What has recently happened to commodity prices is a key indicator of the strains in the world economy, and perhaps a forecaster of the dangers that lie ahead. Equity markets have been generally weak, while Swiss commodity giant Glencore has seen its share price drop by two thirds. What are we to make of the commodity price meltdown?

Throughout our industrial history, concern about commodities has usually focused on anxiety about shortages and high prices. In the 19th century, the great British economist William Jevons forecast industrial growth would grind to a halt because of a shortage of coal. In the early 1970s, the Club of Rome forecast a serious shortage of all essential commodities would cause their prices to surge, thereby inhibiting, perhaps even stopping, economic growth.

More recently, it was fashionable to argue that world economic growth would be halted by China gobbling up the limited supplies of a whole range of commodities. Meanwhile, the world was supposedly not far off “peak oil”, the point after which oil production would fall, resulting in sky-high prices and a drop-off in industrial production.

In each case, these doom-laden predictions have been undone by the fundamental power of the forces of supply and demand. When the prices of commodities rise, at first this does little to incentivise increased supply, since it takes an extended period of time to invest in and develop new mines or develop new oil fields, for example. But supply responds eventually. When increased production comes on stream, prices plunge, stimulating consumption and depressing the incentive for further investment. This sets up the conditions for a subsequent price rise, and so on.

Moreover, commodity production is open to technological progress. As knowledge increases, it becomes possible to drill for oil, and to extract it, from places that earlier would have seemed impossible. Furthermore, high prices provide the incentive for substitutes to be developed and for consumers to economise.

One of the big difficulties in interpreting what goes on in commodity markets is deciding whether a price movement is due to a shift of supply or demand. Quite often it is both, as now. The key influence on demand has been the slowdown in the Chinese economy. Chinese consumption of the key industrial metals has risen from 10pc of the world total in 2000 to 50pc by last year. With production increasing, commodity producers needed the Chinese appetite for commodities to go on increasing at rapid rates.

David Fuller's view

Here is a PDF of Roger Bootle’s article.

The key variable in commodity prices is almost always supply.  This is particularly true for agricultural commodities, where inclement weather or drought can seriously affect crop yields, as can disease or even insect infestations.  These factors can cause prices to soar, encouraging farmers to increase plantings in the next crop cycle, often leading to much lower prices if conditions are favourable.  Over the longer term, superior crop strains and improved farming techniques have exerted long-term downward pressure on agriculture commodity prices. 

Supply is usually the key variable for industrial commodities, and accelerated technological innovation in the last decade has increased both discovery and production more rapidly than ever before.  Low interest rates and a belief that China’s demand for metals would continue to increase exponentially have also contributed to overproduction.  Consequently, prices of industrial commodity prices have also been under considerable downward pressure this year. 

Where do we go from here?  Increased global GDP growth would help to lift commodity prices but supply will remain the key variable.  Moreover, a lead time of several years in developing new mining sites or even upgrading older mines ensures that no producer of industrial commodities wants to reduce output unless forced to by commercial realities.  Consequently, they hold on for as long as possible, hoping that other miners will have to reduce production.  The same is true for producers of oil and gas, as we have seen most dramatically over the last fifteen months. 

We may be close to at least a temporary inflection point if global stock markets continue to recover.  They may seem unrelated to commodity prices but stronger equities would help to reverse some of the bearish expectations for global GDP growth.  This would extend the short covering that we have begun to see in some depressed commodities and also the currencies of their producer countries.  The CRB Continuous Commodity Index has steadied and remains overextended relative to its declining MA.  Similarly, the Brazilian Real has plummeted against the US Dollar but now shows evidence of at least a technical rally towards its MA.

The commodity market slump has created economic problems in the main producer countries for these resources, and this has limited their spending and weakened global GDP growth.  However, the long-term benefits for countless individuals and also companies in developed countries which import commodities, while much more diffuse, will be a tailwind for economic growth.