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G. Chandrashekhar

Mumbai, Aug 8 If you thought the recent downturn in commodity prices across markets – energy, metals, agriculture – signals the end of the bull run of last three years and perhaps marks the beginning of the imminent burst of what is called commodity bubble or super-cycle, think again. Commodity markets may not have peaked; not as yet, in any case.

Without doubt, there has been a change of sentiment and sharp correction in commodity prices. For instance, crude oil pared recent gains by as much as $25 a barrel to trade less than $120 a barrel. Base metal markets too have come off from their highs and are trending lower. Agriculture is no exception. Whether grains (wheat, rice, corn) or vegetable oil (soyabean oil, palm oil), there is a steep decline in prices, much to the relief of consumers, governments and central bankers alike.

There has been heightened volatility across commodities that has been the cause of concern in some quarters. To be sure, it is in the very nature of the market itself. What is a commodity market without volatility? Just as there was a combination of factors - both demand side and supply side - that propelled prices to new highs, currently too a combination of seemingly bearish factors has come to the fore.

However, the market fundamentals are still in tact. In many cases, the demand-supply situation is tightening. So, what has led to the present decline, and will the slide continue and how far?

To a very large extent the perception of market participants matters. It bears repetition that when a market is tightly balanced, expectation of even a small change in either demand or supply or both will have a disproportionately larger impact on prices. The current scenario is just that.

Among the many market drivers, a key driver of both energy and metals markets is economic growth. Most economic data relating especially to industrialised economies suggest a slowdown in growth. The ongoing credit crisis and inflation concerns play a role in sucking liquidity out. So the demand side is beginning to look weak. Reports of demand compression especially for energy products and slowing consumption of industrial and base metals in the OECD area are doing the rounds. Asian demand continues to remain robust, but not enough to neutralise the negative impact of the slowdown in the western world.

On the supply side, inventory levels of energy products and metals are beginning to build. LME stocks of base metals are beginning to rise. Steel demand growth looks sluggish and iron ore inventories are mounting. OPEC crude production is rising. Seasonal factors too have a bearing on consumption. In such an evolving demand-supply equation in commodities, speculators will be the first to exit the market; and that’s exactly what they have done recently.

A considerable amount of speculative froth that had gathered in many markets - energy, precious metals, base metals, agriculture – is beginning to disappear. Speculators holding ‘long’ positions are liquidating their positions, and we currently see the disappearance of the froth. This is clearly borne out by the Commitment of Traders Report.

An additional factor that has somewhat unnerved speculators and forced them to exit the market in a hurry is the looming threat of precipitate action by the US market regulator CFTC as a response to public outcry and political demand to rein in inflation and rising commodity prices. The debate is not whether speculation is good or bad, or whether there has been excessive or even manipulative speculation.

The fact of the matter is that the regulators are investigating; and this by itself creates uncertainty for the market. Little wonder, participants would rather play safe than feel sorry. As for major agricultural markets, weather conditions in major origins led by the US have so far been favourable. There is expectation of a bounce back in farm output in a number of crops such as wheat and oilseeds.

Supply tightness is easing. Across commodities, in the euphoria over positive development relating to prospects of increased supplies and slowing demand, the negative factors that can potentially reverse the market direction and spark a rally have been overlooked. Supply uncertainties had been a key market driver in recent times. They may have faded for the time being, but not entirely disappeared.

Energy markets continue to be vulnerable to geopolitical concerns. Supply disruptions in crude are unpredictable. Non-OPEC crude output growth is far from encouraging. In case of metals, labour action and power problems can disrupt production and supplies.

Even otherwise, there is evidence that mine output is slowing.

As for agriculture, August is known to be treacherous month when weather aberrations can make or break crops. Crops in the US are vulnerable. This season, Indian crops too have turned particularly vulnerable because of the long spell in July. Excessive rains in August can be damaging.

Putting all these factors together, the inference is clear. Although demand conditions for many commodities may have eased or are continuing to ease, there is the real possibility that supply performance can get worse. Supplies are struggling to keep pace with even the slower rate of consumption. The picture can dramatically change if supply problems accentuate. That would create a fertile ground for the re-entry of speculators specialising in going long.

Caution should be the watch word for the next two quarters. The markets are likely to be volatile. Speculators who tasted blood on rising markets are unlikely to back off soon. While falling prices need not unduly dismay commodity producers, consumers have no reason to be complacent, and must stay alert.

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