Friday, November 14, 2008

Commodities boom ends as speculative bubbles evaporate

Vincent Lingga, The Jakarta Post, Jakarta

Indonesia benefited greatly from the boom in the prices of primary commodities since the middle of last year as palm oil, rubber, coffee and cocoa as well as coal, pushed up the Jakarta stock market index to its peak of over 2,800 in April, 2008, bolstering exports and generating greater purchasing power for millions of smallholders in Sumatra, Kalimantan and Sulawesi.

However, the boom cycle abruptly ended last August after the United States financial crisis turned into a crash, setting off a global credit crunch and driving the global economy into a recession-led economic downturn, bringing down the Indonesian (IDX) stock index at one point to below 1,100.

The prices of most commodities collapsed to as low as one third of their market quotations only three months before. Crude palm oil tumbled down from its peak of US$1,300/ton to below $400 last month, rubber from $0.33/kilogram to $0.15, coffee from $2.54/kg to $1.5 and cocoa from almost $3/kg to $1.8.

This development validated analysts' views that what had so far been dubbed as speculative bubbles did play a big part in the earlier sky-high prices of commodities.

Growing global demand probably was the reason for the gradual rise in palm oil prices from an average $470/ton in 2006 to $780 in 2007, but speculative bubbles fueled the rise up to the range of $1,000-1,300 between January and July this year.

The fundamentals of the supply and demand equation were also responsible for the gradual rise in crude oil prices from $20 a barrel to US$40 earlier in the 1990s, and even up to US$60 by mid-2005, but speculative sentiments helped fuel the steep increase to as high as $147/barrel last July before falling steeply to below $60 now.

Even such high-growth emerging economies as India and China with a combined population of more than 2.3 billion people could not have all of a sudden gobbled up enough palm oil, rubber, coal and other commodities to generate such steep price rises in the first half of this year.

The problem is that the price elasticity of both demand and supply is low for commodities like palm oil, cocoa, coffee and rubber. Put another way, neither the underlying supply nor the demand for such commodities could have changed so quickly.

Consumers will still drink one or two cups of coffee even if its price rises sharply, but will not suddenly take ten cups when its price falls. Likewise, people do not abruptly stop frying food even if the price of palm oil skyrockets.

As debt instruments suddenly became illiquid and risky, investors sought safety in commodities. That surge of cash created a new bubble which has recently burst.

Investors such as hedge funds and even such solid institutions as pension funds made speculative purchases as they diversified into alternative investments away from the uncertainties in the financial market.

The sub-prime mortgage crisis started raising its ugly head in the United States in early 2007.

Analysts observed the flood of money from investors into the commodity futures markets, thereby distorting spot markets for physical commodities.

However, speculation by investors to avoid the uncertainty within the financial market was not the only factor behind the one year boom-cycle.

The fundamentals of the supply-demand equation also played a part as the global economy enjoyed one of its high growth periods.

According to the International Monetary Fund, the world economy grew faster, expanding by an average 4.5 percent, 50 basis points higher than most analysts had forecast earlier.

As most analysts have often noted, global economic expansion had been driven mainly by major emerging economies, notably China and India, which grew at an annual average rate of nearly 10 percent for several consecutive years. Given their large populations, this development generated a dramatic rise in demand, particularly for natural commodities.

However, rising prosperity and the speculative bubble were not the only drivers of the commodities boom.

Government-induced distortions have also blunted price signals. In many emerging economies, including Indonesia, governments control the prices of important fuels such as gasoline and food staples.

Even though several countries have removed such price distortions, many others, notably major producers, kept prices fixed, thereby blocking the transmission of market reactions from higher prices to weaker demand.

To reduce carbon emissions, the U.S. government encouraged biofuel production by subsidizing these fuels. Consequently, the demand for biofuel feedstocks such as maize and vegetable oils exploded.

The World Bank estimated biofuel demand was the biggest single reason why food prices soared in the past two years.

Hence, all in all, demand shocks caused by speculative bubbles, higher-than-estimated economic growth and misguided government policies combined together to fuel the commodities boom in the first half of this year.

But now, the world economy is suddenly accelerating into a recession-led downturn and the financial market has crashed, leaving behind a liquidity crunch which has consequently removed the demand shocks caused by previous robust economic growth and speculative bubbles.

The strongest message of this roller-coaster market development is that only the fundamentals of supply and demand are able to generate sustainable price trends in primary commodities.

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