Upwards-only commodity price change is a lie

Have you been exposed to the great commodity swindle?

It goes something like this. The world is incapable of meeting the need of a rising population and growing economic wealth in developing markets. This challenge is being exacerbated by the quantity of physical resources around the world that are finite and, in some cases, commodities are actually in decline. Put these forces together and you have an inexorable upwards pressure on prices for everything from oil to grains, copper to gas. Easy, right? Well, think again.

Gas prices in the US have collapsed to 10-year lows. Coal prices have fallen by 30% in the US during the last 12 months. Metals, in US dollars, are down 21% year-on-year. Food commodities are down 8% in the past 12 months, while milk powder prices have fallen by 20% since the start of 2012.

International butter prices are 30% below their 2011 peak. What’s happening? The market is at work. Instead of blindly following the linear logic that flows from goofy investment banking analysts, real consumers and producers of commodities are responding to demand and supply dynamics.

When prices go up relentlessly, they draw a band of groupies who convince themselves pricing will never change. Remember Irish property in the middle of the last decade — what they miss is the ability of Mr Market to change his behaviour in response to prices.

The reason why natural gas in the US has collapsed is because shale oil production has drawn billions of dollars attracted by high gas prices. The reason why milk powder prices are under pressure today is because milk production in the US and New Zealand has risen in reaction of high prices since 2010.

The reason why Irish house prices have imploded is a massive rise in output and a fall in disposable incomes.

These are all examples of markets at work and ignoring fundamental drivers of price is a dangerous game.

I would not be surprised if oil is the next shoe to drop. The same head-banging analysts who thought grain and gas prices were ever upwards are warbling now about Iran, Chinese demand, and peak oil. Yet oil finds have been enormous over the past five years, demand attributes are changing rapidly (notice the large increases in kilometres per litre consumption in the latest cars) and competing energy (gas, coal, shale oil) supplies are multiplying.

Oil prices are high now because of worries about Iran and unrest in North Africa. Yet oil stocks in the US are at 10-year highs. The last time they were at this level (2002) a barrel of oil was $17, whereas now it is over $100.

Here’s hoping the whole edifice collapses, because a sharp and extended decline in oil prices would equate to a large tax cut in the Western world. At a time when all politicians seem glued to the idea that we can only tax our way out of the current crisis, a break in energy costs would be welcome in an economy which is a large net importer of fuel.

The volatility evident in commodity markets should be watched carefully by farmers too. The line being peddled, that post-2015 Irish agricultural will boom once quotas are unleashed, is dubious. More likely, farm volumes will surge and prices will rollercoast up and down in response to supply changes.

The lesson here is that, when thinking about commodities, assume endless volatility and dispose of the notion that prices only travel in one direction.

* Joe Gill is director of research with Bloxham Stockbrokers