Heavy going for lead-footed commodities

Mining output growth now coming on tap in response to the strong commodity prices of four or five years ago will continue to mitigate the upward pressure an improved economy is having on prices.

Commodity prices are flat.

They are likely to stay subdued or could even weaken as the surge in mining output adds to the global supply of raw materials. This uninspiring outlook for commodity prices is despite the strong recovery in the global economy adding to demand for energy, metals and other commodities. The new supply coming from new mines seems likely to overwhelm the growth in demand to keep prices in check.

No one seriously doubts that global economic conditions are significantly better now than during the middle of 2012. US economic growth is lifting and will soon be strong, while Chinese GDP growth is back above 8 per cent rather than decelerating towards 7 per cent. Even the eurozone, which is mired in a recessionary funk, has stopped bleeding and GDP is likely to turn positive at some stage during 2013. India remains fragile but a series of interest rate cuts from the Reserve Bank of India and the recent budget are both aimed as boosting GDP growth.

Booming share prices and rising government bond yields are sure signs that economic conditions are improving and there is no end in sight to this market rebalancing.

Normally, such a clear improvement in global economic growth would underscore a kick up in commodity prices. The conventional wisdom, established over the last few decades, was that with many commodities having inelastic supply in the short to medium term (it takes years for the higher price signals to encouraging mining companies to start a new nickel or iron ore mine, for example), when the world economy accelerated, as it is now, commodity prices would rise.

The broad measures of commodity prices – which include energy, agricultural goods, precious metals, base metals and the like – are all flat to lower. The Thomson Reuters/Jefferies CRB Commodity Index is actually 10 per cent lower this morning than during the mini-peak in September 2012 and it is more than 20 per cent lower than in early 2011. In broad terms, commodity prices are even below the levels of 2005 and 2006. Commodity prices are not strong.

What is happening is the early stages of a huge supply side response to the higher prices that were seen four or five years ago. The trillions of dollars, euros and yuan that have been pumped into mining exploration, investment and production are starting to deliver higher output. Mines around the world are churning out extra iron ore, coal, gas and other metals and in the next few years, mining output is set to boom.

This growth in output is outpacing demand, even with a stronger global economy, which is why commodity prices are as flat as a tack. It is basic, high school economics – when the supply of a good rises, the price falls or in other words, if the growth in new supply is greater than the increase in demand, the price falls.

The other element of flat or falling commodity prices is that it actually fuels a pick-up in demand which is positive for global economic growth. Firms may take advantage of lower input costs to ramp up production.

For the industrialised world, the money paid for commodities is an input cost along the production chain. If the price of these inputs falls, manufacturers and other firms make higher profits, even if they keep their selling prices stable. This means that inflation remains low, a point that is a feature of the current economic conditions around the industrialised world.

This could also explain why the Australian stock market is currently lagging the rest of the world – the scenario of strong growth based on lower commodity prices will hurt commodity producers, like Australia, but help manufacturing nationals like Japan and the US.

If this is the case, the unrelenting good news on the global economy could occur with soft commodity prices and a weaker Australian dollar remaining the order of the day. This seems to be the case with the stronger global growth news of the last six months or so failing to boost commodity prices while the Australian dollar has weakened a little in recent times.

The current early signs of a sustained global economic pick-up are unusual in that regard. It could be the case that there will be a global economic upswing that does not see higher commodity prices, or higher inflation or for that matter, significant increases in interest rates.

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