A continuing commodities boom?

Photo ParisTech Review / Editors / April 20th, 2011

As recently as mid-February copper prices hit an all time high of $10,157 a metric ton on the London Metal Exchange. While the market has cooled off in the intervening months the spike set off alarm bells for decision makers in government and business on how to approach overheated commodities and energy markets. Should the current climate be viewed as a passing anomaly or a permanent reality? Just how real is the threat of a shortfall?

The foundations of the global economy are deeply rooted in commodities markets. The world’s most developed countries, where close to three-quarters of the economy revolves around high value-added services, are the exception rather than the rule. Production rests on the ability to extract riches from the entrails of the earth in the form of oil, gas, and metals to which can be added the fruits of forestry and agriculture in the form of timber, wool, cotton, and rubber. While economists usually consider commodities as a whole, including other agricultural products, our focus here is on raw materials as used in manufacturing.

Production and the instruments of negotiation for these resources are largely the reserve of some of the world’s largest industrial concerns but they interact with an extremely diverse network of buyers to which in recent years have also been added a rapidly expanding range of financial interests.

Proliferating investment in the dock?
The recently published report “Commodities Trading” (March 2011) by the independent body TheCityUK has illuminated the rapid increase in the volume of commodities being traded on exchanges since the beginning of the new millennium and underlines the increasing attractiveness of the sector in light of the rapidly expanding range of investment options which have allowed ever greater numbers to accede to the markets. The volume of commodities trading on exchanges increased by around a fifth in 2010 and between 2008 and 2011 witnessed a 47% increase despite the fact that within the context of a global economic slowdown actual physical exchanges dropped 2%. Commodity assets under management more than doubled between 2008 and 2010 and inflows into the sector totaled over $60 billion for 2010 alone down from the record $72 billion the previous year.

The bulk of the funds were invested in energy and precious metals and extrapolating outwards we can draw an initial sketch of the outlines of the commodities boom. Uncertainty in the face of massive public debt and the property bubble sent investors fleeing to the relative safety of the commodities markets and the process has been encouraged by the abundance of liquidity created by the historically low interest rates set by central bankers since 2008. Gold as always remains the standard by which others are measured but in recent years oil and a handful of metals, such as copper, have emerged as equally bankable measures of value due to a seemingly insatiable global demand for resources. These commodities are no longer viewed as risky investments and are rather seen as a necessary component of any well-thought out portfolio. Added weight is accorded to the current approach as most commodities are invoiced and priced in dollars and the weakening of the greenback has corresponded with surging commodities prices. Shifting investment to commodities has become a strategy to create a cushion against uncertainty surrounding the value of the dollar.

In an oft-cited report the London consultancy specializing in market analysis for copper, Bloomsbury Minerals Economics, highlighted the recent arrival of banks and other new investors on the market and the way this has contributed to making price setting mechanisms less clear cut on the world’s premier non-ferrous metals market. They have reached the conclusion that the 30% spike that occurred in copper between 2007 and 2008 as well as an even more significant proportion of the current market can be attributed to this cause. A detailed analysis of newly operational mines provides the framework for the British expert’s forecast of an equilibrium price of $5500 a metric ton over the long-term and between $6000 and $8000 over the medium-term, prices that are far from the heights of $10,000 witnessed recently.

Reactions to the current conditions have included a number of observers (here and there) who indicate tell-tale signs of a bubble. They have warned of the day when the Fed and the European Central Bank make the decision to limit their current policies aimed at encouraging liquidity and of the impending threat of a slow-down or indeed bursting of the current bubble.

Weighing the fundamentals
While financial instruments exert a heavy influence on the current markets Pierre-Noël Giraud, Professor of economics at Mines ParisTech and Paris-Dauphine University, warns against placing too much emphasis on the role of derivatives in driving prices upwards. What should be privileged is a thorough understanding of the market fundamentals for a given commodity: productions levels, intensity of demand, and the existence of reserves to smooth out any tension that could result from gaps between supply and demand.

The logic becomes clear when we observe that even in commodities markets that have received little attention from the investment community, and Philippe Chalmin Director of the Cyclope consultancy and Professor at Paris-Dauphine University points to rubber as being a good example, the trend for the market has been rapidly upward. Market fundamentals explain why: the automobile industry was producing 70 million cars before the financial crisis, 74 million in 2010 and is forecast to produce 95 million in 2015. In China alone, market indicators suggest sales of 15 million cars per year representing 20% of the global market which translates into demand for 75 million new tires.

Growth around the world, particularly in emerging economies, would seem to provide a definitive structural rationale for the upward march of the markets. As hundreds of millions of new customers arrive to claim their place in the global market for consumer goods the corresponding demand should continue to experience robust growth. As industrial capacity expands these countries will find themselves occupying an increasing slice of the pie in the global market for raw materials. This has clearly been the case with China which has emerged as the world’s leading consumer of metals in recent years.

The rise in global demand for fossil fuels is still being driven primarily by the developed world but rapid industrialization in emerging economies and the corresponding enrichment of their populations has seen them assuming an increasingly more prominent role. The International Energy Agency has forecast global demand for oil to reach 89.4 million barrels a day representing a 1% increase over the 2010 figure of 87.9 million. According to the IEA’s median forecasts global demand will rise to 99 million in 2035 and 107 million in its “business as usual” forecast.

The imminent threat of penury?
In light of the media frenzy surrounding the publication of an HSBC report suggesting the exhaustion of petroleum resources by the year 2050 should we be reaching for the panic button? Yes, and no.

For illumination we need look no further than the example provided by copper. In 1950, world reserves were estimated at 100 million metric tons, a figure that had risen to 400 million by 1975, and 500 million in 2005. Measuring levels of mineral or fossil fuel reserves is never done in absolute terms and instead functions according to what would be economically sustainable. Another example is found when identifying deposits of iron or nickel, both of which are available in abundance but which are buried so deep beneath the earth’s crust as to make any exploitation impossible because of current limitations. The potential for the discovery of new untapped deposits of resources ensures figures can never be anything more than provisional in nature. What we identify as “reserves” are merely measurements of the quantity of a resource that is exploitable, from an economic and technological perspective under the current conditions. For certain minerals, such as aluminum or uranium, reserves could stretch well into the next century under prevailing conditions. For others, such as silver and antimony, the future is rather less rosy but remains in a state of flux as each new surge in price leads to revised calculations based on new research and cost analysis which expand the size of “available reserves”.

An understanding of the dynamics of the commodities markets rests on the ability to discern the need for adjustments, through an interrogation of which ones are indeed possible, under shifting conditions as dictated by the intensity of demand for a limited resource.

The first type of adjustment is technological in nature and rests on the substitution of one product or technology for another. For example, whereas one component of the process to create galvanized steel, iron, is abundant the other, zinc, most definitely is not and might need to be replaced if it becomes too costly (like aluminum its production requires a lot of electricity). In the case of fossil fuels it seems likely that the conventional method of oil production will sooner or later push up against its limits but the global market for energy could evolve to take in other forms (liquefied natural gas, biofuel, etc.). Consumers and industrial concerns would be expected to modify their behavior in line with successive waves of innovation.

A sustained period of upward pressure such as has been experienced in the global oil markets can lead to collective agreements and industrial decision making leading to a partial modification of the playing field. Within such a context, the methods of extraction evolve as has been witnessed by the potential unleashed through the exploitation of oil sands. It was precisely because of a sustained period of elevated prices that these previously untapped deposits were made attractive enough to encourage the necessary investment and technological innovation required to make them productive. In the case of fossil fuels, rising prices have also led to the development of substitutes, or indeed the creation of entire industries, such as the rapidly evolving “clean fuel vehicle” sector.

But, there is always a but… as each scenario evolves it has the potential to place pressure on the market for other raw materials. The case of the batteries used in electric vehicles illustrates this point as they rely for the most part on lithium. Demand for this resource is set to double in the space of the next few years and the Swiss analyst Marc Taylor recently published a report which penetrates to the heart of the matter and identifies the relationship between two key elements. Each new “clean” vehicle requires between two and ten kilos of lithium, production of which is currently confined to two primary locations: the salt lakes of South America and the spodumene of Western Australia. In light of expected demand the question of access has taken on added urgency. This scenario is part of a much broader picture where the reality of sustained upward pressure on commodities is forcing a complete rethink of the current industrial strategies being deployed at the level of enterprise, and its offshoots, as well those charged with formulating public policy.

Possible outcomes for industry?
In the short-term, upward pressure on the markets creates the potential for consequences on the price of finished consumer goods as well as distortions across the industrial value chain. The recent boom placed immense pressure on actors at various stages of the automobile industry supply chain which reacted to the price increase in raw materials by pushing the burden onto its clients and instituting a system to protect itself from market volatility (usually taking the form of six month contracts). For all appearances these systems have successfully taken the sting out of volatility in the face of sustained upward pressure on the market. Yet, on closer inspection it is plain to see that raw materials represent a mere fraction of the overall costs of supply management and, for an industrial company such as Valeo, purchases of raw materials accounted for only 13.5% of the group’s 2010 balance sheet. Under current conditions it would appear the effects of the boom in commodities prices has been negligible in the major Western economies and what little inflationary pressure does exist is due mainly to oil and gas price volatility.

Over the longer-term the picture is less clear-cut as in affected industries rising commodities prices will permanently alter the structural foundations producing effects of which it is useful to distinguish at least four.

The first relates to the mining sector, in its strictest definition which has been marked by a strong wave of consolidation over the past decade which shows no sign of abating. Industry leaders such as Rio Tinto or BHP Billiton are expected to grow ever larger as are the giants of big oil who have benefited enormously from the current conditions in terms of their valuations on the world’s stock markets. Consolidation is the logical response to the conditions and challenges specific to these industries. The resources required for exploration and extraction are enormous and the sheer scale precludes participation for all but the largest enterprises. Financial markets have nevertheless allowed certain specialized fringe players to arise in the gaps left by larger groups.

A second trend is the rebirth of mining activity in the developed West and for a current illustration we can observe the heated discussion surrounding the potential for shale gas in contemporary Europe.

The maturation of recycling practices is the third clear trend and has expanded beyond its original motivations based on environmental concerns and has become a strategic tool in the service of protecting access to vital resources.

Finally, the industries responsible for the bulk of demand on commodities markets have rediscovered the benefits of vertical integration and have increasingly sought to secure a stake in smaller mining operations in order to ensure supplies to meet future demand.

Strategic planning
Looking abroad, the Chinese experience is emblematic of how to construct a coherent industrial strategy on how the future direction of a specific sector will unfold. Their approach toward tungsten and magnesium since the year 2000 provides one model but it is in recent discussions over the country’s significant reserves of rare-earth metals that discussion becomes most animated. These metals, which share similar chemical properties, are present for the most part in two host minerals whose geographical footprint is limited to China, the United States, Australia, Brazil, India, Malaysia, South Africa, Sri Lanka, and Thailand.

China was accused of practicing a dumping strategy in this sector in the not so distant past in order to price competing mines out of business and has cornered the market for a number of indispensable minerals. Skyrocketing prices, due partly to a recent tightening of export restrictions have created friction with the country’s main trading partners, in particular Japan. Between 2008 and 2011 Chinese exports have been winding down from 115,000 tons to 35,000 tons and are expected to settle somewhere around 30,000 tons.

The strategic decision of the Chinese to create a vertically integrated national policy for this essential resource has elicited a diverse range of responses from the major Western economies. The European Commission has highlighted the need to create a strategic reserve (but how is it to be constituted in such a tight market?). Attempts have also been made to file a formal case against current practices with the WTO but the organization’s rules make no provisions for sanctions against members for implementing export restrictions. Industrial concerns have taken a more pragmatic approach: in Germany this has meant tighter vertical integration and partnerships in Kazakhstan, while in Australia and the United States the mining industry is undergoing a rebirth. Finally, ores which were once considered sterile, due to their low concentration of rare-earth elements, have become more attractive under current conditions.

So the markets provide solutions. In a general way, the boom in commodities prices must be regarded seriously not so much for the threat it poses to Western economies, but for the way it forces states and industrial actors to design new strategies. The whole edifice of vertical integration, while discredited over the course of the 80s in favor subcontracting and outsourcing, is re-emerging as pertinent response to the current dilemma. In such a situation, suggests Pierre-Noël Giraud, the state has a role to play, not so much for its power to direct policy from the top down, but for its ability to encourage economic actors to develop a coherent, coordinated response to prevailing conditions. In some sectors, such as titanium, the process is already well under way while in others the future direction has yet to be seen.

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