The recent drops in commodity prices worry African producers, but the downturn is not the end of the supercycle, just the end of its first phase

Global commodity prices had a wild ride in 2008. Just six months ago it seemed the entire investment world was piling into commodities. Now, it cannot dump them fast enough. 
Almost across the board, commodities hit record prices in 2008; since then, commodities have seen their biggest plunge in almost five decades. Maize fell 14% last year, soyabeans lost 22% and wheat tumbled 33%. At the same time, crude oil plunged 60%, registering a record annual drop amid the deepest economic slump since World War II. The price of copper – a barometer of global industry – fell by 56% in 2008, its biggest drop in 21 years. 


The size and speed of the falls in commodity prices has now called into question the entire idea of the ‘commodities supercycle’. But the outlook for commodities is actually a lot brighter than the headline figures suggest. In fact, the prices of some key commodities could be set for a strong rebound this year as the fundamentals begin to reassert themselves. 


Rapid economic growth in the Asia-Pacific region fuelled real growth in demand for energy, building materials and agricultural commodities. The more industrialised developing countries now use twice the amount of metal per unit of GDP than the more service-based developed countries. That ratio is even higher in China, at four times the average of developed countries. 


The outlook for global commodity prices is closely tied to the economic performance of developing countries. Together, China, India and Russia now account for over half of global economic growth. But China could reach this figure on its own in 2009, having overtaken the US as the biggest contributor to global economic growth in 2008.


Recent news from Asia has not been good however. In China, industrial production grew by a lower-than-predicted 5.4% in November, while it fell by 8.4% in Russia. In October, India’s industrial output fell for the first time in 15 years. Weak figures like those have fuelled fears of a collapse in demand for commodities, but these headline figures overstate the risk to demand. The biggest part of emerging economies’ commodity imports are used to feed domestic demand. 


Just look at China. It consumes almost a quarter of global copper output. Half of that is used in its power industry. Only about 20% of China’s copper imports are used to manufacture goods for export. The same is true of most of the Asian industrial economies, so the global slowdown will only have a limited impact on Asian demand. 


Renewed demand for commodities will also be driven by economic stimulus programmes in the big economies. In the US, President Barack Obama plans to spend at least $850bn on the biggest infrastructure-development programme since the 1950s. In China, the government will spend $586bn to keep the economy growing. Japan has announced two stimulus packages totalling $684bn, and the EU will spend $278bn. These are staggering sums of money. 


The additional spending will not be enough to avoid a global recession, but as its impact takes effect in the second half of 2009, it should give a sharp boost to demand for energy and metals. 


Overall global GDP growth is predicted to slow to 0.9% in 2009, with developing economies expanding by 4.5%. The IMF forecasts that emerging economies will continue to grow by more than 6% per year until 2013, and with it will come a recovery in demand.


Right now, though, commodity prices are overreacting to a short-term slowdown in demand. Rising prices after 2003 led to a massive surge in speculative investment. The value of assets invested in commodities soared from just $13bn at the end of 2003 to $270bn by the middle of 2008. That is an increase of almost 2,000% in less than five years. The resulting commodity price bubble burst in July as the flow of speculative capital went into reverse.


Desperate investors, desperate measures


The pin that burst the bubble was the collapse of the US subprime mortgage market. The fall out from this has saddled financial companies with almost $1trn in losses and write-downs, and wiped off more than $30trn in value from global stock markets in 2008. As markets fall, desperate investors facing massive losses have been forced to raise cash by selling anything they can, including commodities. 


The recent sell-off has been brutal, but is not the result of a collapse in demand. The fundamental supply-and-demand dynamics for many commodities has hardly changed since the middle of 2008 when they were trading at record prices. It is important to differentiate between the real demand in growth from the emerging markets that underpins the commodities supercycle and the short-term speculative spike that occurred in 2008. 


Another factor that cannot be overlooked is the strength of the US dollar, the currency most commodities are traded in. As the value of the US currency declined from the beginning of the decade, commodity prices rose to compensate. This was a major factor in driving up their prices, and this was especially the case with oil. 


As the global financial crisis has intensified, though, investors have been turning to the greenback as a safe haven. The US dollar has risen 15% in the months since July, exaggerating the apparent fall in commodity prices. 


The dollar’s rally is not sustainable. The US Federal Reserve has already extended some $8.5trn in credit to prop up America’s financial system. Now President Obama’s proposed economic stimulus plan will add a further $850bn in new spending to that. America’s attempt to spend its way out of recession by printing money is going to have a disastrous effect on the value of the currency. So investors are increasingly valuing the dollar on its fundamentals rather than as a safe-haven currency. That practically guarantees that prices of dollar-denominated commodities will rise as the currency weakens.


While demand for commodities should continue to hold up, there are going to be short-term disruptions to supply. By the end of 2008, OPEC had already announced 4.5m barrels of production cuts since September in order to revive the oil price, and the International Energy Agency (IEA) forecasts that oil will average $85 per barrel in 2009. 


As the oil price rebounds, demand for cheaper biofuels will soar. It becomes efficient to produce ethanol from maize when oil is above $50 per barrel. Biofuels from sugar are justifiable at an oil price above $39. The higher the oil price, the more sense it makes to produce biofuels. 


Increased production of biofuel crops will mean a diversion of resources away from other food crops. The IEA suggests that 40% of global grain production could go to biofuels by 2030. Africa has the potential to supply a very considerable part of the global demand, and some countries, such as Malawi, are already going down that route. Maize and sugar are currently the two biggest sources of biofuels. Sugar is more economical, and although extremely labour-intensive, this plays to Africa’s strength, as does the climate. 


Supercycle cycles on


Surging demand for biofuels has the potential to change permanently the market for agricultural commodities. Markets are already predicting a rebound in some farm produce prices this year. Based on December 2009 Chicago futures contracts, wheat will jump 13% and maize by 12%.


At the same time, lower prices and tighter financing have led many mining companies to suspend operations and scale back planned expansion. That could soon bring us back to the situation faced in 2003, when years of under-investment in the mining and energy sectors led to bottlenecks as global economic growth rebounded after the recession of 2001.


The commodities supercycle that began in 2003 is not over. In fact, it will probably run on until the middle of the coming decade. The critical point is that a supercycle is made up of smaller cycles. They have their peaks and troughs. What we are seeing now is the end of the first phase of this supercycle. 


Commodity prices may remain volatile over the near term, but renewed demand from Asia as the economic stimulus plans kick in, the weaker US dollar and production cuts in mining and energy look set to spark a rebound in commodity prices in the second half of 2009.