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— G. Krishnaswamy

India has managed to relatively insulate itself from the speculative froth built up in global commodity markets.

Harish Damodaran

From all available indications, it looks as though the extended global bull-run in commodities is over. Since March-April, there has been a falling trend in prices of base metals such as copper, lead, nickel and zinc, alongside an easing of wheat, rice and palm oil from their peaks. The past few weeks have seen a similar unwinding in oil, gold, corn and soybean. The speculative frenzy that had over the last couple of years launched commodities into stratosphere appears t o be finally cooling off.

Table 1 shows the extent of rise in world prices of 15 commodities from December 2005 to July 2006. These range from 36 per cent in aluminium and cotton to over 370 per cent for coal. The only exception has been sugar, which actually recorded a drop, for reasons to be explained later.

The huge price increases in most commodities have partly had to do with the dollar’s decline as a global reserve currency — a reflection of the growing loss of US manufacturing competitiveness and also the undermining of its geopolitical hegemony following the costly war (both in monetary as well as foreign policy terms) waged in Iraq. While in December 2005, a dollar fetched 0.84 euros, in July 2008 it averaged a mere 0.63 euros.

What this means is that the 124 per cent dollar-denominated jump in crude petroleum prices between December 2005 and July 2008 was only worth 68 per cent in euro terms. Likewise, the 99.6 per cent and 160 per cent rise in dollar prices of wheat and corn translated into less than 50 and 95 per cent, respectively when measured in euros. But even after discounting for the dollar’s precipitous free-fall, the fact remains that never before in history have commodity prices surged on as widespread a scale as they have done in the recent period.

This is evident from the International Monetary Fund’s (IMF) indices of primary commodity prices in SDRs or special drawing rights. The latter, representing a basket of currencies (dollar, euro, yen and pound sterling), corrects for any distortions arising from the dollar’s vicissitudes and enables one to gauge better the ‘real’ increase in global commodity prices.

The IMF’s ‘all primary commodities’ price index in SDRs, which averaged 100 in 2005, amounted to 197.7 in July 2008. The ‘food’, ‘metals’ and ‘energy’ indices went up correspondingly to 160.3, 170.2 and 224.1. Commodity prices have, on the whole then, doubled within a space of two-and-a-half years and are now apparently entering the next ‘Great Unwind’ stage.

This extreme price volatility is mainly an outcome of commodities emerging as a distinct ‘asset class’ on a par with equities, bonds, currencies and related financial derivatives — making them attractive to not just the direct stakeholders (farmers, processors, wholesalers, shippers, etc) but to a range of institutional investors from hedge funds, pension plans and exchange-traded index funds.

For these investors — the big funds based on the S&P Goldman Sachs Commodity Index and the Deutsche Bank Liquid Commodity Index were, in fact, floated only in 2006 — commodity contracts are not simply hedging tools against adverse future price movements, but like any other financial instrument. The big difference though is that while the impact of rising (or falling) stock prices is largely limited to the shareholders concerned, the rise or fall in corn prices also affects farmers and households who are not investors in these contracts.

On the other hand, price volatility is a sine qua non for investors having no direct stakes in the underlying commodity either as producer or consumer. The so-called fundamental factors — supply disruptions due to unfavourable weather conditions, diversion of arable land for bio-fuels or the assumed demand pressures from China and India — merely serve as pretexts for pouring in or pulling-out monies and sending prices way beyond their intrinsic values.

In late March, the Economics Editor of Barron’s, Gene Epstein, estimated that index funds accounted for 40 per cent of bullish bets on commodities. “The speculative juices are even more plentiful — nearly 60 per cent of bullish positions — if you count the bets placed by traditional commodity ‘pools’”, he wrote, while predicting a 30-50 per cent drop in commodity prices in the months ahead (that seems to be happening now).

It is this speculative element alone that can explain how international palm oil prices touched $1,350-1,400 a tonne levels in March 2008 — a more than 100 per cent year-on-year jump — and subsequently slid below $750 a tonne. This is not to say there were no fundamental triggers, such as edible palm oil being converted into bio-diesel and its prices getting linked to crude petroleum.

The role of speculative funds, however, lay in amplifying supply-demand mismatches, where they existed, and buying up large chunks of the commodity on paper without ever taking delivery and thereby disproportionately jacking up prices.

In sugar, it was the opposite. The huge production glut, especially in India, meant there was little fund buying interest in the commodity. Instead, they sold heavily, so much so that raw sugar fell from over 18 cents a pound in February 2006 to nine cents by May 2007.

India, on its part, has managed to relatively insulate itself from the speculative froth built up in global commodity markets. The domestic wholesale price indices (WPI) for most commodities have risen by a much lower extent than world levels (Table 2). Again, a weak dollar has helped, with the greenback falling from Rs 45.65 in December 2005 to Rs 42.84 in July 2008.

But the greater contribution has come from government policies. These have extended from administrative vetoes on price hikes (as in petro-products) to tinkering with import duties (edible oils) and ban on exports and futures trading (wheat and rice), which have prevented international price pressures from transmitting into the domestic market.

In other words, a forced de-globalisation of sorts. Only in rubber and cotton have domestic prices gone up more than world prices. And this has been courtesy exports, benefiting Indian farmers at the expense of tyre manufacturers and textile millers.

What now? Well, if present trends are any guide and the sell-off by funds in commodities continues, the shoe could well be on the other foot. The Government may, for instance, have to re-impose Customs duties on edible oils to protect domestic oilseeds growers against any downturn during the ensuing kharif harvest season.

In sugar, the global supply position is tightening (this time, due to India’s considerably lower cane crop); but in the absence of fund buying interest, prices may not spurt the way they would have done a year ago.

As far as oil goes, in the event of crude falling below $100 a barrel and the Government unlikely to rollback diesel and petrol prices to their earlier levels, the public sector oil marketing companies could even see their fortunes turnaround.

More Stories on : Commodity Markets | Commodities | Insight

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