For most of us, commodity markets have little direct impact on our daily lives. How many of us, truth be told, take much notice of the price of a bag of rice at the supermarket? Or the price of cotton for that matter?
But this isn't always the case. Think back to the summer of 2008 and you may remember a public furore, stoked in the media, over rising food and fuel prices. The price of a barrel of oil rose to an historic high of $124, tightening the purse strings of car owners, while those making their weekly trip to the supermarket were unable to ignore sharp rises in the costs of staple goods such as eggs, bread and rice.
For the average British consumer the reaction was one of mild frustration; we grumbled about paying and extra 50p for a bag of flour, but probably went ahead and bought it anyway. In the developing world, however, where the cost of food represents a much higher proportion of peoples' income, the sudden rise in prices caused riots and starvation. As oil prices surged, businesses were left counting the cost. While the cost of a barrel of oil is now just over half what it was back then, many airlines and other fuel-intensive industries are still left with the evidence of 2008's price spike on their balance sheets.
This may be an extreme example but, if current trends are anything to go by, price spikes such as these are likely to become more and more frequent over the coming years.
In his book Hot Commodities, world renowned investor, Jim Rogers, claimed that the world economy was several years into a long-term bull market in commodities, meaning a sustained upward trend in prices. That was five years ago and, so far at least, Rogers has been proved right. Analysts may look to various reasons for this state of affairs: changes in climate, for example. But, in Rogers's opinion at least, there is one fundamental dynamic driving the rise in prices: a supply/demand imbalance. To put it simply, a growing global demand for goods has driven up the price.
It hasn't always been this way. In the late 1970s a prolonged period of weak global economic growth sapped demand for fuel and other industrial goods. Prices of commodities remained in a multi-year slump. The cost of a barrel of oil hovered above $25 a barrel long into the mid 1990s. With prices at such levels and showing no signs of movement, commodities became the forgotten asset class, shunned by investors who found themselves wooed by the exciting world of equity markets. As commodities fell out of fashion, new and exciting asset classes took their place in investment portfolios. In the late 1990s, telecommunications were all the range. Fund managers ploughed their client's cash into internet providers and on-line start ups, leading to what is now remembered as the dot-com crash.
The China Effect
It was around this time that Rogers and other farsighted investors turned their attention back to commodities. Their timing proved perfect. The global demand for raw materials started to show signs of growth. China was just starting to assert itself on the global stage.
Having been a predominantly rural economy up until the 1980s, the government, moving towards free-market principles, embarked on a period of industrialisation. Spurred by the country's model of cheap exports to the West, the manufacturing sector exploded, attracting country dwellers to the city in their millions. To accommodate these new city dwellers, new houses were needed as well as new roads, bridges and railways.
China had prided itself on being a largely self-efficient economy but the sheer force of demand from heavy industry forced the government to look abroad for materials and fuel. Global demand for metals, such as copper and aluminium, rose, so too did prices.
China's agricultural economy was also changing. As farmers downed their tools to look for work in the cities, crop yields were no longer able to sustain the country's rising population, now estimated at 1.4 billion and counting. Staples such as wheat rice and grains were, for the first time, procured in bulk from overseas markets.
Meanwhile, richer Chinese, now earning middle class salaries from sectors such as manufacturing and business, were no longer content to eat rice and vegetables, they wanted meat, driving up not only global demand for port and beef, but for the crops needed to feed a growing population of livestock. The price of soybeans and pulses on world markets started to rise. Sugar is a prime example. To use the appropriate economic terminology, sugar, in developing countries at least, is an income-elastic good. This means that, as people earn more, their demand for sugary foods such as cakes and sweets, products that were once considered luxury items, increases.
In the case of Western consumers, the opposite trend may apply. The wealthier we become, the more likely we are to be health conscious in what we eat, preferring organic and low fat foods such as sushi rather than junk food. In this instance, sugar can be said to be income-inelastic; the more we earn, the less of it we consume.
Some ten years on, China's thirst for commodities is showing no sign of slowing. If anything, it is getting stronger. 2009 proved a record year for Chinese imports. Having been a major exporter of coal as recently as 2001, for the first time China became a net importer. With a $565 billion fiscal stimulus plan providing cheap credit to heavy industry, demand for other industrial goods such as copper and iron ore also surged to record levels as importers took advantage of a rare period of low prices caused by a collapse in western demand.
While industrial activity in the West has been reduced to a trickle by the global economic downturn, China shows no signs of slowing down. According to figures from the world steel association, 49 per cent of the crude steel produced worldwide in 2009 was made by China, that's an awful lot of coal and iron ore heading for just one market.
Why has China's consumption remained so ravenous? Quite simply, it cannot afford to stop spending. The UN expects that 400 million Chinese farmers that will move into the cities within the next decade, all of whom will need somewhere to live and road and rail links with which to get there.
Growth has been helped by the fact that global commodity prices have fallen due to reduced demand in the West. As the rest of the world re-enters the market, it is possible that China will begin to scale back. With signs, in January, that the Chinese government is beginning to tighten the supply of credit made available to banks and businesses in order to prevent inflation, there could be a knock-on effect on the imports of metals and other industrial goods. However, this is unlikely to impact demand for agriculture and livestock.
Are commodities bad for the economy?
With so much fluctuation in commodity prices over the past decade, some economists have pointed the finger at commodity markets where price spikes have driven up levels of inflation worldwide. Central banks have been criticised for lowering interest rates, creating inflationary pressures, which drove up prices of all goods, leaving commodities in the crossfire. Much of the blame may in fact lie with the US Federal Reserve which, since the early noughties, has pursued an aggressive interest-rate cutting policy, which has seen the value of the dollar fall. This is significant because most commodities are traded in the greenback. A weaker dollar sent the price paid for goods higher, a cost which the whole world has to bear. Notice how, as the value of the dollar climbed in 2008 and 2009, when stock markets crashed and investors poured their money into the currency as a safety measure, the price of most commodities fell substantially.
There are also other factors to consider, however. Factors which affect the supply of goods in the short-term, can lead to temporary shortages which drive up the price on global markets. Take sugar. Poor harvests in two of the main areas of production, Brazil and India, have resulted in crop shortages which have driven up the prices on global exchanges to an all-time high.
There is also the impact of speculators. Investors, who seek to gain from swings in the market, gamble on when the price is set to rise and fall and buy or sell contracts accordingly. As more investors buy oil contracts, for example, the price rises. There is nothing wrong with this practise in theory but you might argue that speculators are in the lucky position of being able to trade contracts without ever having to use the goods themselves. It is the real consumer, the airlines and the car owners, who bear the brunt of high prices.
Further to run?
If Rogers's projection proves correct, the current commodity bull market still has several more years left in it. However, that is not to say there won't be bumps along the road. The most direct threat to commodity prices is a potential slowdown in Chinese demand, in particular for metals such as copper and iron ore, as well as coal. Indeed, over the past two weeks, commodity markets have been spooked by indications from the Chinese government that it will look to introduce measures to curb inflation and slow down the current rate of economic growth (the Chinese economy grew by 10.7 per cent in the final quarter of 2009). It will tighten the supply of money within the economy, possibly by raising interest rates and increasing the amount of capital that banks are required to hold and not lend out to businesses. With the heavy industry and construction sectors deprived of the cheap access to money that saw them spend so heavily on resources in 2009, demand for base metals and other industrial goods, such as crude oil, is likely to drop. Indeed, the price of metals and oil has started to fall, as have shares in major mining companies like Rio Tinto and oil majors such as Shell.
Will it be a temporary blip?
China and the other emerging markets, such as India, are not likely to stop growing anytime soon. As their economies and populations grow and lifestyles become ever more Westernised, the demand for goods can only go one way - up. The rate of growth may slow from time to time, as is expected for later this year, but the current super-cycle shows no signs of stopping.