While oil’s precipitous price drop has garnered most of the headlines, the rest of the commodities complex has also been under selling pressure. The DBAs – the US traded ETF that tracks agricultural commodities – are nearing the 0% gain level for the last year. And the DBBs – which track industrial commodities – have lost 10% over the same time period. However, the obvious loser is the energy tracking ETF the DBEs, which are down nearly 45%. All of this is shown in the following chart:
This drop in prices has led some to argue the world economy is in fact weaker than anticipated. To bolster this argument, they have cited the recent World Bank downgrade to their world economic growth projections, which were lowered from 3.4% to 3%:
After growing by an estimated 2.6 percent in 2014, the global economy is projected to expand by 3 percent this year, 3.3 percent in 2016 and 3.2 percent in 2017 , predicts the Bank’s twice-yearly flagship. Developing countries grew by 4.4 percent in 2014 and are expected to edge up to 4.8 percent in 2015, strengthening to 5.3 and 5.4 percent in 2016 and 2017, respectively.
There is clearly some truth to this side of the argument, as several regions are clearly experiencing economic problems. Consider the following
- The EU continues to be mired in an overall economic malaise,
- Russia is facing a large potential drop in overall GDP,
- Japan may be returning to 1990s style deflation.
- Australia has underlying weakness due to its over-reliance on raw material exports to China
- Canada’s exposure to oil may start shaving a small amount off GDP growth
But there are also technical reasons for the various commodity market sell-offs. Saudi Arabia is clearly trying to drive out some of the more marginal US fracking companies in an attempt to regain control of the market. And Chinese hedge funds strategic selling of copper is at least partially behind the recent sell-off. In other words, supply and demand reasons underly the commodity market sell-off.
A Weaker International Economic Environment
The EU: for the last year, EU economic growth has been barely positive, nowhere near high enough to make a dent in its 11.5% unemployment rate. Industrial production is still far below its pre-recession levels and now with oil’s sharp price drop, inflation dropped .2% YOY in its latest printing. And despite record low interest rates and an ECB pledge to do “whatever it takes” to defend the euro, nothing has really changed for the regionl; its’ still near 0% GDP growth.
Russia: Russia derives are least 50% of its exports and government revenue from oil, meaning oil’s drop severely hurt the economy. The Russian central bank increased interest rates to 17% in an attempt to defend the ruble, but all this did was create a perception the bank was panicking. To make matters worse, the sanctions resulting from Russia’s invasion of Ukraine mean Russian companies don’t have access to western financial resources for refinancing. As a result of these two events, the ruble has dropped sharply, spiking inflation. Russia most assuredly faces a recession over the next few quarters.
Japan: Despite Prime Minister Abe’s best efforts, the Japanese economy is in trouble. Although the BOJ successfully increased the monetary base to drive up inflation, the YOY rate of CPI increase is starting to decrease. The sales tax hike last spring sent the economy into a technical recession (two consecutive quarters of contraction). And, his program of structural reforms has been harder to implement than anticipated. Overall, the Japanese economy is not out of the deflationary woods.
Australia: the unemployment rate has been ticking up for the last several years, rising from 5.6% at the beginning of 2013 to its current level of 6.1%. The most recent AIG business surveys of the services, manufacturing and construction sectors all showed fairly widespread weakness. But most of all, the economy is trying to pivot from one centered around raw material exports to China to one with a more varied basis for growth. However, this transition is extremely slow and hasn’t really been made yet.
Canada: Canada is more like Australia in that they are a developed economy that is more centered on raw material exports. A recent speech by a Canadian central banker highlighted the problems low oil prices create for Canada:
However, these gains will be more than reversed over time as lower incomes in the oil patch and along the supply chain spill over to the rest of the economy. The decline in Canada’s terms of trade will also reduce the country’s wealth.
The lower prices, if they are expected to persist, will significantly discourage investment and exploration in the oil sector. As I mentioned earlier, we are already seeing signs of this.
Lower oil prices are also typically accompanied by a weaker Canadian dollar, and this time is no exception. The dollar’s depreciation by over 10 per cent against the U.S. dollar in the past six months will help cushion the economy from the impact of lower oil prices.
Despite the mitigating factors I enumerated, lower oil prices are likely, on the whole, to be bad for Canada. Estimating the magnitude of that overall impact requires carefully analyzing the interplay between the various effects as they work through the economy. That is what we are doing as we prepare next week’s forecast.
The conclusion to draw from the above referenced notes is that large portions of the developed world (Australia, Canada the EU) are at minimum experiencing economic headwinds and others (Japan and Russia) are looking at potentially harsher economic realities. Traders have begun to include the potential for an economic slowdown in a number of regions in their economic calculations and are reacting accordingly.
The Commodities Environment
James Hamilton is my go-to oil analyst, and he has not disappointed. Over the course of several posts at his Econbrowser blog, he has noted a combination of factors behind oil’s price drop. He first references IEA information by noting the EU and Japanese slowdown are clearly effecting oil prices, as the demand curve for oil has lowered in the agencies most recent projection. But he also highlights the importance of US oil production, as it has clearly and meaningfully increased oil supplies. The importance of the shale oil industry is also spotlighted in this article on the website Enterprising Investor.
It is not overshooting. Oil prices have been rising on the back of a pro-cyclical cost curve. That is, service costs and development costs tend to rise as oil prices go up and investments increase well above the market’s needs. The industry has gone from underspending in the late 1990s to overspending – close to $1 trillion a year – on the back of an elusive growth of demand that has been proven incorrect. Efficiency and a less industrial model have proven that the correlation between real GDP growth and energy demand is broken. We do more with less, and the unit of energy needed to create a unit of GDP is lower today than 30 years ago. Now we find that many of those investments made in the 2004-2013 period have created overcapacity in the system.
Saudi Arabia is defending its market share and proving it is low cost. But more importantly, OPEC knows that cutting would be damaging for them and ineffective. The world has about 2.5 million barrels per day of excess supply. Would OPEC cut almost 10% of its production to keep prices higher and support the rise of non-OPEC production, which is growing around 3% per annum? This makes no sense. A cut would only extend the overcapacity and just erode OPEC’s market share.
The above analysis indicates that while demand has dropped, supply is the real problem.
As for the copper market, there are several factors at play, starting with Chinese hedge funds shorting the market:
Chinese hedge funds, once again linked to a powerful sell-off in copper this week, were probably replaying an aggressive short-selling strategy they have also used to target iron ore and coal, according to industry sources.
This indicates the growing clout of the secretive Chinese funds in global commodity markets as they tap their home-ground advantage in the world’s biggest consumer of copper and other commodities.
And, like the oil market, there is a problem with supply, as in there’s too much.
Dr. Copper is widely perceived to be the base metal with a PhD in economics. Many investors view the price of copper as one of the best indicators of global economic activity. Its recent drop is raising fears that maybe the plunge in oil prices is attributable not just to too much supply but also to not enough demand.
That’s possible. But there may also be too much supply of copper, rather than a sudden dearth of demand for the metal. An article on commodity gluts in the 1/11 WSJ observed: “Take copper. The worst performer among base metals last year, it has shed 14% of its value on the back more than four straight years of oversupply. Yet, new mines, including the Sierra Gorda mine in Chile that was inaugurated in October, continue adding to the glut. The Constancia mine, set to begin operations in Peru next year, looks to add even more.”
And finally, consider the level of Australian mining investment over the last 10 years, which clearly add to global copper supply:
Demand is clearly contributing to the commodity sell-off. After all, economies growing below potential obviously demand less of everything. And with several regions experiencing economic problems (Russia, the EU and Japan), overall demand will be lower. But there is also over-supply. Shale oil exploded, adding to supply while also challenging the Saudi dominance of the oil market. They responded as a classic oligopoly: crash the price to push out competition. And copper is also over-supplied. Producers invested heavily, betting on continued Chinese demand. But as China has lowered their GDP growth projections, they are simply demanding a lower amount of raw materials. The summation is that we’re looking at a demand and supply issue.
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