Global commodity markets (Part I): a paradigm shift?30 May, 2011
This blog is focused on European power and gas markets. But it is difficult to have a robust view on the evolution of power and gas markets without reference to global commodity markets. Global coal prices determine the extent to which coal and gas fired power plant compete in setting marginal power prices. Global LNG prices and the oil indexation of gas contracts have become key drivers of European gas hub pricing dynamics. This article explores the evolution of commodity prices in the context of the ‘macro’ drivers common to all commodity markets. A second article to follow focuses specifically on oil, coal and gas markets.
A paradigm shift in commodity markets?
The theory of a structural shift in commodity prices or a commodity ‘supercycle’ has been gaining prominence over the last decade. There has undoubtedly been explosive growth in demand from developing economies in the face of finite global resources. But the fallacy of many previous theories of structural market change has been exposed as the cyclical nature of asset prices prevails.
One of the more recent proponents of a structural shift in commodity prices is of an unusual pedigree. Jeremy Grantham is not an analyst or a market commentator but an investor with a record matched by few of his peers. Grantham is co-founder and Chief Investment Strategist of GMO one of the world’s largest asset management firms. He describes himself and his analytical team as ‘students of asset bubbles’. They focus on the relationship between the cyclical movement of asset prices and their underlying long term price trends. This approach has produced impressive results. Grantham has successfully foreseen and negotiated many of the macro events in financial markets over the last decade; the internet bubble, the US housing bust and associated credit contraction and the recovery in global stock markets in 2009-10.
Grantham’s analysis of commodity markets focuses on the long term evolution of prices rather than a breakdown of the supply and demand balance. He sets out his argument in GMO’s Apr 2011 Quarterly Letter. Grantham argues that there has been a 100 year down trend in commodity prices which ended in 2002. He illustrates this by showing that the price of an equally weighted index of major global commodities has declined in real terms at an annual rate of 1.2% over this period (see Chart 1). Improvements in the efficiency of production have outstripped the increase in cost of extraction causing prices to trend lower.
Chart 1: GMO Commodity Price Index
However the commodity index has erased its 100 year decline in the eight year period since 2002 as a result of rapid growth in developing economies, particularly China. Grantham argues that statistically most commodity prices have deviated so far from their underlying down trend that this deviation can only be explained by a change in this trend. He characterises this change as the start of a ‘Great Paradigm Shift’ in commodity markets and predicts that price pressures and resource shortages will become a permanent feature of our lives.
The counterargument to the Grantham’s paradigm shift theory is human innovation. When faced with resource constraints in the past we have managed to evolve our production and consumption behaviour. New technology has improved access to resources; efficiency and resource substitution have helped constrain consumption. The supply of resources may be fairly unresponsive (or inelastic) to changes in demand in the short term, but scarcity and high prices can drive leaps in production innovation. A recent example of this has been the rapid commercialisation of shale gas reserves in the US which has had a dramatic influence on pricing in the natural gas market.
The paradigm shift versus human innovation debate is unlikely to be resolved in the near term. But is there an outcome which is consistent with both views where tightness in commodity markets remains a feature of the next decade ?
A scenario of commodity market tightness and instability
If the explosive growth in economies such as China and India continues at current rates then for a prolonged period the demand for many commodities may outstrip the ability of producer’s to respond. Compared to the relatively steady growth and cyclical swings of developed economies in the 20th century, the current demand growth from emerging economies is of a different scale. Grantham highlights this point with statistics on China’s current share of global commodity consumption; 10% of oil, 39% of copper and a staggering 47% of coal.
But as Grantham points out, demand from developing countries is unlikely to be stable. Although China’s economy is currently the engine room of global growth it is still a developing economy and is negotiating a withdrawal of stimulus, tightening monetary conditions and a property bubble. Grantham puts the probability of a downturn in China’s economy in the next year at ‘at least’ 25%. If this happens it is very likely to cause sharp declines in global commodity prices.
While the focus of this scenario is on demand, there are also a number of factors which are inhibiting the responsiveness of supply to higher prices. Considerable uncertainty remains in large parts of the global economy and the global deleveraging process in the wake of the financial crisis is set to continue for a number of years. Producers face balance sheet constraints, financing is harder to come by and volatile commodity prices increase production risk. It is brave to under estimate human innovation in the long run but these conditions are likely to constrain the process of investment in new production and technology.
In summary this is not a scenario of steadily rising or even plateauing prices. Rather it is a scenario of underlying commodity market tightness but price instability. The combination of inelastic supply and swings in emerging economy demand growth is likely to result in substantial price swings and volatility. This instability may be magnified by the increasing focus on commodities as an investment asset class. Commodities look attractive as a store of value in a time of unprecedented monetary expansion and rising inflation. While the long term impact of commodity speculation is constrained by the complexities of physical delivery and storage, the shorter term influence of large non-physical investment flows accentuates price swings and volatility.
There are however limitations to considering a scenario of commodity prices in aggregate. To gain a more meaningful understanding of the impact of globally traded commodities on European gas and power markets it is necessary to dig deeper into the supply and demand balance of the hydrocarbon commodities: oil, coal and natural gas.
This is the subject of an article to follow shortly.