World needs stable, not low, commodity prices

In recent months, leading indicators have consistently signalled a slowdown in economic activity around the world, especially in the OECD region. Concerns over the global economic slowdown, triggered primarily by the unresolved sovereign debt crisis in the Euro zone and twin deficits in the US, have resulted in sharp declines in commodity prices in recent weeks. Punters have rapidly liquidated their long positions fearing demand destruction. This has accelerated the price decline.

As a result, the market has witnessed what some experts describe as alarming downgrades of commodity prices. It is not unusual for commodity prices to overshoot either on the upside (say, during bull runs) or the downside (generally, because of the fear factor). Once the euphoria or fear runs its course, markets tend to correct as fundamentals begin to assert.

In the current scenario, the most affected are growth-related commodities such as energy and base metals. The general sell-off has not spared agriculture either. For instance, during the four weeks between end-August and end-September, Nymex crude pared 7.6 per cent of its price to trade at $82 a barrel. Base metals were the worst affected, copper having lost over a fifth to trade a tad below the psychological level of $7,000 a tonne, while nickel performed no better, with a price decline of 15 per cent to $18,670/t on the LME.

Safe haven asset gold and its compatriot silver suffered too. The yellow metal was down over 11 per cent to $1616 an ounce, while silver plummeted by 27 per cent to a recent low of $30/oz. Soybean, sugar and cotton have been no exception too, suffering price declines of varying degrees.

Producers concerned

The ongoing price declines have caused concern among commodity producers. If the bear phase continues longer, producers will begin to review their production, inventory and investment plans.

However, commodity consumers are happy because they are able to cover their requirements at lower prices. One of the views expressed during the market meltdown is that low commodity prices may not, after all, be bad for India. On the face of it, it sounds logical that low commodity prices would benefit any large consuming economy such as India because the country is far from self-sufficient and its growth is dependent on imports of key commodities such as crude oil.

While any import-dependent economy would benefit from lower global commodity prices in the short term, it would be naïve or shortsighted to view the ongoing low price situation as friendly to developing economies in the medium to long run.

India, for instance, is seriously short of resources such as crude oil. Our import dependence of this key commodity that fuels economic growth is already high, at 80 per cent, and may increase to as much as 90 per cent sooner than many imagine.

What would happen if prices of growth commodities such as energy products and base metals continue to rule at low levels? There will be no incentive for new investments in production. Additionally, given the rising cost of production, some producers may even exit if returns turn unattractive. For instance, at the current $2,250/tonne, aluminium prices are close to the cost of production and it is estimated that as much as 25 per cent of global production is losing money.

The copper market, for instance, is in deficit. Yet, prices, at about $7,000/tonne, do not reflect the market fundamentals as sentiment has turned negative. As soon as positive signals of global growth arrive, copper will probably be the first commodity to break out of the bear hug and accelerate towards the $10,000/t levels.

Sustainable plan

In case of crude oil, experts assert that spare capacity has fallen and physical market strength has grown following a supply-side deficit in Q3. It was only five years ago that the world witnessed how Hurricane Katrina battered refineries in the US and prolonged refinery showdowns pushed prices higher. On current reckoning, at anything less than $100 a barrel (Brent equivalent), key producers are likely to feel uncomfortable in the medium term. Currently, economic fear is battering asset classes. This will change.

Commodity supplies usually respond to prices. Higher prices spur production. Similarly, a protracted period of low prices will discourage new investment. This is not desirable.

Indeed, the world needs stable prices of commodities rather than low prices. Current volatility is not because of fundamental factors of demand and supply, but non-fundamental factors such as currency gyrations, geopolitical instabilities and, importantly, flow of speculative capital.

Largely stable or less-volatile global commodity prices that ensure continued flow of investment into production and processing will be in the long-term interest of an importing country such as India. Rampant financialisation of the commodity markets has its own downside risks, as we are witnessing currently.

It is also time for India to design a stable long-term policy for investment in utilising finite natural resources in sustainable ways and with a human face. It is a daunting challenge given scarcity of resources, humungous investment needs, environment considerations and people issues.

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