RATTLED ABOUT OIL AND COMMODITIES / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Rattled about oil and commodities

By John Plender

Published: May 29 2011 12:25

Even by the standards of the commodity markets, the gyrations of oil and non-oil commodities over the past month have been quite something, with a phenomenal surge running into a severe setback.


Last week, with a little help from a change of heart at Goldman Sachs on the oil price, buoyancy re-appeared. These wild switchback movements raise big questions about the way the world economy now works.


In the short run adverse supply shocks push up headline inflation while reducing real income growth in consuming countries. Because higher oil prices have a knock-on effect on food production, which is energy intensive, the impact is contagious. And because oil prices feed into so many other activities, headline inflation tends to pull up core inflation, which excludes food and energy prices, over time.


This leaves monetary policymakers with an intractable dilemma. When the post-crisis recovery remains worryingly fragile, raising interest rates to address commodity-induced inflation is horribly risky.


The longer term question is about a potential new paradigm. Clearly strong demand from China and other emerging markets has been a key factor in driving energy and other commodity prices to record levels.


It is possible that this demand shock will take the price of all commodities, as well as land and water, to permanently higher levels.


Yet, plausible though it sounds, the argument needs to be treated with care because the price mechanism is a powerful force.


The elasticities of supply and substitution ensure that when prices surge, the incentive to invest in new supply and to seek substitutes is substantially increased. Moreover, during the 20th century commodity prices fell consistently in real terms because of productivity gains in extractive industries, although oil has been an exception since the 1970s.


That said, when Jeremy Grantham, one of the world’s most canny investors, recently declared that price pressure and shortages of resources would henceforth be permanent features of our lives and would slow global economic growth, I felt obliged to think again.


In essence he believes there has been a window of time since 1800 in which hydrocarbons partially removed the barriers to rapid population growth, wealth and scientific progress. The rise in population and explosive economic growth has, he says, so eaten into our finite resources that the complete reversal of the 100-year decline in prices of all important commodities bar oil in the period since 2002 marks a change in trend. This suggests the surge in demand is unsustainable. As for the effect of productivity on commodity prices, Mr Grantham thinks it is no more than a historical accident.


So has our luck really run out? There is plenty to worry about in food where despite a huge increase in fertiliser use, the growth in crop yields per acre has been in secular decline since the 1960s. There is limited productive new land and people in emerging markets want to eat more grain intensive meat. Bumping up energy supply is also palpably becoming harder. And prices are indeed signalling that something extraordinary has been going on in recent years.


Yet this period has also been marked by extreme underinvestment in many commodities including oil. A point that is also often overlooked is that the global savings glut and the monetary policy response to the financial crisis have both been helping to push up prices. Lower real interest rates arising from these two very unusual phenomena make it less profitable for producers to extract oil and invest the proceeds in financial markets. Note, too, that with low interest rates, the opportunity cost of holding oil stocks falls. Both these things put upward pressure on oil prices. In the latest OECD Economic Outlook the OECD’s economists estimate that a reduction in the US three month real interest rate by 1 percentage point could push up oil prices by about $4 cumulatively by the end of the second year after a shock has occurred. They have no doubt that the response to the crisis propelled prices upwards.


In short, there were freakish, one-off factors at work in the period since 2002.


Nor is China likely to continue to grow at the same rate. It will almost certainly improve its energy efficiency in future.


It is also worth recalling that pessimistic forecasts about resource exhaustion have often been wrong in the past. The late 18th century forecast by Malthus on the dangers of population growth was wrong, at least until now. The 19th century economist William Stanley Jevons wrongly forecast that the exhaustion of UK coal supplies would kill off the British empire just as the first oil was being discovered. The Club of Rome was too gloomy in the mid-1970s about dwindling natural resources. Yet to be an optimist on all this requires an act of faith in human ingenuity. The numbers involved are growing more awesome.


On a two-year view, subject to shocks, I think commodity prices will fall back. For the long term I remain a rattled agnostic on the paradigm shift.

Copyright The Financial Times Limited 2011.