Sunday, October 2, 2011

Commodity update

It's a nice quiet day at the beach. Blue sky, a few wispy clouds, only a slight breeze, and relatively small waves. It's been a relatively cool summer in general, cloudy more often than not, but today it's almost hot. In the past few months we have had lots of heavy surf which severely eroded the beach. Today I noticed that the sand has come back in size—more than I've seen for a long time. One thing I've learned from living at the beach is that the beach survives, even though sometimes it looks like it will never recover from the beatings. This might be a good metaphor for the commodity markets.

Here's what I think is the best long-term chart of key commodity prices, plotted with monthly data through last Friday. The first thing that jumps out is that gold and spot commodity prices do a pretty good job of tracking each other over time, with gold sometimes leading the way. Plus, gold's price swings, on average, have been more than double that of commodities—note that the right y-axis has double the span of the left y-axis. Both gold and commodities have suffered big setbacks of late: gold down 15%, CRB spot down 12% from their recent highs. But the correction in gold hardly shows up on this chart; in fact gold still looks like it's in an uptrend. Meanwhile, commodities are still higher than they were at the peak in 2008; the correction has been painful but hardly the end of the world. With the Fed in super-accommodative mode, it would be incredible if commodity prices were not the object of speculators' desire. And after having scaled heretofore unimaginable heights, it shouldn't be surprising that they get knocked down every now and then.

Let's zoom in on copper prices. Copper has dropped by a hefty 32% since its February all-time high. But it's still worth five times what it traded at in late 2001. If you had told someone in 1996, when copper was trading at $1.20 a pound, that in the next 10 years it would hit $4, they would have called you insane. Something like that could only happen if the U.S. were ravaged by inflation! And so with copper today at just over $3, we are supposed to be worried about deflation?

Crude oil prices have dropped by a sizable 30% since their late-February high, but that's peanuts compared to the collapse that occurred in 2008. And oil today is still worth six times what it traded for in early 1999. In constant dollar terms, oil today is almost as expensive as it was at its early-1980s peak.

Thanks to new drilling technologies which have hugely boosted U.S. natural gas production and proven reserves, natural gas prices have collapsed by 75% since hitting an all-time high in late 2005. That's a serious decline. But is it deflationary? Hardly. Gas is still three times higher than it was in 1992. Moreover, cheap and abundant natural gas both here and in the U.K. has the ability to transform manufacturing industries, as Mark Perry notes in a recent post.

Natural gas is now cheaper relative to oil than at any time in the past 20 years. It's difficult to imagine the eventual magnitude of the impact this could have on manufacturing and economies in general. It's certainly not something to worry about, with oil still trading at relatively expensive levels. Cheap energy is a big deal.

All of this leads me to think that it's not the recent drop in commodity prices that is a concern. If anything, we should still be focused on how expensive most commodities are relative to their historical trends. Finally, it shouldn't be surprising that commodity prices are still quite elevated, since, as the last chart shows, the dollar is still plumbing all-time lows in real terms against other currencies. Easy money, weak dollar, strong commodity prices; they all tie together, and that's still the dominant theme, even after all the turbulence of recent months.


Benjamin Cole said...

Scott Sumner has a completely different take on gold and copper his blog, "Money Illusion." BTW, the "market monetarist" school, of which Sumner is an elder, seems to be gaining momentum. I hope someday we can welcome Scott Grannis aboard.

I note that many commodities are back to roughly 2006 levels, such as copper and oil (and both look soft). This is inflation?

Natural gas is back to 2000 levels--and the story on natural gas tells a bigger story. It is not only money supply that determines commodities prices, especially in global markets. There is supply and demand and speculation.

If the USA money supply determines commodities prices, explain why natural gas was falling while copper was rising? Now both are falling.

Far more importantly than commodities, USA wage inflation is subzero. Wages are about 60 percent of business costs. Real estate is dead in the water (about 10 percent of business costs) . There simply isn't the recipe there for inflation.

In Japan, they have been fighting inflation for 20 years. They have won. But you do not want to be an investor in Japan. Your equities portfolio is off 75 percent in last 20 years, and your real estate portfolio is off 80 percent. Income per capita, relative to the USA, is falling.

A peevish zeal to "fight inflation" is the Achilles Heel of modern-era "conservative" economics policymakers. Milton Friedman, when he visited Japan in the 1990s, told them to print more money.
Is is a misnomer to think that "conservative" always means tight money There are times when strong medicine is called for, and now is one of those times.

Unless you like the japan model.

Bill said...

Don't you think the concern about a slowdown in China is the primary reason for the correction in commodities?

Benjamin Cole said...

The TIPS market suggests institutional investors expect extremely minor inflation, perhaps deflation, in coming years.

And Bill's comment underscores the point---commodities are soft now on expectations of weak real demand. Not whatever Bernanke decides to do, such as keeping rates at zero for two years.

John said...

"Copper has dropped by a hefty 32% since its February all-time high. But it's still worth five times what it traded at in late 2001."

In the past decade, haven't we seen more speculation in the commodities markets?

From the wikipedia:

"Since 1991 the CFTC has given secret exemptions from hedging regulations to 19 major banks and market participants, allowing them to accumulate essentially unlimited positions. These exemptions were originally given in secret, coming to light only as the 2008 financial crisis unfolded and Congress requested information on market participants. A trader or bank granted an exemption as a bona-fide hedger can affect the price of a commodity without being either its producer or consumer."

The Wikipedia reference comes from Bloomberg.

Benjamin Cole said...


I followed the oil futures market closely for several years. I suspect speculators can and do push that market for up to two years at a time.

It is yet another reason to take commodities movements with a very large grain of salt, as in boulder-sized.

Alex said...

Gold spiked in 2010-11 on the real basis of US dollar devaluation but that spike was enormously exaggerated for purely psychological factors. So I deduce that the price of gold is speculative and therefore have to correct in the near future.
Others commodities prices hiked because of the recovery hopes for the global economy. The mainstream scenario being stagnation, and the alternative scenario: severe recession, there is no more basis for commodities price sustain