Commodities subject to laws of supply, demand

Higher prices, for example in oil, led to a sharp reduction in demand as people lowered consumption or used substitutes. Falling prices shift this balance, especially in energy importers such as China, Japan and India.

It is not clear how much lower global growth is impounded in commodity prices. The fall-off in exports in Asian countries and the collapse in freight rates is especially worrying. Inevitable protectionism (buy "local" and currency "manipulation" to gain export competitiveness) is also a concern.

Short-term factors also affect the outlook. Some oil exporters produce below operating cost to maintain revenues to finance spending plans conceived in more prosperous times. This overproduction distorts prices.

A known unknown is the performance of the U.S. dollar. There is a complex and unstable relationship between commodity prices and the dollar. An IMF study noted that a one per cent increase in the value of the dollar results in a decrease in oil and gold prices of greater than one per cent. Continued volatility in currency markets will be mirrored in commodity prices.

Individual commodities are also highly idiosyncratic -- you can't drink oil, nor can you run your car on gold, though they seem to go quite well on corn tortillas!

Oil prices may have further downside, in the short run, reflecting continued reduction in demand as growth slows. Production cuts by OPEC may not be effective as revenue-strapped sovereign producers maintain volumes to generate cash flow. The outlook for alternative energies is less sanguine. Most alternatives require high oil prices to be economic.

The dislocation in financial markets has benefited gold. Gold prices have performed well, reflecting increasing suspicion about "paper" money and lower interest rates. Other precious metals, platinum, palladium and silver, are likely to be affected by decreased demand, especially the problems in the automobile sector.

Industrial metals (aluminium, copper, lead, nickel, zinc and tin) and bulk commodities (iron ore and coking coal) have been a major proxy for global economic growth, particularly demand from a rapidly industrializing and urbanizing China and India. Slower growth and problems related to inventories and oversupply may mean a continuation of weakness.

After falling in line with commodities generally throughout 2008, in December agricultural products decoupled from other assets. For example, some grains rose sharply in prices by 10 per cent to 20 per cent.

Prices (adjusted for inflation) are around 40 per cent below long-run average prices. Grain inventory levels are low -- around two months of global demand. Problems affecting financing of crops and trade, low prices and difficulty of hedging (increased in margins and hedging costs) have meant that plantings have been low. Major seed producers report a sharp decline in sales. The increased problems of food production from climate change also mean the risk of supply disruption cannot be discounted. Historically, agricultural products have performed well in economic recessions.

Recently an acquaintance in financial markets announced his retirement to a life of rustic simplicity in Umbria, Italy. He had acquired a farm and was restoring it with the help of local "serfs" (his word, not mine). The farm would be self-sufficient, producing essentials of life -- wheat, milk, wine and meat. The plan was to avoid the coming financial Armageddon in financial markets and the money economy.

The newly minted farmer was especially excited by the farm's black pigs that reproduce three times each year. He referred to this as the "velocity" of the pig population. The porcine velocity is much greater than the current velocity of money in financial markets as the recession sets in and the implosion of the financial system becomes institutionalized.

Pigs and food may be well be where the smart money heads in these troubled times. Fundamental demand for food and energy may emerge as key investment drivers -- everybody needs to eat and we are still a fossil-fuel-driven society.

Satyajit Das is a risk consultant and author of a number of key reference works on derivatives and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall). He is also a consultant to Jory Capital of Winnipeg.

Republished from the Winnipeg Free Press print edition March 21, 2009 B11