Crude reality

30/03/2009 | Thierry Ogier

The commodities bubble burst last year with startling drama. To many, the super-cycle which drove prices to record levels is unquestionably finished. But the dangers of price volatility should not be ignored

As the world economy hurtles into its worst recession in over a generation, output and commodity prices are being dragged inexorably down too.

The super-cycle, which saw oil prices surge in recent years, was driven by a combination of factors, including responses to global growth prospects. But it was amplified in part by the role of financial investors, as commodity derivates emerged as an alternative asset class.
The subsequent global deleveraging – combined with the unexpectedly sharp deterioration in global economic forecasts – has led to the precipitous fall in commodity prices.
Demand from emerging markets, particularly China, in many ways also underpinned the preceding era of high prices. But when growth collapsed, commodities were left exposed. The resulting correction has forced oil prices down to less than $40/barrel, while other commodities have also come crashing back to earth. It has also come as a seismic shock to the industry and commodity exporters alike.
To many, the era of abundance has ended in tears. “The combination of high oil prices and high leverage has proved a dangerous one for the global economy,” says Merrill Lynch in a research report.
According to Paul Horsnell, head of commodities research at Barclays Capital, there may be numerous factors at play – not simply one cycle but rather several cycles progressing at once.
While energy prices have “probably” bottomed, Horsnell believes base metal prices may experience further weakness and will be “the last in the cycle to recover”. In contrast, he notes that precious metals “are generally pretty strong” while agricultural commodities have a much shorter cycle – and so could even shift higher through 2009. “There is no common thread that runs right the way through commodities as a whole,” he says.

What now?
Nevertheless, the magnitude of the global economic slump is now so severe that commodity prices may remain depressed for the medium term, after many years of robust demand increases.
In a recent report the Organization of the Petroleum Exporting Countries (Opec) predicts further pressure on prices as global recession reduces demand for energy.“With continued economic deterioration and demand erosion as well as the impending low demand season, there is likelihood of renewed pressure on prices.”
Yet the return of wild swings in the longer term cannot be ruled out, according to some economists. The cyclical downturn in energy prices is pushing investment out of the sector at a time when global oilfield decline rates are accelerating.
Indeed, price volatility has already made a comeback: commodities surged mid-March after the US Federal Reserve announced plans to buy $300 billion of US government debt. Investors switched into commodities as a hedge against the risk of higher inflation.
While commodity investors by and large don’t assume a return of the super-cycle any time soon – as structural factors in the global economy still point to a long period of healing – many experts believe asset demand could rebound sharply in the medium term, against a backdrop of limited supply.
“The cycle will start again,” argue Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas in a recent survey issued by the National Bureau of Economic Research (NBER), a Cambridge, Massachusetts-based research centre.
“The world economy entered the crisis with a chronic excess demand for financial assets. The sharp rise in oil prices following the subprime crisis – nearly 100% in just a matter of months and in the face of recessionary shocks – was the result of a speculative response to the financial crisis itself, in an attempt to rebuild asset supply,” say the economists from MIT, Harvard and Berkeley, respectively.
If and when economic conditions improve and real conditions recover, “asset demand is likely to rise back, recreating the chronic shortage of assets, and the cycle will start again.” Regulation, they say, will be hard-pressed to contain market forces.

Bottoming out
Still, the consensus view is that there will be no return to the super-cycle any time soon.
“We think it is over – definitely, for a couple of years”, says Ruchir Kadakia, associate director at the Cambridge Energy Research Associates’ (Cera) Global Oil Group. “If you go back and look at history, the periods when you had the greatest spikes in oil demand is when you had spare capacity. And that is not much the case anymore.
“It is going to take a number of years to erode all this excess spare capacity, and that alone is going to make it very difficult to get back oil prices to the $150 range,” says Kadakia, who argues that we are now “in the middle of the cycle”.
Oil prices “will probably bottom out this year, but the key question is: will we go sideways for a number of years or do we recover?” he asks.
There is no longer room for complacency as prospects for the global economy look increasingly gloomy, and GDP forecasts are repeatedly revised downwards.
Global oil demand is expected to fall further this year by over 1 million barrels per day (b/d) as the global economic crisis undermines consumption and investments in new oilfields. Both Opec, which has withdrawn over 4 million b/d from the market, and the Paris-based International Energy Agency (IEA) assess global demand at around 84.5 million b/d.
Morgan Stanley is even more bearish. “The magnitude of weakness plaguing emerging market economies – champions of oil demand growth since 2000 – together with continued weakness in OECD economies leads to our belief that oil demand will fall by 1.5 million b/d in 2009,” says the bank’s head of commodities research Hussein Allidina.
But in the 1979 oil price shock, demand shrank by 2.5 million b/d in the first year, and then fell for another two years. That alone suggests the effects of this recession are still to play out.

Smelling blood
Yet this does not mean that the world economy is now spared the challenges that emerged during last summer’s fuel and food crisis, which saw prices spike to record highs.
Horsnell notes that the threat of a major energy crisis has hardly subsided and could lurch back when the global economy recovers – especially as non-Opec supply has been declining steadily. “In retrospect, 2008 can just be looked back on as a kind of early warning signal,” he says. “I don’t think the energy problem is over. It could rebound quite dramatically in the course of the next five to 10 years.”
He argues that “a lot of very dangerous things are happening at the moment” as policy-makers make assumptions based on low prices, companies tear up investment plans and alternative energy investment falls off a cliff. “We are taking precisely the actions that are likely to lead through to a full-blooded energy crisis in the next few years,” he says.
The current decline in capital expenditure is critical. Last year’s sharp price swings demonstrated that the global economy could not maintain its previously robust growth given the existing energy mix, says Horsnell. “It was impossible; it could not happen.”
The solution, he says, is proper investment across the energy spectrum, but instead “where we are heading is [towards] less investment in oil, less investment in alternative energies, less investment in research and technology at precisely the time in the cycle when 2008 really told us we should do more of that.
“In terms of a major energy crisis, last year was just a small appetizer for what might happen,” he warns.
Both Merrill Lynch and Barclays Capital have pointed to the risks of a return to great volatility. “It is all a matter of policy choices of what the world wants. If it wants $40 a barrel of oil now, that means $150 sometimes again further down the path, and it does mean a more serious energy crisis,” says Horsnell.
“Any rebound in global activity growth will likely be felt in commodities first,” according to Merrill Lynch. In a report, the research team led by Francisco Blanch nonetheless points to the risk of a “crisis in one or more feeble emerging markets and the potential contagion to more stable developing nations”.

Latin pressure
While highly leveraged central and eastern European economies have been sucked under by the financial crisis, one of Latin America’s main weaknesses is its high dependency on commodity exports. “The region’s endemic vulnerability to commodity price swings bodes ill for the future,” say Julia Sweig and Shannon O’Neil from the Council on Foreign Relations, a New York-based think-tank.
The collapse in prices has had a severe impact on large oil producers, such as Mexico and Venezuela. Mexico is also suffering from a continuous slide in output. Ecuador has already defaulted twice on its sovereign debt in the past three months.
“Low prices have a potentially destabilizing effect for oil dependent countries,” says Sophie Aldebert, Latin America’s Cera energy director in Rio de Janeiro, who sees social tensions rising in Bolivia and possibly in Venezuela. In the meantime, one possible consequence is that “harsh rhetoric is going to face difficulties to be financed as revenues decline,” she says.
More diversified economies, such as Brazil’s, may prove relatively better protected from commodity price volatility, “but all will be affected,” says Aldebert.
For the time being, the general picture remains bleak against a fragile global financial background. “With lower hydrocarbon prices, tight credit markets and higher cost of capital, aggressive capital budgets might be curtailed, putting the oil and gas production in the region at risk,” says Fitch Ratings, the credit rating agency, in a recent report. “The higher cost of capital and limited access to both the domestic and international debt markets are likely to drive downward revisions in national oil companies.”

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