Oil prices may have further downside, in the short run, reflecting continued reduction in demand as growth slows. Production cuts by OPEC may not be effective as revenue strapped sovereign producers adjust volumes to generate cash flow. Ultimately, the laws of supply and demand, production costs and a finite, constrained resource will support the price.
The outlook for alternative energies is less sanguine. Most alternatives require high oil prices to be economic. Support for alternative cleaner energy is likely to wane as the GFC forces governments to defer climate change initiatives in the face of harsh economic conditions.
The dislocation in financial markets has benefited gold. The gold price has performed well reflecting increasing suspicion about "paper" money and lower interest rates. Governments continue to attempt to re-inflate domestic economies by traditional Keynesian spending, increasing concern about possible inflation providing support for gold. There is a fear of a return to a gold standard leading to hoarding of gold stocks. Emerging market demand for gold, a traditional store of purchasing power, may be fueled by the threat of increased social unrest.
Other precious metals, like platinum, palladium and silver, are likely to be affected by decreased demand, especially due to problems in the automobile sector globally.
Industrial metals (aluminum, copper, lead, nickel, zinc and tin) and bulk commodities (iron ore and coking coal) have been a major proxy for global economic growth, particularly demand from a rapidly industrializing and urbanizing China and India. Slower growth and problems related to inventories and oversupply may mean a continuation of weakness.
The performance of agricultural prices is puzzling. After falling in line with commodities generally throughout 2008, in December agricultural products decoupled from other assets. For example, some grains rose sharply in prices by 10% to 20%.
Prices (adjusted for inflation) are around 40% below long run average prices. Grain inventory levels are low - around 2 months of global demand. Problems affecting financing of crops and trade, low prices and difficulty of hedging (increased in margins and hedging costs) have meant that plantings have been low. Major seed producers report a sharp decline in sales. The increased problems of food production from climate change also means the risk of supply disruption cannot be discounted.
Historically, agricultural products have performed well in economic recessions. Tightening supply, risk of supply shocks and the appeal of a recession resistance asset may underpin prices in relative terms.
Agricultural products that have been linked to oil prices (such as corn, palm oil, soybeans and rapeseed) will be dependent on the broader performance of energy prices.
The current realignment affects financial investments in commodities. The case for commodities as a separate investment asset class has been undermined. Commodities have proved to be highly correlated to other financial assets. The volatility of commodity prices, traditionally high, has proved to be extreme.
One significant change has been the shift in the relationship between spot (immediate) commodity prices and forward (or future) prices. Historically, prices for some commodities, especially non-financial commodities like gold, have exhibited "backwardation"; that is, forward prices have traded below spot prices. This allowed investors to earn the "roll"; that is, they bought forward and then sold the commodity to accrue "the convenience yield" as the contract shortened in maturity. This income, first explained by Keynes, has been a significant source of gain for financial investors.
As commodity prices fall as a result of reduced demand, the backwardation changes into contango; that is, forward prices are above spot prices. The contango reflects the cost of holding the physical commodity adjusted for holding costs (storage, insurance, interest rates, etc). Weak demand exacerbates the contango as excess supply goes into storage. Financial investors cannot benefit from the convenience yield, thereby reducing one of the sources of return. The long-term effect of these dislocations on financial investment in commodity markets is unknown.
During commodity booms, excesses abound. Oil-rich countries enjoying rapid growth in commodity revenues embarked on grand and expensive projects. For example, in this cycle, Dubai undertook an ambitious expansion program based on real estate, luxury hotels, airlines, financial services and English premier league soccer clubs.
Grandiose plans tend to be launched towards the end of the boom cycle. Food may well be where the smart money heads in these troubled times.
Fundamental demand for food and energy may emerge as key investment drivers - everybody needs to eat, and we're still a fossil-fuel-driven society.
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