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Special Topic:  Recent trends in commodity prices and their implications

World prices for a range of commodities, from corn to copper to cotton, have reached high levels in the past month.  This lift in prices extended to New Zealand’s export commodity basket, with the ANZ Commodity Price Index close to regaining its peak in May this year which exceeded the level it reached in mid-2008 before the global financial crisis (GFC).  This article looks at the main factors behind these price increases and their broad implications for the New Zealand economy.

General lift in commodity prices

Commodities can be divided into four broad groups: energy, metals, non-food agricultural and food or soft commodities.  In the past few months, prices for all four groups have moved up, although for different reasons in some cases.  Price movements for these four groups are illustrated in Figure 8, with oil representing energy.

Figure 8 - World commodity prices (in USD)
Figure 8 - World commodity prices (in  USD)   .
Source:  The Economist, DataStream

Oil prices rise on increased global demand

Oil prices are often taken as an indicator of economic prospects.  They recovered from their lows in early 2009 and have risen above $80 recently.  This recovery reflects the stronger than expected growth in the world economy, particularly in developing economies whose growth is energy-intensive.  Oil demand in China expanded 14% in the first half of 2010.  Developed economy demand has also been particularly strong this year.

Supply has expanded almost in step as a result of higher prices and previous investment, but not sufficiently to prevent some rundown in oil stocks, supporting further increases in price as indicated by oil futures pricing.  Although oil accounted for 5% of goods exports in the year to June 2010, New Zealand is still a net oil importer and so higher oil prices reduce the terms of trade.

Metal prices rebound with China’s stimulus

In recent years, metals prices have been the stand-out performers of the commodity markets.  Prices were already at a high level throughout 2006 - 2008.  This is illustrated in the Reserve Bank of Australia’s commodity price index, which is dominated by mineral resources (Figure 9).

Figure 9 - Australian commodity prices (in USD)
Figure 9 - Australian commodity prices  (in USD)   .
Source:  RBA

The resurgence in metal prices in the past two years has been led by the renewed demand from China as it implemented its fiscal stimulus directed at infrastructure projects.  The IMF[1] considers that metal prices will remain high for some time to come as the cycles are typically longer than for some other commodities given the lags from high prices to exploration, discovery and finally production.  The long- term outlook for demand is also positive with China and India expected to continue to invest heavily in infrastructure.

Grains prices driven by strong demand …

Prices for food commodities have not increased as much as some other commodities, but they did not fall as far following the GFC.  Price increases have been concentrated in crops and reflect supply factors as well as increases in demand, particularly from China.  Wheat prices peaked earlier in the year as drought hit Russian production and an export ban was imposed; floods in Pakistan and Canada also curtailed supply and drove prices up.  More recently, a downward revision of corn yields in the US, combined with ongoing high demand from China, took corn prices to their highest level in two years.  Low stock levels have limited markets’ capacity to absorb supply shocks from weather events.

… pushing dairy and meat prices higher

Grain prices are pushing up other agricultural prices through their use as stock feed, particularly in the US dairy and beef industries.  World dairy prices recovered strongly in September and consolidated in October at around US$3,500 for whole milk powder on Fonterra’s on-line auction.  Prices are likely to remain firm as expected increases in production for most exporting countries are offset by ongoing robust demand from China, India and the Middle East.  Fonterra reaffirmed its forecast payout of NZ$6.60/kg for the 2010/11 season, up 50c from last season.
Beef prices have also lifted in the US as a result of the higher feed costs, combined with low stock levels.  Production is likely to be limited in the coming year, giving a positive outlook for prices.  Declining availability of lamb has maintained international prices at high levels, especially in the UK.  The snowstorms in Southland in September will further reduce NZ supply and maintain upward pressure on prices but not sufficiently to compensate for stock losses.

Non-food agricultural prices also rising

Cotton prices have recently soared to US$1.30/pd, their highest ever recorded level.  Reduced production resulting from weather events and substitution to more profitable food crops, combined with rapidly growing demand from China and India (the world’s largest cotton consumers) and low stock levels, have led to the very high prices.  This is being reflected in prices for wool, with NZ crossbred prices up 50% since May on increased demand and reduced supply.

Forestry is also included in this category and world prices have increased rapidly with high demand from China for logs as part of its infrastructure investment; prices are also being supported by Russia’s 25% tax on log exports.  NZ forestry prices have eased from their peak in May this year, but are up 20% from a year ago.

Developing economies a common factor …

Although there are specific factors influencing prices for individual commodities, there are also common factors affecting commodity prices in general.  One recurrent theme in the discussion above was the increase in demand from developing economies, especially China.  The recovery in the world economy in the first half of 2010 is a major driver of the recent recovery in commodity prices, but the rapid rates of growth in emerging economies, their rising market share in the global economy, huge populations and large potential for growth make them a major force in commodity markets.

The generally higher world commodity prices in the past decade reflect the increasing importance of the emerging economies.  The outlook is positive for commodity prices as these economies continue to grow at a faster rate than the major developed economies and income levels rise.

.. and macro drivers are also relevant …

There are other macroeconomic factors common to all commodity markets which are also providing support for prices at present.  As most commodity prices are quoted in US dollars, the weakness of the greenback is a factor explaining some of the increases in nominal terms.  Price increases may not be as great in end-user terms, nor in the currencies of producers if they have appreciated against the US dollar, as the NZ dollar has.

One of the main factors in the weakness of the US dollar has been loose monetary policy, both the provision of liquidity at the time of the global financial crisis and the exceptionally low interest rates.  The anticipation of further quantitative easing (QE) in the US is also likely to be a factor in the recent increases in some commodity prices. The transmission mechanism can operate in a number of ways:  QE acts to lower interest rates thus making borrowing cheap and also encouraging investors to seek higher yields in other investment classes.  QE is also likely to lead to higher inflation and so investors may seek a hedge against that in commodities such as gold.

… compounded by extreme weather events

There is also a pattern of commodity markets being affected by extreme weather events.  Such events have an exaggerated effect when stocks are already low and demand is strong, as is the case for many commodities at present.  An extreme La Nina weather pattern is emerging which could affect New Zealand production levels in the current season; the 2008 drought in New Zealand was the result of La Nina conditions.  On the positive side, the Australian drought has broken, boosting agricultural production.

Higher prices are positive for New Zealand

Higher commodity prices are positive in net terms for the New Zealand economy as they lead to higher terms of trade which lift incomes for commodity exporters and the economy as a whole, leading to higher nominal GDP (Figure 10). 

The flow-through to the rest of the economy may be less in the current environment as farmers reduce debt rather than increase spending.  Higher commodity prices will also boost the surplus on merchandise trade, offsetting some of the deficit on investment income flows and reducing the deficit on the balance of payments.

Figure 10 - New Zealand commodity prices and terms of trade
Figure 10 - New Zealand commodity prices  and terms of trade   .
Source:  Statistics NZ, ANZ

Higher commodity prices are also likely to lead to a stronger NZ dollar, holding all else equal.  The stronger currency acts as a buffer smoothing out some of the variation in international prices.  However, it also acts as a brake on those export industries not enjoying high international prices, but it brings greater international purchasing power to all in the economy, including consumers, by making imports cheaper.

The higher world prices for minerals have led to a mining boom in Australia, New Zealand’s major trading partner.  A strongly performing Australian economy is beneficial for New Zealand in terms of goods and services exports.  Because Australia is enjoying a greater commodity boom than New Zealand at present, the NZ dollar remains relatively low against the Australian dollar, supporting exports to that market.
On the negative side, higher world prices for commodities are likely to result in higher inflation as the prices of those goods rise in New Zealand; dairy product prices have already reflected some of the international price increases and increases for other foodstuffs and products are likely.

Notes

  • [1]World Economic Outlook, October 2010, p.51-53.
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