Wednesday, December 10, 2014

Commodity prices are down, but they aren't cheap

There's lots of talk these days about the "collapse" of commodity prices, particularly crude oil, which has fallen by over 40% since last June. Many see falling prices as symptomatic of weak demand, and worry that another global growth slowdown is underway with policymakers helpless to avoid a disaster. But that's a hasty conclusion that ignores the other side of the supply-demand equation.

In the case of oil, we know that supply has increased enormously in recent years, thanks to fracking technology. As the first chart above shows, U.S. crude oil production is up over 80% since late 2008. As the second chart shows, U.S. oil consumption has fallen over the same period. Since 2008, the U.S. has added over 4 mbd to the global oil market, while at the same time reducing its consumption of oil by about 2 mbd. The net effect has been to add upwards of 6 mbd to global oil supplies. This strongly suggests that the collapse of oil prices is almost entirely due to increased supply, rather than weaker demand, in which case lower prices are a blessing, and not a portent of disaster. With lower energy costs we are very likely to see stronger economies going forward.

And even though oil prices have plunged over 40% in the past six months, oil is still relatively expensive from a long-term historical perspective. As the chart above shows, nominal crude prices today are up 400% from early 1999. 

The charts above show the history of nominal and real oil prices since the early 1970s. After adjusting for inflation, oil today is orders of magnitude more expensive than it was in back in 1970 and throughout most of the 1980s and 1990s. 

The chart above documents the incredible degree to which the U.S. economy has responded to expensive oil prices. Oil consumption per unit of output across the entire economy has fallen by over 60% since the early 1970s, thanks to more efficient technology and conservation efforts. Oil got very expensive, so we had an incentive to figure out how to use less of it, and we did. Big time. So our demand for oil softened, but only in a good way—we just don't need it so much.

The chart above shows the history of my favorite commodity price index since 1981. Yes, commodity prices are down 20% from their 2011 highs. But they are still up over 130% from their late 2001 lows.

The chart above shows the same commodity index, adjusted for inflation. Here we see that commodities today cost just about as much as they did over 30 years ago,

The chart above shows the inflation-adjusted prices of a broader commodity index (which includes food prices as well as industrial commodity prices). In real terms, commodity prices today are about 7% below their long-term average. Not expensive, but not cheap either.

Copper prices are down 35% from their 2011 highs. Does that make copper cheap? Hardly. Copper is still almost five times more expensive today than it was in 2001. Copper was cheap in the latter half of the 1990s, at a time when the economy was booming—real growth was over 4% a year. In an historical context, copper is still expensive, and that may be one reason why the current recovery has been the weakest on record. Viewed from that perspective, lower copper prices today are like a reduced headwind to growth. Good news.

So all the concerns about falling commodity prices may just be another "wall of worry" that the stock market will sooner or later overcome.


Burt said...

To show that crude is not yet cheap, here is a graph.
The x-axis is the 2014 price of crude, deflated with the CPI and the value of the$US.
The y-axis is the forward 10-year gain/loss of the crude price, also adjusted for inflation.
The red line is where we are now.

Benjamin Cole said...

Nice wrap-up.

As pointed out, long-term (over decades) commodity prices (adjusted for inflation) seem to be slightly trending down, despite increases in demand.

I see no connection between commodity prices (which are set by global demand) and US monetary policy.

There was a one-time and seemingly permanent bump up in corn prices after ethanol was seriously introduced in the US, in the Bush Administration Corn feeds into a number of other items, such as beef and corn syrup. But corn is no longer rising.

My guess is commodities are soft for a very long time. Demand from Chindia will grow, but the surge in demand is past.

OIl seems to have a ceiling around $100, due to conservation and substitution. I think we have hit Peak Demand already, forget about Peak Oil.

We may see lithium batteries with 3X current capability by 2020.

I see a cleaner and more prosperous future.

William McKibbin said...

Declining commodity prices is a sure sign that interest rates are about to rise -- watch and learn...

steve said...

A) one thing you fail to mention is WHY crude and other commodity supply is up-TECHNOLOGY, which makes "stuff" cheaper over the long run. not only are we more efficient in our usage but way more efficient in our extraction (fracking).

B)doc mckinnen is just the latest pundit to predict higher rates. seems to me that falling crude is DEflationary and therefore would tend to portend falling yields NOT rising

Matthew Grech said...

I have no personal position in oil or oil stocks. I would just note that based on oil's relationship with gold since 1971, oil is cheap. This observation, of course, takes no position on the future direction of gold.

William said...

RE: Savings Deposits have mushroomed to $7.5 trillion

I asked a tennis friend who works at the Federal Reserve Bank in Richmond what these funds were. He consulted with folks and the answer is:

Money Market Deposit Accounts = $4.678 Trillion
(The MMDC accounts offer limited checking.)

Other Savings Deposits = $2.105 Trillion

He added: "FDIC excludes credit unions which would add probably another $500 billion."

Hans said...

Very informative thread, Mr Grannis!

Thank you!

Kelly Starkey said...

I would like to use your commodity index for raw materials on a project I am working on, is it possible to get the raw data so the chart can be a higher quality?

Scott Grannis said...

Re: commodity price data. The indices I use can be found here:

Bhoomi Desai said...

Interesting article and one which should be more widely known about in my view. Your level of detail is good and the clarity of writing is excellent. I have bookmarked it for you so that others will be able to see what you have to say.
Best NCDEX Tips