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p. 30 of 36 BACK | NEXT Foreword 1. Developing Asia and the world II. Economic trends and prospects in developing Asia III. Developing Asia's imprint on global commodity markets Introduction Commodity price drivers Commodity prices: Short and long views Developing Asia’s imprint on global commodity markets The outlook for commodity demand, trade, and prices to 2015 Conclusions Appendix Statistical notes and tables ADO forecasting performance for GDP growth and inflation

Asian Development Outlook 2006 Update : III. Developing Asia's imprint on global commodity markets

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Commodity prices: Short and long views

Various factors seem to lie behind the recent escalation in commodity prices. These are best considered in a longer context and by main commodity class: energy and nonenergy, the latter including food and beverages, agricultural raw materials, and metals.

Energy commodities

Figure 3.6 shows the trajectory of the real price of the energy basket, along with a similarly deflated benchmark Brent crude price from 1983 through July 2006. Since 2001, real energy prices have more than doubled. Prices are also high measured over a much longer period. Real gains have been most pronounced for energy among all commodity classes. Since energy is also an intermediate input into the production of many other primary commodities, its price movements reverberate through other markets. Crude oil prices, which are primarily responsible for energy price movements, have risen steadily higher, leading to a strong run-up well into the first half of 2006. As can be seen from the graph, crude oil prices and the energy price index move almost in lockstep.

The world demand for oil is dominated by the industrial countries, with the G7 accounting for roughly half of total demand over the last two decades. However, growth in oil demand has generally been much faster in the developing world—growing by 79.2% over 1990–2005 (excluding former Soviet Union countries). This compares with just 12.5% growth for the G7. Developing Asia alone has accounted for nearly 60% of the growth in world demand for oil. Figure 3.7 shows the rising importance of developing Asia for oil demand since 1990.

The special chapter on the challenge of higher oil prices in Asian Development Outlook 2005 Update examined the global factors in the recent surge in oil prices. These included strong demand growth (associated with the strength of global economic recovery and expansion since 2002), tight supply conditions (related to limited spare capacity and binding infrastructure constraints), and a significant risk premium (based on geopolitical uncertainties). Little has changed in the last 12 months. Low levels of spare capacity continue to put upward pressure on global oil prices (Figure 3.8). Declining output at maturing oil fields is an important factor and significant delays are likely before new fields open up.

There are indications that significant uncertainties surrounding supply/demand conditions may continue. Oil futures market volatility reflects heightened uncertainty over supply. In particular, the movements of futures prices have closely mirrored fluctuations of spot prices—these tend to be more sensitive to “news”—suggesting a lack of clarity about longer-term direction. Over the course of 2006, oil futures prices have tracked up for all time horizons, suggesting that the market thinks unlikely a meaningful improvement in the oil supply and demand balance in the near-term future (Figure 3.9). Moreover, oil futures prices are again in “contango” (distant futures prices exceed spot prices), encouraging a continuing buildup in inventories, which itself is usually a tell-tale sign of jittery market sentiment (Box 3.3). Indeed, average commercial stock holdings in Organisation for Economic Co-operation and Development countries have increased since 2004, despite rising prices (Figure 3.10).

Nonenergy commodities

3.4 Energy and the cost structure of primary commodity production Higher energy prices generally translate into higher nonenergy commodity prices, since typically, the production of basic commodities and semifinished manufactures (e.g., fertilizers) is highly dependent on oil and energy products. Box table 1 reports different degrees of energy intensity for various industries as reported by the Canadian Offi ce of Energy Effi ciency. As these estimates are indicative and sensitive to technological factors and relative prices, they cannot be replicated with any degree of certainty for other countries. Metallurgy and smelting are highly energy intensive, suggesting that high oil prices are likely to have a pronounced effect on their costs of production, and hence price. Paper and pulp, cement, and fertilizer industries also rank high in terms of their energy intensity. Fertilizer costs are most likely to influence the prices of agricultural food commodities. High oil prices also have indirect effects on nonenergy commodity demand and prices. For instance, some agricultural commodities are used to produce energy substitutes, such as sugar and soya beans for the production of ethanol and other bio-fuel. Demand for natural rubber also rises as energy prices increase, given the relatively high energy intensity of synthetic alternatives. A more formal way of investigating the relationship between oil and non-oil commodity prices is to test whether changes in oil prices “cause” changes in non-oil commodity prices. This can be done by examining whether lagged values of the nominal oil price have a statistically significant (and positive) impact on subsequent (nominal) prices for non-oil commodities. Tests were conducted using monthly data with lags up to 12 months, spanning the period from January 1983 to July 2006. The results strongly suggest that movements in nominal oil prices precede movements in nominal nonenergy commodity prices (and in the same direction), but not the other way around. The results are statistically significant, with greatest significance for energy prices lagged by 1 month (see Box table 2). Even when this test is conducted with real rather than nominal prices, the result is robust. This suggests that energy prices influence other commodity prices to a greater extent than they do the manufactured goods price basket.

Nonenergy commodities have seen the price rally that began around 2001 stretch into May 2006, largely on strong base metal prices (Figure 3.11). Although prices are high compared both with 2001 and with their 1995 base (= 100), they are at about the same levels seen at the beginning of the 1980s. Despite some similarities in price movements across groups, individual commodities are frequently subject to idiosyncratic influences, both short term and structural (the supply of agricultural commodities, for example, is influenced by the weather). One common factor though, is the influence of energy prices, as many nonenergy commodities are energy intensive in their production (Box 3.4).

Food and beverages. Real prices of food and beverages have been trending down for a century or more, owing to increased agricultural productivity and low income elasticities of demand for some foodstuffs. Trends for the last quarter century are shown in Figure 3.12 and show the drift down. Real prices of food and beverages declined rather sharply during the 1980s and remained depressed until 2001. Food prices, particularly those of vegetable oils and meals, as well as meat, have since picked up but remain well below the prices of the early and mid-1980s.

Relatively stable food prices in recent years reflect firm demand. For some food commodities, such as rice, soya beans, meat, and fruits and vegetables, Asian (particularly PRC) demand has been strong, largely reflecting rapidly changing dietary patterns and rising income levels (Figure 3.13). A surge in soya bean imports by the PRC bears witness to its growing consumption as feedstock for live animals. In the past few years, high crude oil prices have also lifted demand for soya beans and sugar to produce bio-fuel, as a partial substitute for transportation fuels.

Agricultural raw materials. After falling at the time of the Asian financial crisis, agricultural raw material prices subsequently recovered. Since then, they have changed little (Figure 3.11). But the aggregate index masks important changes in the prices of component commodities (Figure 3.14). Most notably, rubber (which had hitherto been on a long descent) and timber prices have climbed from 2001’s levels. Surging automobile production in the PRC has lifted rubber prices, and tire production in the PRC has increased at about 20% a year since the early 1990s (International Rubber Study Group 2004), making the PRC the world’s largest consumer of natural rubber in 2001. Rubber prices have also increased as demand has switched away from synthetic alternatives, whose prices have soared with oil’s. Timber prices have held up as a consequence of the construction boom in the PRC and growth of its domestic-furniture industry.

Base metals. Prices of base metals have made handsome gains since 2001, reflecting strong demand, low inventories, and high oil prices (Figure 3.15). Lifted by vigorous industrial growth in developing Asia, including the PRC—the PRC is currently the world’s biggest importer of iron and steel, and second-biggest importer of metal ores and nonferrous metals—the prices of iron ore, lead, copper, zinc, nickel, aluminum, and other widely used metals have surged in recent years.

In real terms, base metal prices grew at an annual average rate of 13.2% from 2001 to 2005. Nickel, copper, iron ore, and lead (in descending order) were the strongest movers. Zinc prices have increased sharply in 2006. These metals are generally used in steel production, a rapidly growing industry in both the PRC and India, as well as in electrical wires and cables, and building infrastructure. Comparing the first 6 months of 2006 to the first 6 months of 2001, copper prices more than tripled, whereas the prices of zinc, nickel, iron ore, and lead more than doubled.

The fate of different metal prices is also critically influenced by supply. For example, during the May 2006 market sell off, the price of nickel held its ground, due to low inventory levels. Copper and zinc rebounded fairly quickly, on the back of tight supply conditions. But aluminum and lead, with rising and strong inventory positions, have not seen a recovery in their prices.

More generally, base metal production has been constrained by generally tight mining and smelting capacity. A rather long period of depressed prices and capacity overhang through the 1990s led the mining industry to reduce excess capacity by means of mergers and restructuring. It also slashed investment in exploration and development of new mines. Even when metal demand started to rise after the Asian crisis, several major producers continued to reduce their inventory overhang rather than add new production capacity, a process that is now becoming more drawn out as regulations tighten, reflecting environmental concerns.

Summary

Since the beginning of 2001, primary commodity prices have surged in both nominal and real terms (measured relative to the prices of manufactured goods). During this boom, fast growth in developing Asia has played a significant role in propelling commodity demand. Although the region is still small compared with the United States or European Union in terms of overall economic mass, its brisk growth implies a disproportionate impact on the expansion of global demand for commodities and other goods. Developing Asia also punches above its weight in global commodity markets because the processes of rapid industrialization and urbanization, through which it is passing, place particularly heavy demands on energy and metals.

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