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Investor exit behind fall in commodity prices

Date Released: Mon, 24 November 2014 09:13 +0200

THE rapid fall in the oil price to below $80 a barrel will provide welcome relief to cash-strapped South Africans.

Lower oil prices mean cheaper petrol, leaving motorists with a bit more to spend on other goods and services. Lower transport costs should reduce upward pressures on prices. This will lessen the need for the Reserve Bank to raise interest rates, making life a little easier for debt-strapped households and businesses.

The fall in the oil price was caused by rising supply, mainly from shale gas producers in the US, which was only recently overtaken by China as the world’s largest importer of crude oil. Now it is predicted that the US will soon become self-sufficient in energy production. It recently started exporting oil to Korea — its first oil exports in about 40 years.

Higher prices over the past decade inevitably led to more efficient usage of oil — for example, through smaller and more fuel-efficient car engines. Economic growth in China and, therefore, more demand for oil has slowed. In absolute terms, the annual growth in economic activity in China remains immense because its economy has more than doubled in size over the past decade. Nonetheless, global demand for oil is now growing more slowly than was expected.

In competitive markets, the combination of rising supply and slower growth in demand inevitably leads to lower prices. But oil is not a fully competitive market. Producers created the Organisation of Petroleum Exporting Countries cartel to protect higher prices by controlling supply. But producers sometimes break ranks. Thus, the sudden fall in prices from more than $100 a barrel in August to just more than $75 today was triggered by Saudi Arabia, the world’s largest oil producer, accepting lower prices rather than cutting its production to support the higher price.

Saudi Arabia’s decision may be motivated by a desire to maximise its own export revenues. But it is probably hoping that lower prices will disrupt future expansion of non-conventional oil production such as shale gas. Higher production costs for these producers make them reliant on high oil prices for their continued profitability. Already, new projects have been put on hold because of the fall in the oil price.

Lower oil prices have been accompanied by falls in the prices of a wide range of global commodities. The sharp fall in the price of iron ore can be explained, like that of oil, by big supply increases and now slowing growth in demand from China, the world’s largest importer of the metal. But why has the price of platinum, of which supply was dramatically curtailed until recently by the strike in SA, also fallen? Why have the prices of products as diverse as gold and wheat also fallen? One possible explanation lies in the mass exit from commodities by investors.

When commodity prices started to rise after 2003, pension funds were persuaded that commodities should in future be treated as a separate asset class. It was argued that rather than just buying shares in mining or oil companies, pension funds should invest directly in commodities themselves. This would give them direct exposure to China’s extraordinary growth which, it was claimed, would provide good returns from an asset class delinked from fluctuations in the share and bond markets.

The size of global pension funds dwarfs that of global commodity markets, so the shift of only a small proportion of their funds into commodities was very significant relative to the size of commodity markets. According to Barclays Bank, commodity investments rose from less than $50bn in 2004 to more than $400bn in 2012.

Importantly, these commodity funds often invested in baskets of commodities rather than a single commodity. The baskets included products as diverse as oil and wheat. Thus, the growth in demand for commodities as an investment contributed to rising prices across the board for commodities traded on global exchanges. Commodity funds make money for their investors only if prices rise. This has not been happening for some time. As a result, investors have now become net sellers of commodities.

Sales accelerated recently when the oil price fell, pushing prices of other commodities down at the same time. According to Barclays, commodity investments have fallen from their 2012 peak of $280bn. It notes that net sales of commodity index holdings of baskets of commodities have risen to $17bn so far this year, already much more than double last year’s sales of $7bn. As a result, lower oil prices have been accompanied by declines in the global prices of many of the commodities SA produces, including gold, platinum, iron ore, coal and some agricultural products.

If sustained, these declines will reduce the revenue of our most important exporters. This will put additional pressure on miners of gold and platinum in particular because many of them were already making losses at higher prices. If lower prices are sustained, this will inevitably lead to job losses, lower production and reduced exports, offsetting much of the benefits of lower oil prices.

Article by : Gavin Keeton.

Article source : Business Day.

Source:Business Day.