The Hindu Business Line : Commodity prices up; upturn unlikely

A look at the correlation of the various categories of commodities to global industrial activity since 1987 indicates that the strongest correlation is with metal prices. This correlation is as high as 0.64 whereas oil is much lower. Gold has a negative correlation.

GEOPOLITICAL tensions have kept oil prices firm over the last few months. One of the factors keeping the prices firm is the fear of war with Iraq and threat of oil supply disruptions. Venezuela, the world's third largest oil producer, is going through an unprecedented oil sector strike and has not produced any oil for over a month. The oil story is a bit predictable and the world has been gearing to face it in its own way. Any hostilities would not come as a sudden surprise.

However, it is the non-oil commodity prices that have been in an uptrend after a very long period of stagnation. These commodities include food, non-food agricultural products, base metals and gold. Conventional wisdom suggests that non-oil commodity price increase could indicate upturn in global economy. In case the upturn is strong, it also creates fear of inflation. In this article, we look at the increase in commodity prices and see if it indicates any of the above.

Commodity Research Bureau publishes an index that tracks the trend in commodity prices. The index indicates that commodity prices have risen by around 30 per cent from their lows seen in October 2001. The uptrend has been caused mainly by rise in oil, precious metals, food and other agricultural commodities.

It is important to evaluate whether the increase in prices have been driven by supply or demand considerations. Some of the commodities have historically shown strong correlation to the overall economic activity. Are the price rises significant in such commodities?

Now let us look at the food category: Grain and oilseed prices have risen sharply in the second half of last year after hitting their lows in 2001.

According to the Thompson financial data, food prices have increased around 21 per cent from the lows seen in October 2001. However, these increases reflect poor growing conditions in major exporting countries and falling stock levels. An expectation of better crop in this year has resulted in some correction. Supply disruptions have been the prime mover in this category, for example the civil war in Ivory Coast has almost doubled cocoa prices.

One category that has shown the largest increase is non-food agricultural products. Their prices have seen an increase of 33 per cent in a similar period. Cotton constitutes around one third of this category. Cotton prices have increased by around 90 per cent since October 2001. These increases once again are prompted by supply disruptions; bad weather and poor growing conditions have damaged cotton quality. Besides cotton, timber has also been hit by unusual mill shutdowns. Palm oil, coconut oil and soya prices have risen by around 50 per cent since the end of 2001, mainly due to supply reasons.

Base metals have the closest relationship with the global manufacturing activity. It seems fund short position covering and long position building has pushed the prices of three major base metals — aluminium, copper and nickel.

Prices in these are up by around 10 per cent over the last quarter. Overall, base metals prices are up by 8 per cent on year-on-year basis. Precious metals have seen the largest increases. Platinum has been pushed up due to the strength of auto sales.

Gold has flared up to pierce $350 per Troy ounce level, mainly due to the safe-haven status in the scenario of war with Iraq, falling dollar and increase in oil prices.

Oil prices usually reflect supply disruptions and gold is often held for its safe-haven status. Hence the increase in their prices can often be unrelated to the global economic activity.

Commodity prices had risen sharply in 1994, but that time the increase was driven primarily by higher metal prices. At that time, metal prices had increased by over 60 per cent. Comparatively, the base metals price rise over the last year is very small (just 8 per cent).

The commodity prices have largely gone up due to food and non-food agricultural products. The increases have not been triggered by demand increases. This indicates that there may not be any economic activity upturn.

Global inflation remains pretty subdued. On the other hand, such a scenario may be counterproductive as companies may not be able to pass on the cost of higher prices to customers and cause a cost shock.

This once again supports the outlook of extended period of stagnant growth.

(The author is Senior Manager, Corporate Treasury Sales - Southern India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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