a stronger recovery can only be a matter of time.

And what was that about a slowdown in China? That sounds bad, considering Chinese demand propels the prices of iron ore and, with some help from India, coal.

At least China is the only major economy not in some crisis or other. It was growing too fast but, hey, that's easy to fix.

No, its big problem is most of its trading partners have one. That's prompted it to turn inwards, beefing up its infrastructure and housing by loosening credit.

Fortunately,this penchant whenever growth wobbles for building whole cities, which typically nobody can afford to live in, is nearly as good for Australian commodity exports.

Black gold

The question is, if three-quarters of the global economy is experiencing negative or sub-par growth, how come oil prices are on a roll?

That the emerging Asian economies (which are growing nicely, thank you), not to mention China itself, are oil guzzlers is one reason.

But there's also an element of speculation, which gets back to the US printing money on demand and running next-to-zero interest rates. Being so low, you can't even call it negative gearing to buy oil futures contracts on borrowed money. Cheap finance from central banks is bound to rub off on other commodities, too.

Indeed, oil might well be a more palatable alternative to gold for hedge funds and the like, for example, because its price has nothing to do with central bank holdings.

Foodstuffs and fuel prices move together as fertiliser and transport are significant costs for farms.

Oil is also susceptible to political upheavals, the latest being reports of Iran threatening to disrupt supplies.

Crucial for the prices of bulk commodities such as iron ore and coal is that new mines aren't being dug.

Well, maybe they are but it takes years for one to begin producing.

Besides, just as commodity prices have soared in the past couple of years, so have the costs of mining, making what would have been potentially attractive mines unprofitable.

Because that limits the competition it's even better for us, considering we're such a low-cost producer of minerals.

There's a "massive undersupply" of iron ore, which is being exacerbated by a 25 per cent cut in exports by India, while China has become "desperately short" of copper, according to the mining analyst for UBS, Tom Price.

Also, thermal coal is "trading close to its marginal cost of production", Price says. A fall would curtail output, which in turn would create a shortage.

In which case, bulk commodity prices might be down but they're not out.

Precious metal see-saws

THE world's financial system is wobbling again, yet gold has gone missing in action.

Its price has been subdued by recent standards, that is.

Oddly enough, the safe haven is suddenly seen as risky.

Gold is still way off its record $US1921 an ounce of three months ago and that was well under the $US2292 it would be if it had kept pace with inflation since its 1980 peak.

The local price, thanks to the stronger currency, is even more lacklustre.

So, on face value, gold hasn't even done its job as a hedge against inflation.

Still, you can argue that the other way round as well: as an alternative to paper money it's really showing the collapse in the US dollar's value because it buys less bullion.

Besides, bullion had to bear relentless central-bank selling including by, guess who, but Martin Place is a clue at the bottom for 20 years. So what is gold worth?

Unlike other commodities, its price is almost purely demand-driven and that's based on sentiment. No, make that fear.

If anything, there's an artificial shortage because central banks have switched from being sellers to buyers. Then there's the soaring cost of mining gold.

Although seen as the last resort in a paper world, in truth a lot of gold's value has to do with near-zero interest rates in the US and Europe. They pull down the value of the US dollar, in which gold is quoted, as well as overcome its inherent disadvantage of not paying anything.

Needless to say, many have tried to value it. One popular method is comparing how much an ounce of gold would buy on Wall Street.

If you pretend the entire Dow index is one stock, then a share would be worth about 7 ounces of gold. Since the average is 10 ounces it dropped to only one ounce in 1980 that suggests either Wall Street is undervalued or gold is overvalued.

Another way of valuing it is comparing it with oil. It recently took 0.05 ounces of gold to buy a barrel of oil, which was smack on the long-term average, according to a study by UBS.

The US-dollar gold price has been rising an average 16 per cent a year since its run began 11 years ago but, in the past three years, this has accelerated to 20 per cent or more.

Since the US Federal Reserve has promised not to lift interest rates for another two years, there's no reason to expect the gold price to drop soon. By the same token, though, there's nothing to push it up much further.

The US recovery appears to be finally gaining some traction, which could be expected to push up the US dollar and so hurt gold.

Gold bugs point to the world's central banks printing more money which, in normal times, would be inflationary. But, with high unemployment in the US and Europe in deflation mode as spending is slashed and taxes raised, an inflationary surge is some way off.

Long-time gold bull Angus Geddes, a director of tip sheet Fat Prophets, says the price will depend "on how much money the central banks print. If the past is anything to go by, $US3000 to $US6000 an ounce would have to be on the cards, looking further out to five years."

From farm or mine to your portfolio without the fuss

THE sharemarket has proved it is not much chop when it comes to punting on commodity prices.

But that's about to change.

In two years, the Reserve Bank's commodity price index jumped 52 per cent, while shares of what should have been the biggest beneficiary, BHP Billiton, slumped 15 per cent.

One problem is that the stronger dollar eats away some of the price gains.

So, can you buy commodities without an exchange-rate risk or the hassle of choosing stocks which, in the case of some keenly traded ones, such as corn or soybeans, aren't even available?

An exchange traded fund (ETF), a managed fund listed on the Australian Stock Exchange, which, in this case, covers agriculture, was recently launched by BetaShares and will be followed by copper and commodities funds next year.

Although they trade on the ASX, these funds don't come with sharemarket risk. Unlike shares, an ETF is structured so its price can't stray from the value of the underlying assets.

The agricultural ETF, under the ASX code QAG, will track a basket of four of the most traded commodities: wheat, sugar, corn and soybeans. It would be especially attractive if you think food prices generally can only go up as urbanisation encroaches on former farmland.

The copper ETF will have the ASX code QCP.

The commodities basket (QCB) will be based on the 24 commodities in the S&P Light Energy Index, which tracks energy, metals, agriculture and livestock.

The funds will be able to be bought and sold just like shares.

There are already crude oil (OOO) and bullion (QAU) ETFs, which are also currency-hedged.

But, note, they follow an index, not the commodity spot price.

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