Piecing together the commodity markets puzzle

The violent shift in commodity prices is about a lot more than the fundamentals of supply and demand.

The across-the-board sell-off of all commodities has driven the Bloomberg Commodity Index to levels last seen in 2002 despite record imports of commodities by China last year.

There’s something more than physical supply and demand at work here.

There is no dispute that the commodities boom was driven by China and its frenetic growth rate post-crisis. Equally, the 'slowdown' and shifting patterns of activity within China has played a major role in the collapse of commodity prices.

China’s economy is, however, still growing at around 7 per cent a year off a base more than twice as large as it was pre-crisis, and its demand for commodities is growing, albeit at a more subdued rate. Iron ore imports, for instance, grew by almost 14 per cent last year and copper by about 6 per cent.

The extraordinary price levels for commodities reached at the peak of the boom did produce a dramatic supply-side response and has resulted in an over-supply of all the major commodities, ranging from iron ore to oil. That in turn has produced an equally dramatic collapse in prices, interestingly for both hard and soft commodities.

The fundamentals of supply and demand explain much of the action in commodity markets over the past half dozen or so years, but not the exaggerated impact on prices that created the level of over-supply which is now wreaking havoc on producers and those businesses that underpin them.

The other piece of the puzzle that underlies the violent shift in commodity prices is the emergence of hard commodities as financial assets over the past decade and particularly in the post-crisis period, when credit was cheap and returns from conventional asset classes were meagre.

Until the crisis, commodity derivative markets were quite under-developed, with little liquidity. Post-crisis they have grown quite dramatically, with a proliferation of exchange-traded funds holding either or both physical commodities or commodity derivatives, a lot of hedge fund activity and both over-the-counter and indexed-based derivative trading.

Commodities became a financial asset class, attracting the big Wall Street banks and investors, with prices reflecting not just near term supply and demand balances but speculative overlays that built the 'stronger for longer' thesis into prices and created a feedback loop between pricing and production.

The nearing of the end of the quantitative easing program in the US (and thus the prospect of the end of the era of ultra-cheap funding), the consequent surge in the value of the US dollar (the base currency for almost all commodities), some wobbles within China’s economy and financial sector and the extent to which the prices had encouraged over-supply burst what, with hindsight, can be seen as a bubble.

The Bloomberg index peaked in April 2011 and has fallen about 42 per cent since then, with an acceleration of the slide occurring through last year.

The dramatic spike in prices at the height of the commodity bubble didn’t just attract more supply but high-cost supply and it inflated costs more generally across the entire sector.

Now it isn’t just commodity prices that are deflating but those broader costs as the sector struggles for survival in the new pricing environment. Much of the higher-cost supply will simply disappear in a process being quickened by the strategies of the big traditional low-cost producers like Rio Tinto and BHP Billiton in iron ore or the Saudis in oil. Their emphasis on driving volume into an over-supplied market is exaggerating the price declines and increasing the pressure on higher-cost rivals.

There is a chicken-and-egg element to any assessment of what has occurred and is still occurring within commodity markets.

It would seem reasonable to assume that the physical market -- the shortfall of supply that occurred as China’s demand for commodities soared -- led and encouraged the financial market activity. It would also seem reasonable to conclude that the levels of financial activity and the leverage associated with them got out of kilter with the real markets for the commodities.

In the physical market, the consequences are obvious and brutal. The supply of the commodities will have to be brought back into line with demand and will have to do so on the basis of far lower prices.

The low-cost supply from the Rios and the Saudis will continue to drive prices down and to drive a lot of production and producers from the market until there is a more even relationship between demand and supply.

In the financial markets there has been and will be losses for investors in commodity producers, their suppliers, ETFs, hedge funds and financiers and big, self-fuelling flows of funds away from commodity exposures to asset classes seen as safer havens. Given the strengthening of the US dollar, those funds have been and probably will continue to be driven towards the US bond and equity markets.

What we don’t really know is the extent to which the financial engineers within Wall Street structured leveraged products around commodities, although there have been some speculative estimates that more than $US20 trillion of derivative products were created during the boom period.

Whatever the magnitude of the financial overlay to the markets, however, it was clearly very substantial and its unwinding is playing a role in the implosions in prices and will continue to do so and represent an over-hang on the markets until prices stabilise.

The re-balancing of the commodity fundamentals of supply and demand may not, if the unwinding of financial exposures has yet to be completed, be the only prerequisite for more orderly commodity markets. It will make it difficult, if not impossible, to assess whether prices, having over-shot during the boom/bubble, are now over-shooting in the other direction.

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